Dan's portfolio business plan

[earthtodan]

Hi all,
I decided to write up a portfolio business plan in order to apply some structure between my portfolio and my mind. Please offer your comments and suggestions. It is of course a work in progress, and probably will remain so for years.

Dan's Portfolio Business Plan

Goal

Build a recurring revenue stream that grows faster than inflation during retirement, and is large enough to provide financial independence with no other sources of income. Target a retirement age of 60.

Strategy

Aim for a double digit total return CAGR over roughly a 30 year timeframe, using primarily dividend growth stocks in a taxable brokerage account and a Roth IRA. Contribute a predetermined amount every month to the taxable account.

Dividends will be invested selectively and opportunistically, using commission-free trading from MerrillEdge. In the absence of value in the market, preference may be given to reinvesting in the company that paid the dividend, or it may be held as cash.

Upon retirement, gradually rebalance the portfolio from a total return strategy to an income oriented strategy. Aim to sell non-dividend paying stocks during years when I have little earned income, in order to minimize capital gains taxes.

Theory of Dividends As Part of a Total Return Strategy

Dividends are the portion of a company’s earnings left over after management has invested in normal business growth, and which shareholders can use more accretively than management by reinvesting in more shares. The mathematical action of dividend compounding is treated as a more certain means of return than price appreciation. However, total return can consist of any combination of price appreciation and yield.

Balance

Stocks are grouped into four profiles, defined by yield.

High Yield (> 5%) - Any high yielding stock regardless of projected growth
Balanced (2% - 5%) - Most blue chip dividend growth stocks should fall into this profile.
Growth (0%-2%) - This can include new dividend growers, maturing companies with accelerated dividend growth and payout ratios, and non-dividend paying companies with a track record of strong earnings growth.
Speculative (0%) - Companies with a good story but negative, non-existent or unreliable earnings to date

The balance of the portfolio by yield profile is tracked in the portfolio spreadsheet. There is no target balance except as determined by the target sizes of individual positions. However there is a maximum allocation for each category at any time.

High Yield: 30% max
Balanced: 75% max
Growth: 50% max
Speculative: 15% max

Individual Target Allocations

Individual stocks are assigned a level of conviction on a scale of 1-5. The percentage allocation of each conviction point is 100 divided by the sum total of all conviction points. The portfolio spreadsheet determines each position target in dollars.

Conviction ( C ) is determined by the formula C = [1.5Y + y + H/25 + h + .9G + c - (D - 1) + .5(d - 1)] / 5

Where:
Y = Portion of the yield that is within the target payout ratio, or under 60% payout ratio, whichever is lower
y = Implied yield capacity, or the amount that could be added to the current yield to get to a targeted payout ratio. This number can also be negative.
H = History of consecutive dividend increases, in years (in local currency)
h = 1 if the company has raised the dividend for 10 consecutive years
G = 5-year forward EPS growth estimate as shown on Finviz.com, weighted toward management guidance if it is different
c = Personal conviction adjustment based on my macro view (0-3)
D = Debt/equity ratio, rounded to the nearest 1
d = Current ratio, rounded to the nearest 1

The result is rounded to the nearest 1, with a limit of 5. A position must score at least 2 to be included in the portfolio. I reserve the right to adjust the final score due to factors not included in the formula.

A stock's total return projection (Y + G) must equal at least 12, unless justified by adjustments such as y, H or c.

The portfolio should not exceed 35 stocks.

Rebalancing

A position outgrowing its target allocation due to price appreciation alone will not merit rebalancing, unless it becomes seriously overvalued or the bull thesis changes. Winners will be allowed to keep winning.

I may opportunistically buy a larger position than my target allocation if the stock becomes undervalued. Growth of an opportunistically large purchase is an acceptable reason to trim it back to the target allocation, although it will not be required.

Treatment of Dividend Freezes and Cuts

An unexpected dividend freeze or cut will require that I give the company an honest reanalysis. It will not trigger an immediate sell requirement, especially if there is a sudden price drop. The reanalysis will not have a deadline, and may include waiting to see what the company does with the dividend in future quarters.

Roth IRA

Transfer the maximum allowed contribution to the Roth from the taxable account in cash at the beginning of each year.

REITs should be exclusively held in the Roth for tax purposes. High yield stocks should be preferentially allocated to the Roth in order to minimize the tax burden, after the REIT positions are full. Balanced stocks can be held in the Roth if there is room left over after the REITs and high yield positions are fully allocated, and so forth.

Foreign securities whose dividends are taxed at the source cannot be held in the Roth unless there is a tax withholding treaty.

Options Strategies

Write ATM puts to generate cash, with the strike secured on margin, since MerrillEdge does not charge interest for margin-secured puts. Attempt to write puts with a 1 year duration, and ladder the expirations so that they are not all vulnerable to a single market event. Give preference to defensive companies with share buyback programs, and aim for a 10% premium. Put liabilities are not considered the equivalent of stock ownership, but should only be written on stocks I am willing to own.

Long calls can be used as a speculative strategy for high conviction stocks with binary catalysts and low market correlation.

Exclusions

MLPs, BDCs, ETFs, metals, commodities, futures, and forex are excluded. Companies that I find morally objectionable are excluded. Anything that carries a maintenance fee is excluded. Shorting is excluded. Direct real estate ownership, while a future possibility, is not currently considered as part of the business plan.

[ChadR]

Looks good. I understand not wanting companies that are morally objectionable in your business plan, but why not MLPs or ETFs?

[earthtodan]

Hi Chad,
ETFs don't pass the maintenance fee test. I do take a passing interest in them as a source of ideas for individual stocks. For example, I got interested in lithium, so I looked at the LIT ETF, analyzed some of the holdings and picked out ROC for my portfolio.

I have nothing against MLPs, I just don't feel like climbing the tax learning curve. I feel like that sector is covered with KMI so there's no pressing need.

[Kerim]

That's great, Dan -- thanks very much for sharing. You've clearly put a lot of thought into it.

I'd love to understand your conviction formula better, and how it is translated into allocations. So if you had 30 stocks, with a total of 75 conviction points, then each point is worth 1.33 percent allocation. And a stock with a conviction score of 4 would get a 5.33 percent (roughly) allocation?

And in the "C" formula itself, I have questions about Y and y. I think that the number of companies that have explicit payout ratio targets is relatively small -- so do you assign these yourself, and based on what criteria? And what do you mean exactly by "portion of the yield that is within the target payout ratio"? If the target is a payout ratio of 60 percent, and the actual payout ratio is 50 percent, then does Y get a value of 1.00?

Thanks!

[Dividend Watcher]

I read this a few times and had to ponder over it.

Regardless, I think it was an awesome effort, Dan. Now you have something solid to refer back to and refine. I found my plan made me think more with each transaction and how it affected my goals.

Have you tried your formula on a test portfolio of 20-30 stocks? Were the results as expected? I like that you're using a rating system. I've been mulling that over for a while since, at these levels, you have to be more selective. Just haven't come up with something definitive that I like yet.

My one concern or question is about the 'c' (your conviction) variable. Is that to add your own 'gut feeling' about the stock or is that an out to push something higher up in the ratings because you 'like' the company. Don't let emotions control the process. You can't eliminate emotions entirely but something to be cautious about.

Great job!

[earthtodan]

Thanks for the comments guys! I know it takes some effort to digest this stuff.

(05-12-2014, 08:45 PM)Kerim Wrote: So if you had 30 stocks, with a total of 75 conviction points, then each point is worth 1.33 percent allocation. And a stock with a conviction score of 4 would get a 5.33 percent (roughly) allocation?

Exactly. I have a Google Docs spreadsheet that calculates my allocations, streams prices and tells me in real time how many shares I need to add to (or subtract from) any position to bring my portfolio into balance. If I want to add a new position, I don't have to manually rebalance my allocations, the spreadsheet does it for me. This method takes some of the thinking off my plate and also frees me from round-number psychological targets like $1000's and %'s.

Quote:And in the "C" formula itself, I have questions about Y and y. I think that the number of companies that have explicit payout ratio targets is relatively small -- so do you assign these yourself, and based on what criteria? And what do you mean exactly by "portion of the yield that is within the target payout ratio"? If the target is a payout ratio of 60 percent, and the actual payout ratio is 50 percent, then does Y get a value of 1.00?

Thanks!

"Y" is simply the dividend in most cases. The dividend is given a 1.5x weighting in the formula. For example, GIS yields 3% as of today's close, so the yield would be given a weighting of 3 x 1.5 = 4.5.

One thing that bothers me a little is that "Y" varies with the stock price. If the stock goes down and the yield goes up, should that change the investment thesis? That could get a little messy. I'll have to sort that out. Ideally I'll come up with a target price separate from the conviction level.

"y" is the part of the equation I like the least and will probably change first. This is an adjustment factor for dividends that are likely to grow faster or slower than earnings. For example, QCOM is raising its dividend 20% per year on 15% EPS growth due to its massive cash pile and lack of debt, and management says they intend to stay on that trajectory for a while. This could also apply to tech giants like CSCO, IBM, MSFT, or any maturing company that is making a shift from growth toward value.

As a negative example, I think SDRL is likely to grow its dividend slower than earnings, so I need a way to adjust for that and not give a 1.5x multiple to the entire 11% dividend. In this case "y" could be a negative number on some part of the dividend to bring the weighting down.

However now that I think about it, the debt/equity ratio sort of captures this already. I could probably give more weight to that and get rid of "y".

(05-12-2014, 09:28 PM)Dividend Watcher Wrote: Have you tried your formula on a test portfolio of 20-30 stocks? Were the results as expected?

I spot checked the results against my portfolio, and it came surprisingly close to the convictions I had already assigned. That is, after applying the "5" denominator, which has no meaning except to make the numbers fall into the 1-5 category. Anyway, I'm pretty happy that the formula approximates how I've come to think about the stocks I own. However, I'm not ready to hand the keys over just yet!

Quote:My one concern or question is about the 'c' (your conviction) variable. Is that to add your own 'gut feeling' about the stock or is that an out to push something higher up in the ratings because you 'like' the company.

That's exactly what it is. Maybe I should call it "M" for macro view. It has pretty limited power to move the result.


I'll post an update when I make some sort of meaningful improvement.

[cannew]

(05-13-2014, 12:43 AM)earthtodan Wrote: Exactly. I have a Google Docs spreadsheet that calculates my allocations, streams prices and tells me in real time how many shares I need to add to (or subtract from) any position to bring my portfolio into balance. If I want to add a new position, I don't have to manually rebalance my allocations, the spreadsheet does it for me. This method takes some of the thinking off my plate and also frees me from round-number psychological targets like $1000's and %'s.

If one wishes to rebalance than this sounds like a good system, however, I would not sell good stocks just to rebalance.

(05-13-2014, 12:43 AM)earthtodan Wrote: One thing that bothers me a little is that "Y" varies with the stock price. If the stock goes down and the yield goes up, should that change the investment thesis? That could get a little messy. I'll have to sort that out. Ideally I'll come up with a target price separate from the conviction level.

For me that's my initial watch point. I want the price to go down so I can buy more of the stocks I own and increase my yield. I'd gladly add more of one stock (even if it means I own much more of it than any other) if I could buy it at a value price.

[hendi_alex]

Looks to me like many are making this thing way too complicated. Of course if that is what it takes to make the process both interesting and provide a comfort level, then such is probably the correct recipe for a given individual.

[earthtodan]

(05-18-2014, 07:46 AM)cannew Wrote: If one wishes to rebalance than this sounds like a good system, however, I would not sell good stocks just to rebalance.

Agreed, active rebalancing is not in the plan. It is reserved for when I swoop up way too much of a stock on sale like SDRL or ARCP, and hopefully get an opportunity to lighten them up at a profit later, and collect a cool dividend in the meantime.
To this point, the cell in my spreadsheet that calculates the amount I should theoretically rebalance says "Buy [#]" if I'm underallocated, but says nothing if I'm overallocated.

(05-18-2014, 08:43 AM)hendi_alex Wrote: Looks to me like many are making this thing way too complicated. Of course if that is what it takes to make the process both interesting and provide a comfort level, then such is probably the correct recipe for a given individual.

Alex,
True. I tend to overanalyze things when I get the bug to study and understand. There's no way I can ever know the true quantitative risk or value profile of a stock, so in the end I just have to invest and diversify, and go about my life. However as you observed, the goal of this exercise is for my own comfort. Having come up with a rational formula that somewhat mirrors the convictions I've arrived at intuitively gives me some assurance that I'm not just throwing darts. I guess in the end I don't actually want to use a formula, I'm just trying to confirm that I can trust myself to invest my own money.

I grew up in a family that viewed the financial universe with great suspicion, and as a result I never learned anything about investing. My grandfather, after living through the Great Depression, put all his savings in US treasury bonds and never touched a stock in his life, and my parents manage their money very simply. Anything that smacks of Wall St they avoid with a shudder. In fact, I didn't even really understand what a bond was, or that my family used them, until recently. So, I'm climbing a steep learning curve. When I do that I tend to dive in a little deep. The catalyst was working for a company that went public, finding myself with a bunch of money to manage, and then realizing that I'll need it to retire. The investing universe is large and there's a lot to unravel, and I find intrinsic stock valuation baffling, which is probably why I find it so interesting. Eventually I'll wear myself out and move on to the next thing, at which point I will hopefully be able to execute my dividend growth strategy with minimal attention.

[earthtodan]

So I decided to drop the equation from the business plan, because realistically I'm not using it. Ultimately my level of conviction is subjective and personal, and the equation will answer to what I like rather than the other way around. The rest of the document reflects the rules I've decided to adopt, and is still in effect.

[Dividend Watcher]

Ahhh, first revision. I've had concerns about the 'c' factor since I first saw it. I was afraid that was your 'out' to make the formula do what you wanted it to do.

The nice thing about revising, it gets easier to revise again as you gain experience and see how Mr. Market reacts to different events.

Good job, dan.