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Friday, December 24, 2021

DivGro Target Weights

I updated my system for determining target weights for DivGro positions. 

The system is both dynamic and flexible. It adjusts to prevailing market conditions and allows me to calibrate factors when my goals change. 

In this article, I present the updated system for determining DivGro target weights. I replaced one of the factors and added three new factors, for a total of seven factors that contribute to the target weight calculation. 

I'll summarize each contributing factor and explain how I calculate and use target weights. 


Background


I used to set a target weight for my DivGro positions based on the size of an equal-weighted position. As the number of positions in my portfolio increased, the average position size (and my target weight) naturally decreased. With about 100 positions, it works out to a target weight of about 1%. 

While trivially simple, using the average position size as a target weight fails to recognize that some positions may be more important than others. Proper risk management is one reason to have non-equal target weights. 

In May 2021, I decided to develop a dynamic and flexible system for determining target weights. My primary motivation was to rebalance DivGro more evenly among the Cyclical, Defensive, and Sensitive super sectors. But I also wanted to favor investing in higher-quality stocks with more substantial upside potential. 

The system worked well enough to help improve DivGro's super sector distribution:


Super sector distribution of DivGro stocks in October 2020

Super sector distribution of DivGro stocks in November 2021

But now, I want to capture additional factors I deem essential for portfolio risk management. In fact, I'm dropping Super Sector in favor of Defensiveness to better reflect my focus on safety

  Old Factors   New Factors
  • Quality Score
  • Upside Potential  
  • Super Sector
  • Sector Rank
  •  -
  •  -
  •  -
  • Quality Score
  • Upside Potential  
  • Defensiveness Score 
  • Sector Rank
  • Income Outlook
  • Dividend Safety
  • Growth Prospect

Factors


Let's look at each of the new factors in turn.

Quality Score

Proposition: Favor higher-quality stocks.

I use DVK Quality Snapshots to assess the quality of stocks. The system employs five widely used quality indicators from independent sources and assigns 0-5 points to each quality indicator for a maximum quality score of 25 points. My rating system maps to different quality score ranges, and I consider stocks with quality scores of 15 and higher Investment Grade.

I set the base weight as follows:

Rating  Quality Score   Base Weight 
 Exceptional  25 2.5%
Excellent 23-24 2.0%
Fine 19-22 1.5%
Decent 15-18 1.0%
Poor 10-14 0.5%
Inferior 0-9 0.0%


Upside Potential

Proposition: Favor stocks with higher upside potential.

One way I measure upside potential is to use the Chowder Number [CDN], a popular metric for modeling the likelihood that a stock will deliver annualized returns of at least 8%. To obtain the CDN, you simply add a stock's current yield to its 5-year dividend growth rate [DGR]. 

The Chowder rule determines how to interpret CDNs. The rule is somewhat involved and depends on a stock's current yield and whether it is a Utilities sector stock. The following table provides a summary and shows how this factor contributes to weights: 

 Upside at least 
 8% per year 
 Yield < 3%   Yield ≥ 3%   Utilities 
 Yield ≥ 4%
 Weight 
 Contribution 
Likely CDN ≥ 15 CDN ≥ 12 CDN ≥ 8 +1.5%
Less Likely  10 ≤ CDN < 15   8 ≤ CDN < 12   5 ≤ CDN < 8  +1.0%
Unlikely CDN < 10 CDN < 8 CDN < 5 +0.0%


Defensiveness Score

Proposition: Favor defensive, safer stocks.

David Van Knapp [DVK] developed a defensiveness scoring system based on how stocks satisfy common notions of safety. I like the system because it identifies stocks with defensive characteristics regardless of their sector membership. 

The system assigns 0-3 points to four different safety indicators, for a maximum defensiveness score of 12. 

For now, I'm using a weight contribution calculated as follows:
Contribution = (Defensiveness Score) / 12 %

With this linear function, the maximum weight contribution is +1.0%.


Sector Rank 

Proposition: Favor the top-ranked stocks in each sector.

To rank stocks, I sort them by descending quality scores and use the following tie-breaking metrics, in turn:
These rankings do not take sector membership into account. 

But I want to consider the sector rank of stocks and favor the 10 top-ranked stocks in each sector, regardless of their overall rankings. This factor recognizes that some sectors have lower overall rankings than others, as illustrated in the following table that provides the average, minimum, and maximum quality score of the 10 top-ranked stocks in each sector.

Sector Average
 Quality Score 
Minimum
 Quality Score 
Maximum
 Quality Score 
 Communication Services  15.7 10 23
Consumer Discretionary 20.2 17 25
Consumer Staples 23.3 22 25
Energy 16.5 15 19
Financials 21.3 21 24
Health Care 23.6 22
25
Industrials 23.2 22 24
Information Technology 24.2 24
25
Materials 20.1 17
23
Real Estate 16.7 15
18
Utilities 21.3 20
22

For this factor, the weight contribution is calculated as follows:
Contribution = ( 11 – Sector Rank ) / 10 %

For example, a stock ranked first in its sector will get a contribution of +1.0%, while a stock ranked tenth in its sector will get a contribution of +0.1% for this factor. 

Income Outlook 

Proposition: Favor stocks with a substantial income outlook. 

The 5-year Yield on Cost [YoC] is an income-oriented metric that indicates what your YoC would be after buying a stock and holding it for five years, assuming the current 5-year DGR rate is maintained. 

To calculate the 5-year YoC is easy:
5-year YoC = Forward Yield × (1 + 5-year DGR)5
  Income 
  Outlook 
 Range  Weight 
 Contribution
Strong 5-year YoC ≥ 4.0% +1.5%
 Medium   2.5% ≤ 5-year YoC < 4.0%  +1.0%
Weak 5-year YoC < 2.5% +0.5%

If a stock's 5-year DGR is negative, its weight contribution is 0.0%.

Dividend Safety

Proposition: Favor stocks with higher Dividend Safety Scores.

Dividend Safety is crucially important to me, so I consider this factor separately even though it contributes to the quality and defensiveness scores. 

When looking for new stocks to add to my portfolio, I choose only Very Safe and Safe dividends. Once I own a stock and its Dividend Safety Score drops below 61, I'll consider closing or trimming my position. And if the Dividend Safety Score drops below 21, I'll immediately close my position.

Source: Simply Safe Dividends

Here is the formula I use to calculate the weight contribution for Dividend Safety:

Contribution = 2 × ( Dividend Safety Score – 49 ) / 100 %

In essence, only Dividend Safety Scores in the range of 50-99 count. 

Growth Prospect

Proposition: Favor stocks with a solid trailing total return.

The 5-year trailing total return [TTR] measures a stock's performance over the past five years and includes stock price appreciation and total dividends received. While the 5-year TTR is a backward-looking metric, it represents a longer-term growth trend that suggests how a stock may perform in the foreseeable future. 

Rating  Range   Weight Contribution 
 Spectacular   5-year TTR ≥ 30%  1.5%
Impressive  20% ≤ 5-year TTR < 30%  1.0%
Strong 10% ≤ 5-year TTR < 20% 0.5%

Calculating Target Weights


The abovementioned base and contribution weights represent the relative weight of each stock in my portfolio. The maximum possible weight per stock is 2.5% + 1.5% + 1.0% + 1.0% + 1.0% + 1.5% = 6%.

 Factor  Maximum Weight 
 Quality Score  2.5%
 Upside Potential  1.5%
 Defensiveness Score  1.0%
Sector Rank 1.0%
Income Outlook 1.5%
Dividend Safety 1.0%
Growth Prospect 1.5%
TOTAL 10.0%  

To calculate a stock's target weight, I simply divide its total weight by the sum of all total weights. 

The following table shows some example target weight calculations for stocks in my portfolio. (At the time of writing this article, the sum of all total weights was 548.4%).

 Ticker  AAPL   HD   JNJ   NKE   O   TJX   VZ 
 Quality Score  2.00% 2.00% 2.50% 2.50% 1.50% 1.50% 2.00%
 Upside Potential  1.00% 1.50% 0.00% 1.00% 1.00% 0.00% 0.00%
 Defensiveness Score  0.50% 0.92% 1.00% 0.83% 0.83% 0.25% 1.00%
Sector Rank 0.60% 0.90% 1.00% 1.00% 0.40% 0.00% 0.90%
Income Outlook 0.50% 1.50% 1.00% 0.50% 1.50% 0.50% 1.50%
Dividend Safety 1.00% 0.76% 1.00% 1.00% 0.42% 0.62% 0.76%
Growth Prospect 1.00% 1.00% 0.00% 0.50% 0.00% 0.00% 0.00%
Total Weight  6.60%  8.58%  6.50%  7.33%  5.65%  2.87%  6.16%
Target Weight  1.20%  1.56%  1.19%  1.34%  1.03%  0.52%  1.12%

At 1.56%, The Home Depot (HD) has the highest target weight of all stocks in my portfolio. In contrast, The TJX Companies (TJX) has the lowest target weight of all stocks in my portfolio.

Here is a chart comparing DivGro's current weights with calculated target weights:


There are many outliers, such as Apple (AAPL), which is significantly overweight, and NIKE, Inc (NKE), which is significantly underweight. 

Using Target Weights


I have a spreadsheet that calculates the current weight of each position in my portfolio. Given the target weight as calculated above, I can quickly determine whether I need to buy or sell shares to move a position to its target weight. In fact, I use the current stock price to determine the exact number of shares I would need to buy or sell to reach the target weight. 

Here's a table showing the current situation for the abovementioned stocks:

 Ticker  AAPL   HD   JNJ   NKE   O   TJX   VZ 
Target Weight 1.20% 1.56% 1.19% 1.34%  1.03%   0.52%  1.12%
 Current Weight 2.84% 2.24% 1.71% 0.20%  0.84%   0.59%  1.06%
(Sell) Buy Shares (115) (21) (31) 85 35 (12) 15
 Recent Stock Price  176 397 168 166 69 74 53
Trade Impact  (20,240)   (12,307)   (5,208)   14,110   2,415  (888) (795)
Buy Below Price 137 365 186 154 60 65 63
 (Discount) Premium  29% 9% (10%)7% 15% 14%  (17%) 

Note that I wouldn't necessarily execute these trades. In fact, I would consider many other factors before deciding to execute a trade, including whether the stock is trading above or below fair value, whether the stock is "involved" in a short covered call option, and possible tax implications. 

Note also that the spreadsheet is dynamic, meaning the data updates all the time. If a stock's price changes, then the stock's current weight will change, and the possible action might also change. It would be fruitless to execute trades to match the target weights exactly. 

I use conditional formatting in my spreadsheet to show only "significant" trades, say ones with a trade impact of at least $2,500 shares either way. 

Looking at the possible actions above, only four trades are "significant": 
  • Apple (AAPL) – HOLD (dire tax implications for a six-bagger!)
  • Home Depot (HD) – HOLD (tax implications when selling a home run stock!)
  • Johnson & Johnson (JNJ) – HOLD (JNJ is discounted 10% to my Buy Below price)
  • Nike (NKE) – HOLD (NKE is trading at a 7% premium) 

Concluding Remarks


I recently updated my system to determine target weights for DivGro positions. The system is both dynamic and flexible, adjusting to prevailing market conditions while also allowing me to calibrate the system as my goals change. Seven factors influence target weight calculation: quality score, upside potential, defensiveness score, sector rank, income outlook, dividend safety, and growth prospect. 

Thanks for reading, and happy investing!
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