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
|
 |
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 |
|
|
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:
- Simply Safe Dividends Dividend Safety Score
- Standards & Poors Credit Rating
- Current Dividend Yield
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.
No comments :
Post a Comment
Please don't include links in comments. I will mark such comments as spam and the comment won't be published. To make me aware of your blog or website, comment on my Blogrole page instead.