Investment Objectives
The Dividend SMA strategy seeks to provide a combination of capital appreciation and a secure, growing stream of dividend income from large, domestic companies.
In pursuit of this objective, the team will focus on achieving three goals, which we believe have the potential to result in better risk-adjusted returns than the benchmark over the long-term:
- Offer peace of mind by owning a portfolio of quality businesses that we believe should deliver lower-than-market volatility and return cash to shareholders (such as through dividends or share buybacks).
- Provide a higher yield than the benchmark, the S&P 500.
- Earn acceptable returns on a rolling three-year basis, as measured by gross returns at or above benchmark levels, downside capture below 100% and an upside/downside capture ratio greater than 1:1.
Portfolio Managers
Who should invest?
This strategy fits in the large-cap domestic equity slice of an asset allocation. Investors who identify as “conservative” should consider the Dividend SMA strategy. Investors may prefer cash-returning equities because dividends and buybacks are historically responsible for a significant portion of long-term total stock returns, because companies able to generate excess cash tend to be established and stable businesses, or because these companies may experience lower volatility than less mature businesses. Regardless of the preference reason, this strategy may appeal to retirees (who withdraw dividends for living expenses) or risk-averse investors still in capital accumulation mode (who reinvest dividends).
We will select investments that are appropriate for taxable and tax-deferred account types (avoiding partnerships).
Philosophy and Strategy
We believe that A. great businesses that adopt a meaningful, disciplined capital return preference can generate wonderful investing outcomes over time and B. cash returns are a more reliable part of total return than capital gains. We believe that shareholders benefit from both dividends and share buybacks, with general tax considerations being among the many factors that would lead a company to favor reducing shares outstanding rather than paying a regular dividend.
We aim to maximize shareholder yield, which we define as dividend yield plus net buyback yield, without jeopardizing the safety of principal, the income stream, or long-term total return potential. Our strategy is guided by three principles:
- Business first – Own great businesses that are focused on returning cash to shareholders.
- Shareholder return second – Strive to provide a safe, significant, and growing stream of cash returned to the pockets of shareholders, but not at the expense of optimizing business health.
- Foolish mindset – Maintain a long-term, ownership mentality.
Most dividend investing is narrowly focused on maximizing dividend yield, which results in sector concentration, ownership stakes in deteriorating businesses, and ignoring funding and business risks. Our Dividend SMA strategy is about owning great businesses that happen to have great capital return and allocation policies, and holding them for the long term. Still, this portfolio will likely have sector concentrations that look vastly different than its benchmark and gravitate to some sectors over others.
We will invest in stocks (large- and mid-cap, domestic), preferred stocks (high-quality, large-cap, domestic companies that may or may not pay a dividend), and Exchange Traded Funds (or ETFs). Holdings will be combined in an effort to achieve the objective, uphold our philosophy, and provide diversification.
Portfolio Management Process
Portfolio Construction
The Dividend SMA strategy will typically hold 15-30 investments and be near fully invested at all times. We seek to achieve diversification the following ways:
- Asset Type: Typically, at least 75% of the strategy’s allocation will be to high-quality, dividend-paying, domestic stocks, with a minority allocated to preferred stocks and ETFs. We will also hold non-dividend payers that we feel have well-constructed and reliable capital allocation strategies. This will include companies that return excess cash through share buybacks. The common and preferred stocks will be issued by domestic companies with a market cap greater than $3 billion. If any ETFs are owned in the strategy, they will be classified as large-cap on a holding-weighted market capitalization basis.
- Market Cap: In normal times, at least 75% of the equity exposure of the strategy will be to large-capitalization stocks. Up to 25% may be invested in mid-cap stocks (with a market capitalization at time of purchase greater than $3 billion). With only rare exceptions, the strategy will avoid overlap with the US Small and Mid Cap SMA strategy holdings.
- Sector: The portfolio will be structured to achieve adequate sector diversification, with no single sector accounting for more than 35% of assets.*
- Style: We believe stylistic diversification within the dividend-producing investment universe is important. The primary distinctions across this “style” framework are the balance between dividend yield, dividend growth, and buyback practices all with respect to the stability of financial performance.
We believe a portfolio built upon core established dividend payers and augmented with faster-growing businesses that still maintain a cash-returning discipline has the best chance of achieving the Dividend SMA strategy’s objective and goals. In addition, this stylistic diversification affords the ability to construct a portfolio with a total return profile driven by shareholder yield, supported by dividend growth, and exposed to capital appreciation potential.
Investment Selection
Our investments will be chosen based on in-depth, bottom-up, fundamental research and a commitment to respecting the Strategy’s goals and objectives. Our research will be pointed at identifying wonderful businesses that have adopted a capital allocation policy committed to shareholder return. We give particular care to:
- Dividend Safety: cash flow coverage, capital allocation philosophy, competitive advantage, and stability of financial performance
- Growth Potential: end market demand, cash flow growth and payout characteristics, financial flexibility, and reinvestment needs
- Attributes of the entire portfolio: dividend yield, shareholder yield, dividend growth, sector diversification, and style diversification
Ultimately, we will select a mix of investments that we feel have an attractive combination of yield and growth potential to drive satisfactory total returns over time. We prefer companies with a history of strong cash returns and growth, modest reinvestment needs, and stable demand for their products and services. We seek to pay reasonable prices for these investments.
Position Sizing
The strategy will typically have 15-30 positions that vary in size based on their style classification and yield-plus-growth attractiveness. Allocations will typically range from 3% to 10% of the portfolio, with a maximum individual position size of 12% to allow our winners to compound.
Our largest allocations will be to high-quality businesses, of which we expect to have the potential for remarkably resilient operational performance and therefore have a high degree of confidence in our assessment of cash return safety and growth. Less established holdings with a shorter track record of returning cash and growing these payments will generally be restricted to smaller allocations.
Position Management
Given our preference for high-quality businesses trading at reasonable prices, we expect the Dividend SMA strategy to exhibit low turnover. We will adjust the portfolio over time as new information about each company’s business and prospects becomes available. We look to add to positions in businesses with improving competitive positions, strengthening financial profiles, and capital allocation philosophies which in turn improve the prospects for safety and growth. We will sell positions in businesses that exhibit poor capital allocation choices; deteriorating competitive positions, business performance, or financial strength; and payout philosophies likely to negatively impact their safety and growth.
We may trim or add to positions to achieve more balanced sector- and business-risk diversification. However, we will not mechanically sell a position that exceeds our position-size maximum guideline. Business quality and shareholder return considerations will always remain the primary drivers of position management actions.
Investment Risks
The value of investments in the Dividend SMA strategy may increase or decrease, which will cause the value of the investor’s portfolio to increase or decrease. The investor may lose money on their investment and there can be no assurance that the strategy will achieve its investment objective and goals.
In general, we would expect the Dividend SMA strategy to underperform its benchmark in strongly rising markets and outperform in strongly falling markets.
Risks inherent in this strategy are:
- Dividend income risk – Companies that issue common or preferred stocks that pay dividends are not required to continue to pay dividends, therefore, there is the possibility that a company could reduce or eliminate its dividend.
- Share buyback risk – The timing of share buybacks relative to a company’s intrinsic value determines whether a buyback creates value for existing shareholders. If management decides to repurchase stock when shares are overvalued, the transaction will transfer value to selling shareholders at the expense of existing shareholders. There is also no guarantee that well-timed buybacks will immediately lead to a higher share price.
- Potential changes to dividend tax rates relative to capital gains tax rates could impact a corporation’s willingness to return capital to shareholders through either dividends or share buybacks.
- Sector concentration – High dividend payers tend to cluster in certain sectors (financials, utilities, telecommunications), so it is reasonable to believe the Dividend SMA strategy will have significant exposure to these sectors at any given time.
- Interest rate risk – High yielding stocks often compete with other income-producing investments that are linked to interest rates. If yields on those other investment choices increase, the relative attractiveness of dividend paying stocks may decline.
Please see Appendix B to our Investment Advisory Agreement for a discussion of additional risk associated with this strategy. A link to the Investment Advisory Agreement is provided at the bottom of this page.
Each client portfolio is subject to an account minimum, which varies based on the strategies included in the portfolio. Motley Fool Wealth Management retains the right to revise or modify portfolios and strategies if it believes such modifications would be in the best interests of its clients, and we may modify allocations within a client's account subject to the constraints of each client's current risk score and objective. Clients should be aware that their individual account results may not exactly match the performance of the Model Portfolios.