Here's a dividend-investment strategy designed to outperform in down markets

The Reality Shares DIVCON Leaders Dividend ETF screens for quality, based on the likelihood of large-cap companies raising payouts to shareholders.

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Blockforce Capital, formerly Reality Shares, has a passive strategy to select large-cap dividend-paying stocks based on the likelihood that the companies will raise dividend payments.

The company has used this approach for the Reality Shares DIVCON Leaders ETF (LEAD), since early 2016, and the results have been good so far. The icing on the cake may be that the ETF's conservative strategy is designed to outperform during down markets.

When we first covered Reality Shares' DIVCON strategy in October 2015, the company was only running one ETF, the Reality Shares DIVS ETF (DIVY) which is essentially a play on how much S&P 500 (.SPX) member companies increase their dividends.

But DIVY is really a conservative investment, which Blockforce senior analyst Kian Salehizadeh describes as "more of a fixed-income ETF replacement or compliment," which is expected to have low volatility and a "consistent 3% to 5% return per year." For three years through Oct. 9, DIVY had an average annual return of 5.5%, with a four-star rating (the second highest) in Morningstar's "multialternative" category.

Reality Shares was founded in 2012 and is headquartered in San Diego, with about $260 million in assets under management. The company was renamed Blockforce Capital in August, to reflect the fact that a considerable portion of its assets under management are now in the Reality Shares Nasdaq NexGen Economy ETF (BLCN) which invests in companies that use blockchain technology, and the Nasdaq NexGen Economy China ETF (BCNA) which seeks to do the same but with a focus on companies operating in China.

DIVCON for growth and two other strategies

In January 2016, Reality Shares established three ETFs that select stocks based on the firm's DIVCON scores. A company's DIVCON score predicts how likely it is to increase its dividend over the next 12 months. A score of 5 is best, 1 is worst. The score incorporates financial-statement analysis, a company's history of raising or cutting dividend payouts, as well as stock-buyback activity. The idea is to highlight quality based on improving earnings and cash flow, as well as a history of rewarding investors with significant increases in dividend payouts, irrespective of current dividend yields.

LEAD

The Reality Shares DIVCON Leaders Dividend ETF typically holds 40 to 60 stocks of companies with the highest DIVCON ratings among the 500 largest U.S. companies by market value. The ETF is rebalanced once a year in December and stocks are weighted by their DIVCON scores (within the broad scores of 5 and sometimes 4). Here's how it has performed since it was established on Jan. 6, 2016, against the S&P 500:

So the ETF has outperformed the S&P 500 slightly during its life of nearly three years.

In an interview on Oct. 9, Salehizadeh said he would expect LEAD "not to correct as much as the broad market" in the event of a downturn, because of the high DIVCON scores, adding that "they are likely to do better in a rising-rate environment ... because they tend to be growth stocks."

Here are comments from Salehizadeh about five stocks with DIVCON 5 ratings:

  • Estee Lauder (EL) "Five-year annualized dividend growth rate of 16%. Lots of free cash flow to support future dividend growth. Funds can be reallocated from future buybacks to dividend increases. The company continues to find innovative ways to stay relevant with millennials."
  • Nike (NKE) "Five-year annualized dividend growth rate of 14%, with plenty of free cash flow to support future dividend growth and forward earnings look very healthy. A lot of money currently being allocated to buybacks, which could be re-purposed for future dividend increases. The new marketing campaign with Colin Kaepernick has really boosted sales and brand awareness."
  • Nvidia (NVDA) "Five-year annualized dividend growth rate of 15%, with very strong earnings growth. More than double the DIVCON Leaders' average in levered free cash flow available to support future dividend increases. Could allocate a lot of funds away from buybacks to future dividend increases. As long as gaming, AI and crypto sectors continue to shine, Nvidia will be a top pick. Datacenter sales continue to be key drivers and gaming sales are also huge. They had a big boost early in the year because they were developing crypto products, which later fizzled a bit."
  • United Healthcare (UNH) "Five-year annualized dividend growth rate of 27%. Strong expected 12-month dividend growth. Lots of levered free cash flow (above the DIVCON Leaders average) to support future dividend growth. Very strong earnings growth. Analysts see an abundance of organic and inorganic growth opportunities over the next several years."
  • Visa (V) "Five-year annualized dividend growth rate of 20%, with double-digit dividend growth expected over the next 12 months. Lots of levered free cash flow (above the DIVCON Leaders average) to support future dividend increases. The company can also reallocate away from buybacks to support future dividend growth. Visa continues to innovate in the payment-processing space, incorporating new technologies for peer-to-peer money transfers, among other areas."

DFND

The Reality Shares DIVCON Dividend Defender ETF (DFND) follows a continuous long/short strategy, which Salehizadeh described as "the most conservative" of the three DIVCON strategies, appropriate for investors "looking for an opportunity to invest in the best names while taking advantage of downside for the laggards."

When DFND is rebalanced each December, it is 75% invested in the same long positions as LEAD, with the other 25% short positions in companies with DIVCON scores of 1 and sometimes 2, "to meet the minimum number of names," according to Salehizadeh.

It's not a surprise to see that DFND has underperformed the S&P 500 since the ETF was established on Jan. 6, 2016, considering the strength of the bull market:

GARD

The Reality Shares DIVCON Dividend Guard ETF (GARD) alternates between the strategies of LEAD and DFND, depending on the "Guard Indicator," which "predicts market health and long-term trends by analyzing downside deviation, price momentum, and volatility across S&P market sectors." So if the Guard Indicator is positive, the fund will be invested the same way as LEAD. But if the indicator is negative, the fund will be 50% invested in long positions as LEAD is, with 50% in short positions (where DFND is always 25% short).

GARD's track record since it was established on Jan. 14, 2016, has been the worst of the three DIVCON ETFs:

Salehizadeh said that, since GARD was launched, "the market didn't end up behaving as logically" as the Blockforce team would have expected when the Guard Indicator was negative.

"Investors were flocking to low-quality, high-yielding names in the first instance, contrary to what was expected, and that hurt the portfolio on the short side," he said. "And more recently, the Indicator ended up triggering too late, and the strategy switched to long/short after the market had already started broadly recovering. This was primarily due to the increase in volatility at that time."

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