Income strategies for your portfolio
Previously we looked at the reasons for using yield, safety and growth as the main concepts around which to shape a dividend investment strategy. In this section, we’re going to look at how six well known income strategies have sought to track down great dividend stocks and see how these approaches stack up, both in theory and in practice. As will see, these three factors are rarely treated equally - different investors place more or less emphasis on one or another, as they see fit.
These strategies are quantitative and/or semi-mechanical. As part of evaluating them, dividend investors have to ask themselves whether they wish to approach dividend investing with an active stock picking approach (as alpha hunters) or with a passive quantitative portfolio approach (as beta farmers). Making that decision depends on your tolerance for risk and personal day to day passion for stock picking. As we discovered in a chapter of How to Make Money in Value Stocks many modern investors are learning that the passive approach can be just as lucrative, less stressful and can help to avoid the myriad ways in which investors manage to trick themselves out of their fortune.
We have deliberately made the following pages concise & formulaic to allow quick comparison of the pros and cons of each strategy. We track the relative performance of each of these strategies in our Screening Centre, including our own variants where we see scope for improving the approach (we also review a couple of more obscure dividend strategies in the Appendix).
Strategy 1: Dogs of the Dow
“Beating the Dow is based on simple logic that will produce exceptional returns in any rational market”, Michael O’Higgins
Perhaps the most famous high yield investing strategy around is the “Dogs of the Dow”, first popularized back in 1991 by Michael Higgins in the book Beating the Dow.
How it works Simply invest an equal sum in the top 10 highest yielding stocks (“the Dogs”) in the Dow Jones Industrial Average (or an equivalent large-cap index such as the FTSE 100) once per year. Rinse and Repeat. O’Higgins argued that, by doing so, you could beat the Dow and with it probably the majority of most active fund managers.
Why it works The thinking behind the Dogs of the Dow strategy is that blue chip companies do not alter their dividend to reflect trading conditions whereas share prices fluctuate. Companies with a high yield, i.e. high dividend relative to price, are therefore near the bottom of their business cycle and should see their stock price increase faster than low yield companies. The screen theoretically offers a conservative option that produces a list of well-financed companies that have long histories of weathering economic turmoil. But of course there’s theory and there’s practice…
Can it beat the market? In his back-testing, O’Higgins demonstrated that over a 17-year period from 1973 to 1989, the Dogs strategy averaged a return of 17.9 percent annually, compared to 11.1 percent for the Dow. The Dogs of the Dow website suggests that, for the 20 years from 1992 to 2011, the Dogs of the Dow matched the average annual total return of the Dow (10.8 percent) and outperformed the S&P 500 (9.6 percent). It did however struggle to keep up with the Dow during latter stages of the dot-com boom and the 080/09 financial crisis, suggesting that an investor would be best served by viewing this as a longer-term strategy.
Key issues
No safety filter (other than index membership): Although the Dogs approach has the advantage of simplicity, the great disservice that O’Higgins did for investors was to encourage them to look primarily at the list of highest yielding stocks in an index without filtering for dividend sustainability and growth. In the 80s and 90s Dow Jones index stocks were extremely stable, but these days with the disruptive nature of internet competitors and tough credit markets, the giants of yesterday are more at risk than ever before.
Higher risk of dividend cuts: The singular focus on the highest possible yield means that the approach has had a tendency to pick for inclusion troubled names like Eastman Kodak whose broken business models led to bankruptcy.
High sector concentration risk: Stocks in the same sector tend to go out of favour or into trouble at the same time e.g. Lloyds and RBS in the UK during the financial crisis.
Trading costs: The annual review of the portfolio is likely to mean making major changes thus triggering trading costs and possibly crystallising capital gains taxes.
Strategy 2: Geraldine Weiss’ Yield Range
“Anyone can be a successful investor… you confine your selections to blue-chip stocks, you buy them when they are undervalued, and you sell them when they become overvalued” Geraldine Weiss
Rather than focusing on high absolute yield, an alternative strategy focuses in on relative yield over time - the most renowned advocate of this kind of ‘range-trading’ approach was Geraldine Weiss, known as the Grand Dame of Dividends. For more than 50 years, Weiss has been regarded as one of the investment community’s most astute dividend hunters. The now retired editor of the US dividend newsletter Investment Quality Trends, Weiss developed a formula for identifying companies with strong dividend track records that are attractively valued in the market, which she documented in two best-sellers, “Dividends Don’t Lie” and “The Dividend Connection”.
How it works At its heart, the technique uses the dividend yield as the critical measure of its valuation. If the yield is high, it may signal a buying opportunity and, if the yield is low or drifting lower, then that could be an indication to sell. As well as looking for low yields on a historical basis, there is a filter for high quality stocks - each company needs to have a good quality track record and pass an additional set of robust “blue chip” criteria to prove it.
Stock Selection Criteria: 1. Dividend yield must be undervalued vs. its historical average 2. It must be a growth stock that has raised dividends at a rate of at least 10 percent over the past 12 years. 3. It must be selling for two times book value or less. 4. It must have a P/E ratio of 20-to-1 or below. 5. It must have a dividend payout ratio in the 50 percent area (or less) to ensure dividend safety with room for growth. 6. Its debt must be 50 percent or less of total capitalization. 7. It must be “blue chip”, defined as: - The dividend raised five times in the last 12 years - It should carry an A rating from S&P - It should have at least 5 million shares outstanding - It should have at least 80 institutional investors hold the stock - It should have had 25 uninterrupted years of dividend history - There should be earnings improvements in seven of the last 12 years.
Why it works It’s easy to understand the blended emphasis on relative value and quality. Weiss argues that stock valuations from a yield perspective move in their own specific bull to bear cycles as sentiment ebbs and flows. The average time for a stock to raise from undervalue to overvalue is three years, while the downhill run is usually two years. This strategy seeks to exploit those relatively predictable cycles.
Can it beat the market? Weiss has now retired but, as of 2002, Investment Quality Trends was said to be the number one performing investment newsletter in the US over the previous 15 years, earning an impressive 12.4 percent annualised. It had placed third for the prior ten years and third over the prior five years.
Key issues
Charting based: This approach involves aspects of technical analysis. Its reliance on historic patterns may concern fundamentals-focused investors, although the charting is not purely based on price action.
Higher risk of dividend cuts: Focusing on historically high yields may lead investors into dividend traps, although the quality filters help here.
Accessibility: It’s difficult to replicate some of these criteria exactly for the UK market (e.g. the S&P A rating or the 25 year dividend history as this is as rare as hen’s teeth in the UK market).
Strategy 3: HYP - High Yield Portfolio
“You buy the top high-yielding stocks - building a diversified portfolio across all sectors. And you simply sit back and allow the dividends to pile up” Stephen Bland
A strategy which shares some of the same thinking as Dogs of the Dow is the ‘High Yield Portfolio’, a passive large-cap income investing strategy popularized by the writer and investor Stephen Bland in a series of Motley Fool articles back in 2000.
How it works This is a buy and hold forever strategy aiming to build a well diversified portfolio of shares in big, solid companies chosen primarily for high yield to provide increasing retirement income from dividends. All forecasts and opinions on stocks are ignored and stock positions are never sold. The stock selection approach is as follows:
Rank a large-cap universe by highest forecast yield.
Select one stock from each different sector
Examine fundamentals to make sure the yield is sustainable:
Less than 50 percent gearing, except in special cases like utilities. b. Dividend cover of at least 1.5x c. A history of dividend growth over, say, the last five years. However, Bland also notes that these rules are flexible “for the sake of essen- tial sector diversification”.
Can it beat the market? Over the 10 years to November 2011, the strategy was reported to have generated a 4.95 percent income return per annum.
Key issues
This is a combined yield and safety approach but the safety filters are fairly basic and - as with the Dogs - the focus on the very highest yielding stocks looks misguided (the 2nd and 3rd decile tend to deliver higher risk-adjusted returns). Perhaps unsurprisingly, in the 2008 credit crunch, the HYP portfolio suffered a number of high profile issues from a capital perspective, including picking Lloyds and BP.
Strategy 4: DGI - Dividend Growth Investing
“The stockmarket also contains an escalator, one that allows you to stay invested and ride the roller coaster with something ap- proaching peace of mind” Roxann Klugman
This is an increasingly popular income investing strategy in the United States. One of the earliest books to focus on DGI in detail as a strategy was Roxann Klugman’s 2001 title, The Dividend Growth Investment Strategy. As a more populist school of investment thinking, Dividend Growth Investing has emerged in recent years out of the blogosphere, via sites like Van Knapp’s Sensible Stocks and the writings of oth- ers like David Fish, Chuck Carnevale and Norman Tweed on social finance site, Seeking Alpha.
How it works This approach involves buying stocks with a long history of increasing dividend payments, i.e. Dividend Champions, and reinvesting any proceeds. While a long dividend streak is considered crucial, it’s also important to find a company that is growing at a sustainable rate, with low debts and lots of cash inflows. There is usually a strong Buffettesque focus on the quality of the underlying business franchise to ensure sustainability of the dividend payment. As with the HYP approach, there is more emphasis on the income stream generated by the portfolio, than the portfolio value per se.
Stock Selection Criteria DGI is a fairly broad church but a typical set of criteria to find candidate stocks might be: 1. Consistent history of dividend increases: This usually starts with the list of companies with a 25+ year record of maintaining or increasing dividends. 2. Strong historic dividend growth rate: A minimum five-year dividend growth rate of 10 percent or more, or a 10-year dividend growth rate at the same level. 3. A minimum dividend yield of 3 or 4 percent: If the current yield of an existing holding drops below 3 percent, this might trigger a decision to sell and deploy the cash elsewhere. 4. Increased dividend payout yield (either in relation to EPS or free cash flow): This is more controversial since some DGI investors target low payout ratios as a sign of sustainability.
Why it works? We discussed earlier the way companies with long dividend streaks are signalling the stability of their business model, their confidence about future earnings and their commitment to paying dividends. Companies think very carefully before increasing dividends in this way - as a result, they tend to be very high quality businesses that are able to grow profits over a long period of time by selling / manufacturing / distributing products that people really need.
Can it beat the market? Given its popularity, the evidence whether Dividend Growth Investing delivers excess long-term returns is surprisingly mixed. While a number of its supporters have back-tested the performance of the Dividend Champions list, this work is based on a data-set that suffers from significant survivorship bias (i.e. it does not show companies that cut their dividends or went bankrupt). However, one international study by Cass University of UK stocks, Consistent Dividend Growth Investment Strategies examined data for the London Stock Exchange from 1975-2006. It found that firms with 10+ years of consistent dividend growth (especially small-caps) returned considerably more than the equity market as a whole, with the additional benefits of lower volatility and smaller drawdowns.
In any case, the idea is that, rather than beating the market through capital growth, a portfolio of DGI stocks should provide a sufficient income stream to retire on, without the need to touch the principal (i.e. the appropriate benchmark is total return).
Key issues
Unbalanced approach: As blogger Financial Uproar writes, the proponents of DGI can appear somewhat myopic in their focus on growth to the exclusion of other concerns: “I like dividends too. The problem is with the almost singular focus on it. As long as a company is growing the bottom line and their inves- tors get that yearly dividend hike, dividend growth investors are happy to buy, all other metrics be damned”.
Limited focus on valuation: Given the lack of focus on yield, there is a risk that valuation may be overlooked as a key pa- rameter for these kinds of stocks. A related concern is that the DGI approach is becoming very popular in the US, which could lead to a bubble in these kinds of stocks (discussed below).
Strategy 5: BSD - Big Safe Dividends
“Find stocks with above-average appreciation potential and safe and growing dividends, and buy them at attractive prices” Charles Carlson
Charles Carlson is the boss of an investment advisory and publishing group called Horizon which publishes “The DRIP Investor” newsletter. Carlson wrote a book called The Little Book of Big Dividends in which he laid out his own algorithm for picking safe yielding stocks. He is generally wary of high yield stocks and, unlike some of the previous strategies, he suggests that investors should be cautious about stocks with dividend yields that greatly exceed the yields of companies in the same sector or industry, the overall market, or the stock’s own long-term historical average.
How it works Carlson discuss two approaches - Advanced & Simple Big, Safe Dividends (BSD). The Simple version relies on the Dividend Payout Ratio and his own proprietary Quadrix score, the details of which are not disclosed. However, the Advanced BSD Formula uses the following ten weighted fundamental and momentum factors to arrive at a composite score. The idea is to focus on the best-scoring companies and Carlson’s website provides a list of them for the S&P 1500.
Primary Factor
Dividend Payout Ratio (30 percent Weighting) – Using this ap- proach, the most important factor is how well covered the divi- dend is by company profits.
Major Factors
Interest Cover (10 percent Weighting) - measures how well a company profits cover its interest payments. Companies with lots of debt may struggle to pay the dividend if business conditions deteriorate.
Three Year Dividend Growth (10 percent Weighting) – Carlson observes that companies that have a history of raising their dividend on a regular basis tend to continue to do so.
Long Term Expected Growth (10 percent Weighting) - While not a perfect measure given the poor record of analyst forecasts, Carlson feels that it is a reasonable way to get some view on a firm’s future growth prospects.
Tangible Change in Book Value (10 percent Weighting) - This is used as a check on a company’s balance sheet quality.
6 Month Relative Strength (10 percent Weighting) - Carlson notes that weak share price movements can often anticipate dividend cuts.
Minor Factors
Cashflow to Net Income (5 percent Weighting) - While profits can be seen as the primary funding source of dividends, you need actual cash to pay the dividend.
Three Year Cash Flow Growth (5 percent Weighting) – A focus on companies that have a record of boosting cash flows on a regular basis.
Three Year Earnings Growth (5 percent Weighting) – Preferable to bet on a company with a history of boosting earnings than one that does not.
Dividend Yield (5 percent Weighting) - Carlson includes it but warns against focusing overly on dividend yield.
Can it beat the market? According to the book, Carlson back-tested his approach to 1994. A hypothetical investor that bought all of the S&P 1500 stocks that were in the top 20 percent of the Advanced BSD screen and in the top 25 percent of his Quadrix ranking system, with annual rebalancing, would apparently have outperformed the S&P 1500 Index by more than 6 percent per year.
Key issues
Debatable parameters: While Carlson’s approach is interesting, it does appear to be something of a laundry list of financial indicators that might (or might not!) impact dividend safety, plus a fairly arbitrary set of weightings. The approach is said to be focused on safety but also seems to include factors that are assessing the prospects for dividend payout growth.
Omissions: There are a few surprising omissions from the algorithm such as the size of the firm in question which do tend to be predictive. Finally, as we’ve discussed, it’s not always clear that a low payout ratio is always a good thing so its heavy reliance on this metric is open to question.
Proprietary aspects: The full back-tested results rely on Carlson’s Quadrix ranking system, the details of which are not disclosed.
Strategy 6: SG Quality Income
“There are very sound logical reasons for being biased towards high quality/low risk stocks. There are even more sound reasons for being biased towards sustainable dividend payers” Dylan Grice, Societe Generale
In May 2012, the equity strategy team of SocGen sought to produce an investment strategy that would provide a tonic to ten years of depressed equity growth and stagnating bond returns. What SocGen’s team came up with was a ‘Quality Income Index’ designed to track large cap stocks with robust balance sheets, strong fundamentals and healthy yields. The barometer of quality essentially rests on the broad shoulders of the Piotroski F-Score. They have subsequently launched an ETN based on the Index.
How it works Their stock selection criteria consists of the following metrics: 1. As a measure of quality, a stock must have a Piotroski F- Score of 7 or greater (out of 9) 2. It must also have a balance sheet risk score in the safest 40 percent of the universe. 3. A forecast dividend yield above 4 percent or 125 percent of the average universe yield. 4. Market capitalisation has to be at least $3bn.
Their “universe” is a global mix of ‘eligible countries’ subject to a few turnover minimisation techniques, quarterly rebalancing and a basket size of between 25 and 75 stocks. Financial companies are excluded.
Why it works The idea of bringing both high quality and high income together into a portfolio strategy has some very sound behavioural foundations as it helps in avoiding overconfident managers and avoiding overpaying for lottery tickets. We’ve already looked at why high yield stocks tend to do well; the fact that company management are generally bad at allocating capital means that distributing cash to shareholders seems to improve the discipline and skill of managers at reinvesting capital. Meanwhile, high quality businesses tend to be steady stalwarts that are often ignored by fund managers as being just too boring. Fund managers have to do something from day to day and need a bit of pizzazz to keep them excited about their work and possible bonuses. As a result they’ll tend to pay more money for stocks that have the capacity to double from year to year. Just like lottery ticket buyers, they pay over the odds to play, systematically underbidding quality stocks in the process.
Can it beat the market? Many in the market now appreciate that both higher ‘quality’ stocks and higher yielding stocks tend to outperform. According to SocGen’s backtesting, stocks that share both qualities put together offer total returns that have averaged 11.6 percent per year since 1990, more than doubling the return of the global equity markets at a significantly reduced volatility.
But what is more striking is the return of the portfolio since the market topped in 2000 - a genuinely miserable time for all. While the total return of stock markets has actually been negative in that time period, the Quality Income index almost tripled. We’re now tracking the screen for the UK market to see how it holds up under live tracking as opposed to back-testing.
Key issues
Of all the dividend strategies discussed, this is the one we consider has the soundest foundations in terms of the underlying research and thinking. On the negative side, the Distance to Default measure used to assess balance sheet risk is somewhat esoteric, although in our own modelling of it, we’ve used the Altman Z-Score as a substitute.