A good dividend yield, low payout ratio and consistent dividend growth are an essential combination for a long-term successful dividend stocks strategy, but what about reducing the risk? In order to find out good yielding stocks with high reward to risk ratio, I looked for stocks with high Sharpe ratio.
A ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting the risk-free rate - such as that of the 10-year U.S. Treasury bond - from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.
The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed.
I have searched for companies that are included in the Russell 3000 index with a healthy dividend yield and with a low payout ratio that consistently have raised dividend payments and have a high Sharpe ratio.
Russell 3000 Index
The Russell 3000 Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market. The Russell 3000 Index is constructed to provide a comprehensive, unbiased, and stable barometer of the broad market and is completely reconstituted annually to ensure new and growing equities are reflected.
The screen's method requires all stocks to comply with all following demands:
- Dividend yield is greater than 3%.
- The payout ratio is less than 100%.
- The annual rate of dividend growth over the past five years is greater than zero.
- Sharpe ratio is greater than 1.0.
- The five stocks with the highest Sharpe ratio among all the stocks that complied with the first four demands.
I used the Portfolio123's powerful screener to perform the search and to run back-tests. Nonetheless, the screening method should only serve as a basis for further research. All the data for this article were taken from Portfolio123.
After running this screen on June 05, 2013, before the market open, I discovered the following five stocks: Black Hills Corp (NYSE:BKH), American States Water Co (NYSE:AWR), Johnson & Johnson (NYSE:JNJ), Mattel Inc. (NASDAQ:MAT) and Inergy LP (NRGY).
The table below presents the five companies, their last price, their market cap and their industry.
The table below presents the dividend yield, the payout ratio, the annual rate of dividend growth over the past five years, the trailing P/E, the average annual earnings growth for the past five years, and the debt-to-equity ratio for the five companies.
BKH Dividend data by YCharts
AWR Dividend data by YCharts
JNJ Dividend data by YCharts
MAT Dividend data by YCharts
NRGY Dividend data by YCharts
In order to find out how such a screening formula would have performed during the last five years, and last 14 years, I ran the back-tests, which are available by the Portfolio123's screener.
The back-test takes into account running the screen every four weeks and replacing the stocks that no longer comply with the screening requirement with other stocks that comply with the requirement. The theoretical return is calculated in comparison to the benchmarks (S&P 500 and Russell 3000), considering 0.25% slippage for each trade and 1.5% annual carry cost (broker cost). The back-tests results are shown in the charts and the tables below.
Five years back-test
The table below presents the five companies originated by the screen formula five years before, on June 28, 2008.
14 years back-test
The table below presents the five companies originated by the screen formula 14 years before, on January 02, 1999.
The high reward to risk ratio screen has given much better returns during the last five years and the last 14 years than the S&P 500 and Russell 3000 benchmarks. The Sharpe ratio was also much better in both tests. Furthermore, the maximum drawdown which normally is much bigger in small portfolio than in the benchmarks was much smaller in both tests.
The five-year average annual return of the screen was at 13.71% while the return of the S&P 500 index during the same period was at 3.24%, and the return of the Russell 3000 was at 3.79%. The maximum drawdown of the screen was at 29.36% while the maximum drawdown of the S&P 500 index during the same period was at 50.92%, and the maximum drawdown of the Russell 3000 was at 51.81%. The difference between the high reward to risk ratio screen to the S&P 500 and Russell 3000 benchmarks was even more noticeable in the 14 years back-test. The 14-year average annual return of the screen was at 15.44% while the average annual return of the S&P 500 index during the same period was only 1.98%, and the return of the Russell 3000 was at 2.65%. The maximum drawdown of the screen was at 34.46% while the maximum drawdown of the S&P 500 index during the same period was at 56.39%, and the maximum drawdown of the Russell 3000 was at 57.07%. Although this screening system has given superior results, I recommend readers use this list of stocks as a basis for further research.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.