Triple Play Income Investing

Oct.27.10 | About: iShares iBoxx (HYG)

One of the phrases almost guaranteed to catch an investor’s attention is “yield,” or more particularly “good yield.” That’s especially so nowadays, with interest rates so close to zero forcing many who would prefer to stay in Treasuries or CDs to venture wherever they can, including the equity markets, in pursuit of income. The good news is that better returns can be generated in this area. The bad news is that you have to learn to live with and think strategically about tradeoffs.

We can approach income investing using a three-by-three framework: three broad issues and three different strategic responses.

Issue One: Safety

One tradeoff involves the potential for a company to reduce or even eliminate its payout, usually because earnings have deteriorated rendering continued payment of the dividend unfeasible. This was a huge issue for REITs, yield superstars of the mid-2000s that got hammered later in the decade after the real-estate/financial crisis forced payouts to shrink or vanish.

The details change, but the story remains the same; the higher the yield, the more you need to worry about the safety of the dividend. There are no free lunches. A yield that looks too good to be true probably is. And if you’re looking at high yields, don’t for a single moment allow yourself to be seduced by nonsense often spouted by pushy brokers about how many years a company has gone without reducing or eliminating its payout. As many REIT and bank-stock investors learned the hard way, an unprecedented deterioration in business will usually be followed by a similarly unprecedented slashing of the dividend.

Issue Two: Yield Versus Growth

Another key decision involves yield versus growth. The idea, here, is that there may often be situations in which it’s better to accept a lower yield in return for a dividend that is likely to grow more rapidly.

This is a vital factor, especially if you’re saving for retirement. Consider a stock that yields 1% today, based, say, on a price of $100 and a $1.00 per year payout. That is not impressive. Suppose, though, that the dividend grows 20% per year. In year five, the dividend would be $2.07. The stock might rise as well so it might still yield 1%, or possibly less, to those who buy in year five. But for you, the $2.07-and-still-rising payout is measured against a $100 investment. And by the way, if you decide to sell the stock, the potential capital gain is nothing to sneer at.

Again, though, there is no free lunch. You’re not likely to get a 5% or 6% yield today on a stock that’s likely to benefit from briskly rising dividends. To benefit from strong growth in the future, you’ll have to expect to start with a lower initial yield.

May investors understand this intellectually, but find it very hard to summon up the willpower to implement such an approach with real money. Yield is something we can see. We know it’s there. And better still, we can immediately reinvest the cash we receive thereby adding a bit more to our returns. (In fixed-income, interest-on-interest is recognized as an important component of return but with equities, it tends to get less attention, perhaps because the absence of a maturity date makes it harder to pin down numerically.)

When it comes to dividend growth, all we have is an expectation. Maybe it will be realized. Maybe we’ll come up short. So there’s a strong and understandable tendency on the part of investors to tilt the scales in favor of yield.

But before rushing headlong in this direction, we have to consider one more issue.

Issue Three: Interest Rate Expectations

The higher the yield (and the corresponding probability that dividends will grow more slowly if at all), the more likely it is that a stock will trade in a fixed-income-like manner and, hence, respond closely to changes in interest rates. If interest rates are high and likely to fall in the future causing a rally in bonds and bond-like stocks, that would be a good thing. Indeed, that’s what we’ve had for the lion’s share of the past generation, and is the reason why so many financial planners were so often able to present such terrific brochures extolling the virtue of income investing.

But that’s not the present situation. Interest rates today are spectacularly low. Looking ahead three- to five-years, the best-case scenario would be for rates to go nowhere. Most likely, they will be higher, perhaps significantly so. That would lead to capital losses in bonds and bond-like stocks. So toss the brochures; they’re irrelevant. Be prepared to think about downward pressure on principal.

Strategy One: Tilting Toward Dividend Growth

The StockScreen123.com “Dividend Income” model falls into this category. It clearly and unapologetically sacrifices current yield in favor of prospects for strong dividend growth. When it comes to dividend safety, the model goes way over the top. It seeks companies that can do far more than merely maintain their payouts; all tests are designed to find firms that can boost payouts a lot in the years ahead. Historical dividend is one factor that is considered but it is by no means the only thing, so the model will, occasionally, show companies whose dividends haven’t grown all that briskly in the past. It also relies on a general-purpose ranking system that is quite stringent regarding corporate fundamentals across the board.

Details and performance data are in the Appendix below. The stocks that currently pass the model are set forth in Table 1. (click on tables to enlarge)

Table 1

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Considering the current state of the market, I think this approach warrants at least some consideration even by those who deep in their hearts, would really prefer to emphasize yield. If there is, indeed, a bond bubble that will crack when interest rates rise, this is the approach that would best be able to cope. If interest rates rise because of improved economic activity, corporate profits would benefit and that would support attractive rates of dividend growth. With regard to the historic growth rates listed above, we know that past performance is no assurance of future outcomes, as the lawyers constantly remind us. But considering where we are in the economic cycle (kicking and screaming and trying to get the economy moving once and for all following a dreadful recession), I suspect the probability of achieving growth akin to what we saw in Table 1 ought to be a heck of a lot better, or at least no worse, than what we know, after the fact, about the situation five years ago.

Strategy Two: Tilting Toward Current Yield

The “Dividend Income – Yield Oriented” model I created on StockScreen123.com is a modified version of the above model. I increased the minimum yield threshold and cut back on the dividend safety factors, not so much as to significantly boost the odds of dividend cuts, but enough to shift the focus away from growth and more toward maintenance of the existing payout. This group of stocks is listed in Table 2.

Table 2

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In terms of share price performance, I have to say I think this strategy is a lot more vulnerable to potential reactions to a bursting of a bond bubble. But when it comes to satisfying a here-and-now desire for immediate income, accompanied presumably, by confidence that one would be able to productively reinvest proceeds not used for other aspects of living, this screen will have a lot more appeal to many who want or need immediate income.

Strategy Three: All Yield All The Way

Yield. Growth. Yield. Growth. Yield. Growth. Z-z-z-z-z-z-z. That’s all well and good for those who are into MBA-speak. Sometimes, though, an investor just wants income without theorizing it to death.

Here’s something that will wake you up: I’m going to suggest that this strategy can best be implemented outside the stock market with junk bonds, or more specifically, an ETF or mutual fund that invests in junk bonds.

Yes, junk bonds are risky. Yes, there are defaults when times are bad. Yes, odd trading occurrences occur in this wild-west-like section of the financial market (though it’s not nearly as wild today as it was when I managed a junk bond fund back in the Drexel era.) But if you really want to max out on yield, you can’t expect to escape these, or comparable, consequences.

And actually, believe it or not, the risks here may still be less than those attached to comparable-yielding stocks. Testing I’ve done on higher-yielding equity strategies showed performance levels that were worse than those any of the variations on junk bond strategies I examined. Frankly, that’s not a surprise. If you’re looking at a stock with a yield of 10% or so, you’re probably facing some very serious baggage. The equity market may not be as “efficient” as academicians suggest, but nor is it completely stupid. The biggest yields are likely to be found among companies that feature every bit as much risk as you’ll find among the multitude of junk-bond issuers.

Given that risk is more-or-less comparable between junk bonds and max-yield equities, I’ll give the nod to junk bond funds (not individual junk bonds – definitely not those – but to funds).

For one thing, there are more names, meaning more diversification. I know the writings of those who advocate focusing on a small number of best ideas. I don’t necessarily buy into that for stocks (a topic for another day) but I’m all the more adamantly opposed when we’re deliberately taking on the sorts of risk we are when we chase yield.

More importantly, perhaps, is the fact that junk bond portfolio managers and analysts have a much bigger palate available to them. As you’ll see if you examine the portfolios of junk bond mutual funds or ETFs, there are many entities that issue junk bonds but don’t have publicly-traded equity. Often, they shun the equity market because their businesses aren’t really designed to achieve the growth bias favored in the stock investors. They tend to be stable low-growth businesses that produce great results for their private owners but would, if public, attract apathy or scorn. The fact that junk-bond funds can hold these names may be a major reason why, according to my tests, they tend to fare better than portfolios of comparable-yielding equities.

By the way, if you’re into concerned with compounding your return by reinvesting interest, be aware that funds are especially appealing, since they typically pay dividends monthly rather than quarterly.

As to market conditions, if you buy into the idea of sustainable-recovery, then you’d necessarily be assuming healthier trends in corporate profits, and hence, diminishing credit risk for these bonds. That, in turn, would make junk bond funds or ETFs a good choice at this time.

If you decide to go this route, one approach would be to select a diversified collection of such funds. Actually, in the ETF world, there are so few, you might just as well own them all.

That may be fine. For what it’s worth, though, my backtesting on StockScreen123 suggests we might be able to improve our situation by doing some modeling in an effort to choose just one junk-bond ETF. Given the very small size of the sample, and the very short amount of time during which more than one was available my conviction in this regard is light. That said, the ETF I’d favor right now is:

iShares iBoxx High Yield ETF (NYSEARCA:HYG) Yield: 8.68%

The Triple Play Income Portfolio

Table 4 pulls it all together and presents the complete Triple-Play Income Portfolio as it stands today. I’m assuming for now that the junk-bond component is weighted 50% and that the others have 25% weightings. It is assumed that the full portfolio, or any of the individual strategies, will be rebalanced every three months. This interval is important, not just because these stocks are less fluid than regular equity investments and need more time to work out than the one or four-week periods with which I usually work, but with the stocks, it is important that we hold each long enough to collect the typically-once-per-quarter equity dividends.

Table 4

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I trade on FolioInvesting.com, so for me, commissions are irrelevant. (I pay a flat annual fee for unlimited trading during the firm’s two daily “trading windows.”) But even for others, trading costs may be reasonable considering we rebalance only once every three months. If you want to implement a strategy like this and need to trim commissions, you might consider eliminating Strategy Two and giving a higher weight to Strategy One.

APPENDIX

The “Tilting Toward Dividend Growth” model begins with a screen that's built as follows:

  1. Basic liquidity rules: OTC stocks are barred, market capitalization is at least $250 million, and share price is at least 5
  2. Eliminate companies classified in the Miscellaneous Financial Services Industry, most of which are investment companies and funds and not the kind of stocks sought by most users
  3. Eliminate ADRs
  4. Stock yield is at least 50% of yield on 10-year Treasury (stocks are expected to yield less than treasuries since dividends grow, while treasury interest payments do not)
  5. Stock yield plus 5-year dividend growth rate is at least 50% above yield on 10-year Treasury
  6. 5-year dividend growth rate is at least 10% above the industry average
  7. Trailing 12 month payout ratio can be up to 25% above industry average
  8. 5-year capital spending growth rate is positive at least 90% of industry average (suggests pent-up capital spending needs are not likely to compete heavily with dividend payments)
  9. Current yield relative to industry average is no higher than 10% above the five-year average relative yield (a test that shows no special market concern regarding the safety of the dividend)

From the stocks that pass the screen, we select the top 15 based on the StcokScreen123 QVG Ranking system, which has three components:

  1. Quality (return on capital, margin, turnover and financial strength)
  2. Value (price-earnings, price-sales, price-cash flow, and price-book)
  3. Growth (long- and short-term sales and EPS growth and acceleration)

If, at any point, fewer than 15 stocks pass the screen, we assume that portion of the portfolio is allocated to cash. In other words, no stock ever starts a three-month period with a stake higher than 6.7%.

Figure 1 shows the performance record of the screen assuming that the model is refreshed and the list reconstituted every three months.

(click on figures to enlarge)

Figure 1

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The “Tilting Toward Current Yield” model begins with a screen that's built as follows:

  1. Basic liquidity rules: OTC stocks are barred, market capitalization is at least $250 million, and share price is at least 5
  2. Eliminate companies classified in the Miscellaneous Financial Services Industry, most of which are investment companies and funds and not the kind of stocks sought by most users
  3. Eliminate ADRs
  4. Stock yield is at least 150% of yield on 10-year Treasury
  5. Current yield relative to industry average is no higher than twice the five-year average relative yield (allows for some measure of market concern regarding safety of dividend so long as it’s not exorbitant)

From the stocks that pass the screen, we select the top 15 based on the StcokScreen123 QVG Ranking system, which has three components:

  1. Quality (return on capital, margin, turnover and financial strength)
  2. Value (price-earnings, price-sales, price-cash flow, and price-book)
  3. Growth (long- and short-term sales and EPS growth and acceleration)

If, at any point, fewer than 15 stocks pass the screen, we assume that portion of the portfolio is allocated to cash. In other words, no stock ever starts a three-month period with a stake higher than 6.7%.

Figure 2 shows the performance record of the screen assuming that the model is refreshed and the list reconstituted every three months.

Figure 2

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The “All Yield All The Way” Model selects the top rated domestic junk-bond ETF based on the following factors:

  • Sharpe Ratio (50%)

1. 1-Year Sharpe Ratio - higher is better (50% of this subcategory)

2. 2-Year Sharpe Ratio - higher is better (50% of this subcategory)

  • Sortino Ratio (50%)

1. 1-Year Sortino Ratio - higher is better (50% of this subcategory)

2. 2-Year Sortino Ratio - higher is better (50% of this subcategory)

Figure 3 shows the performance record of the screen assuming that the model is refreshed and the list reconstituted every three months.

Figure 3

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To get a sense of why I prefer a junk bond fund to very high yielding equities, consider this variation of the “Tilting Toward Current Yield Model," where I modify the yield filter by looking for stocks whose current yield is at least 175% of the treasury yield. This change adds about three percentage points to the average portfolio yield, but detracts considerably from the market performance of the shares, as seen in Figure 4.

Figure 4

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If we compare the three main approaches, it looks as if Strategy One, the growth model, fares poorly. Indeed, on a start-to-finish basis, its low yield did cause it to underperform:


Strategy One (growth-oriented equities):

Start-to-finish gain: 68.6%

Annualized rate of gain: 5.6%

Estimated Typical Yield: 2.8%

Estimated Typical Annual total Return: 8.4%

Strategy Two (yield-oriented equities):

Start-to-finish gain: 54.4%

Annualized rate of gain: 4.6%

Estimated Typical Yield: 8%

Estimated Typical Annual total Return: 12.6%

Strategy Three (junk bond ETF):

Start-to-finish gain: 80.8%

Annualized rate of gain: 6.4%

Estimated Typical Yield: 9.5%

Estimated Typical Annual total Return: 15.8%

But remember the warning against over-reliance on past performance. The growth-oriented strategy fared worst during the most recent years, the period dominated by crisis and fledgling recovery. During the more “normal” years, it was the top performer. Consider the 2004-06 period:


Strategy One (growth-oriented equities):

Start-to-finish gain: 55.8%

Annualized rate of gain: 15.9%

Estimated Typical Yield: 2.8%

Estimated Typical Annual total Return: 18.7%

Strategy Two (yield-oriented equities):

Start-to-finish gain: 11.3%

Annualized rate of gain: 3.6%

Estimated Typical Yield: 8%

Estimated Typical Annual total Return: 11.6%

Strategy Three (junk bond ETF):

Start-to-finish gain: 9.5%

Annualized rate of gain: 3.1%

Estimated Typical Yield: 9.5%

Estimated Typical Annual total Return: 12.6%

As noted in the main article, assessment of market conditions is an important decision point. There is good reason to believe that once we leave recession behind us, Strategy One may again deliver the best returns.

That said, we’re not out of the woods yet. This is why I am presently giving Strategy One a weight of just 25%. There will be opportunities to change it later on.



Author's Disclosure: Long ATR, KO, ADM, CPO, GIS, PG, CVX, ATNI, TJX, CASY, RDK, SYY, BBY, TE, WR, KMB, ARLP, BPL, CINF, BMY, T, BCE, RRD, FL, ALE, CHG, D, DPL, PNM, WGL, HYG