How to Be a Prudent Yield-Hog

by: Marc Gerstein

It almost seems redundant to suggest that income-oriented investors place great emphasis on yield. After all, collecting income is often seen as an antidote to the seemingly more tenuous pursuit of share price appreciation. I and others can and do write till we’re blue in the face about how dangerous it can be to get too carried away by the chasing high yields (the higher the yield, the greater the business risk and the more likely it is that the dividend will stagnate at best or be cut). But emotions are a factor: When yields rise above 10%, it’s amazing how willing we think we are to accept the risks of capital loss. Beside emotion, we have to consider need when we actually want or have to spend cash generated by investment portfolios.

In other articles, such as the Triple-Play income strategy I introduced recently, I offered one way to balance a quest for yield with considerations of growth and safety, one that divides the income universe into three aspects (tilting a bit toward growth, tilting a bit toward yield, and full-out yield) and leaves it to the investor to decide how to allocate among them. Now, I want to change it up a bit. The strategy being introduced here is for people who want to maximize yield, and minimize hemming, hawing and preaching.

Seeking Yield – A Basic Quest

You’d think this would be no big deal, today, given all the free screeners on the internet. All that need be done is articulate one rule, “Yield greater than 12%” for example, sort the results by yield, and pick however many stocks you want from the top. How good is that!

Actually, it’s not so good.

Figure 1 shows the results of a backtest for that strategy from 3/31/01 through 2/28/11 assuming 15 positions and re-balancing every three months.

Figure 1

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(Click charts to enlarge)

We’re used to seeing big losses in 2008 (most strategies suffered at that time), so this approach can’t be condemned for that. Notice, though, that the portfolio started rolling downhill as far back as late-2004,well before the crisis took hold, and that it didn’t participate in the 2009-10 recovery enjoyed by so many others. It’s easy to talk about accepting capital-loss risk when the yield is well up in double digits, but it becomes a lot harder when we realize how significant the losses can actually be. (By the way, I could show a much, much better backtest result if I wanted to strip out some basic universe-defining filters, but the stocks you’d then see, at or near penny-stock levels, aren’t the sort income investors would want to own.)

By the way, the chart does not include the impact of dividend payments. It shows price performance only. But can you imagine any dividend-receiving scenario that would have made the overall 79.1% loss (minus 14.65 per year) acceptable?

Seeking Yield – Tweaking The Search

We shouldn’t be surprised at what we saw above. Any investment guru will recognize this as an example of the dangers of blindly chasing yield. So let’s do an experiment. Let’s tweak the strategy to make the yield-chase a little less blind. In addition to the aforementioned universe-defining filters and my 12% minimum-yield threshold, I also require that the stock rank at least 50 (zero being worst and 100 being best) in the general-purpose QVGM (quality-value-growth-momentum) ranking system I built. Here are the backtest results.

Figure 2

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It’s still bad. The overall capital loss amounted to 54.2%, and on an annualized basis, that works out to 7.5%. But it’s less bad than what we saw in the first test, and the question of whether it’s possible to get enough income to make a 7.5% annual loss tolerable is, at least, a legitimate topic of conversation. Assuming an average portfolio yield of 14%, which is what we often saw, the total return would amount to about 6.5% per year. If one doesn’t really need all the money and can reinvest all or some of that in income-bearing securities, so much the better.

Speaking for myself, it’s not the sort of strategy that appeals to me. That’s still a lot of loss. Moreover, there were quite a few occasions when only seven stocks or fewer made the screen leaving me with less diversification than I’d like to have, especially when aiming so high in terms of risk. Also, as with the approach depicted in Figure 1, the portfolio’s troubles can’t be entirely blamed on the 2008 financial crisis: It was going bad beforehand and didn’t recover much afterward.

Nevertheless, Figure 2 is significant. It offers some hope that we might be able to pre-qualify our universe in such a way as to make it feasible to actually be yield hogs. What I did here was not especially bold. I took a ranking system designed to help select stocks in general, not high-yielding stocks in particular, and instead of using the model to identify the best, I just used it to try to eliminate the most likely basket cases. That alone generated enough improvement to at least justify serious conversation around the yield-hog approach. More important, it whets the appetite for the prospect of generating better returns using a more thoughtful approach to pre-qualifying the universe.

Seeking Yield – Getting Serious

Imagine you’re a sales person. If you are or were in sales, put on your professional hat for a moment. Assume you’re going to prospect for new customers, whether through cold calling or any other method. You have two lists of names available to you. List A is large, but has a random quality, like a copy of names drawn from a White-Pages telephone book. List B is smaller, but is limited to prospects for which there is some indication that they may be favorably inclined toward your product or service. Which list would you like to use?

Not only are you likely to choose List B, you may even pay up to get your hands on it. This doesn’t mean everybody listed on B will buy from you; in fact, the overwhelming majority may still hang up on you. But it’s likely, very highly likely, that List B will be much more productive than List A, so much so, that your ability to have a successful sales career may depend on your ability to get lists like B and avoid those like A.

Pre-qualification can be a powerful difference maker. Moreover, this activity is not limited to sales people. Any time anyone uses a screen and/or ranking system to generate stock ideas, they’re pre-qualifying the prospects before they roll up their sleeves and review individual candidates in depth.

The Prudent Yield Hog strategy is all about pre-qualification.

Like any yield hog, we’re going to grab the highest yields we can find. The difference, though, is the list from which we choose. The naïve yield hog is like a sales person who tries to make a living using List A, the biggest list he or she can find. The Prudent Yield Hog is like a sales person who takes the trouble to find List B, a pre-qualified list that shows only those candidates that have already been evaluated and who seem, based on some sort of objective evidence, to be plausible candidates.

Actually, we have two layers of pre-qualification.

The first is a screen1 that sets broad boundaries on our income-stock universe. It starts out just like the ones referred to in connection with Figures 1 and 2. It weeds out the least liquid stocks, ADRs (data issues involving ADR dividends can sometimes produce odd results) and companies classified as Financial Services (Miscellaneous), most of which are closed-end mutual funds. Then it continues to add some yield boundaries. As you would expect with any such screen, there’s a lower limit (two-thirds of the ten-year Treasury rate). Unlike most income screens, however, this one goes further. It adds an upper boundary; five times the ten-year treasury rate. This alone goes a long way toward eliminating the riskiest situations. Given where treasury rates are today, don’t expect the see stocks yielding 20%.

Finally, the screen requires that each stock meet a minimum threshold under a ranking system designed specifically to qualify potential income stocks. This is, perhaps, the most flexible part of the screen. I set the default threshold score at 60 (out of a possible 100). One who wanted to raise the threshold would get a more conservative, but lower-yielding, list. Lowering the threshold would have the opposite effect.

Not surprisingly for an income stock, this ranking system considers payout ratio (relative to industry peers). Also not surprisingly, it considers growth; not just dividend growth, but sales and EPS growth, which make dividend growth feasible. Very surprisingly, it contains a hefty dose of sentiment-oriented factors. Having already screened out the riskiest situations, it’s now reasonable to assume a stock won’t rate well under sentiment factors unless investors are assuming business trends that are no worse than decent, and more importantly, good enough to at least maintain the dividend.

Click here to see details of the screen and here to see details of the ranking system.

Figure 3 shows the results of a 3/31/01 through 2/28/11 backtest of the strategy.

Figure 3

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The comparison above between Figures 1 and 2 suggested we could boost overall performance by even a simple pre-qualification of candidates before we reach for the highest yields. Comparing Figures 2 and 3 shows we can further boost performance by more thoughtfully pre-qualifying under a protocol designed specifically for income stocks.

The overall percent gain for the Figure-3 portfolio was 106.7%, equivalent to an annualized rate of plus 7.6%. If we add that to an average portfolio yield of, say, 9%, we’d be looking at an annual total return above 16%.

Obviously, this isn’t like a bond that can be counted upon to return 16% per year. We all know the lingo about past performance not assuring future results, and saw a crushing dose of that in 2008. But unlike what we saw in Figures 1 and 2, the bad times here were largely associated with the financial crisis that hit Wall Street and the economy as a whole. Also, unlike the naive yield-hog approaches, this one participated in the post-2008 recovery.

Table 1 shows the stocks that currently make the basic yield-hog portfolio (with the rating threshold set at the default 60 level).

Table 1

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Real Estate firms, typically REITs, are at the top of the yield-sorted list. Surprise, surprise! Another great non-surprise: these are the riskier sort of REITs, the ones that invest in mortgages and the like. (Less-risky property-owning REITs would find it hard to make it into this portfolio at this point in time since their yields tend to be low by income standards, due to prior dividend cuts and/or price run-ups in anticipation of better days.)

Mortgage-type REITs are not easy to swallow. They were right, smack, in the epic-center of the financial explosion and even under the best of conditions, capable credit underwriting has typically been seen as being riskier than ownership of and day-to-day management of property. But that view may be oversimplified. Property-owning REITs are not necessarily a picnic today. There’s been a lot of overbuilding in certain types of commercial real estate (especially retail) and going forward, evaluating a package of mortgages may be a piece of cake compared the burden of having to fill the properties with enough rent-paying tenants, especially since the mortgages already blew up so capable REIT operators can now distinguish between which loans are priced properly in the secondary market and which ones aren’t.

Ultimately, though, it all comes back to being a yield hog. Even prudent ones have to take risks. We try to moderate the risks, and the backtest results indicate the strategy has done a capable job of that. But there’s still a difference between being a prudent yield hog and a prudent income investor in general (one for who yields would more likely be in the 3%-6% range).

REITs aside, we also see strong exposure to communications firms, albeit not the Verizons (NYSE:VZ) of the world. Again, if you want to be a yield hog, you’ll have to reach a bit, as we do here, for companies far removed from the mainstream. We also see exposure to some other typical income plays such as energy, shipping energy. Most interesting, perhaps, is the column that shows market capitalizations. Notice that these issues are generally a lot smaller than what income investors typically see. This reinforces the point made with communications: to get good yield plays without getting reckless, we probably will often have to look at smaller, less visible, companies.

If I were to dial up the risk a bit, by reducing the rating threshold below 60, we’d be seeing more REITs. If I opted for more conservatism, more energy partnerships would be present.

Anyway, the portfolio shown here has an average yield of around 9% which seems not bad at all for a portfolio I’d classify as having mid-level risk in the Prudent Yield Hog context.

Disclosure: I am long VLCCF.