Sometimes, I think the world has lost a lot since the good old days, when an income investor could simply pick up a few high-grade corporate bonds and some utility stocks and call it a day. It’s so easy for such investors to articulate a goal: Income. How hard was that? Unfortunately, implementation in the modern era can be a nightmare.
For one thing, interest rates remain ridiculously low. Commentators speak of this as an unconditional blessing, but such notions are hogwash to suppliers of capital; i.e. those who see interest as an income item rather than an expense. Even so, high single-digit and even double-digit yields can be found. But these tend to be surrounded by so many dire warnings as to almost make smoking seem blasé. Then, too, we have the financial preachers who extoll the virtues of dividend growth so much as to almost make income-seekers feel guilty if they aren’t loading up on stocks like Microsoft (MSFT) or Wal-Mart (WMT), with yields of 2.5% and 2.8% respectively.
Let’s try to make sense of this by seeing if we can identify some sort of “ideal” dividend yield; one we can aim for if we don’t want sleepless nights prompted by fear of big losses, or visions of growth which may or may not actually materialize.
Remember: There Are No Free Lunches!
We’re going to start by asking you to recognize and truly accept a very important assertion, not just for income investing but for all kinds of investing:
- There are no free lunches in the financial markets, so don’t think you’re going to put anything over on anybody.
Nowadays, many investors have heard time and again of how Wall Street is an ignorant mob waiting to be outwitted by you. There’s some pretty impressive pedigree behind such notions. One example is the mythological Mr. Market character invented by Ben Graham and popularized by Warren Buffett. (Mr. Market is a supposedly emotionally unstable being who feels elated one day, so offers you outrageously high prices for your stocks, and deeply depressive the next day whereupon he’ll only offer ridiculously low prices. You, supposedly, know better and will focus on the right price.)
So you, as an income investor, may look at a 15% yield, attribute it to a bout of depression on the part of Mr. Market that is causing him to price the stock at a needlessly low level and you--a keen student of Graham and Buffett--may rush to buy.
Don’t do it! Or at least don’t do it without doing deep research that reflects the risk you’re facing.
Regardless of how intrigued you are by the romantic notion of outfoxing Mr. Market, there’s no getting around the fact that we’re living today in the information age. It’s easy for everyone, including Mr. Market and even including complete novices, to get hold of basic information about the securities in which they invest. Different investors make different choices regarding how big a collection of facts they’ll accumulate, which facts they’ll analyze and which ones they’ll emphasize most heavily. Few, however, will be completely out of it when it comes to basic information.
Therefore, if we’re in an environment characterized by CD yields at or below 1% with income investors finding so many equities with yields in the 3%-5% range, you should stop and think before you buy a stock with a double-digit yield. Similarly, if you examine the portfolio of a so-called income fund and see holdings with yields of, say 1.5%-2.5%, don’t be in a hurry to call the fund manager to complain. These managers are presumably experienced investment professional and are surrounded by batteries of lawyers insisting they follow the prospectuses. So it will probably be worthwhile to try to figure out what they have in mind.
Making Sense Of the Menu
We’re going to consider, here, how to identify what I’m going to call an Ideal Total Return (ITR), which is going to consist of two components:
- Capital Gains/Losses
Suppose we encounter two stocks, one with a yield of 2.5%, and the other with a yield of 12%. Assuming ITR is equal for both (as we should if we’re going to recognize that nobody is getting a free lunch), we can assume capital gains are likely for one while capital losses are anticipated for the other.
Now let’s try to calculate Ideal Total Return through a method which has a pretty impressive pedigree in its own right, a Nobel Prize winning pedigree in fact. Specifically I’m referring to William Sharpe’s Capital Asset Pricing Model. (NOTE: We’re going to be doing some math here, but don’t worry. Professor Sharpe did the hard stuff when he derived the model. What he’s given to us is an equation that is well within the capabilities of the typical fourth grader.)
This Capital Asset Pricing Model (CAPM) is not something you should take literally. It’s vital for finance students who expect to pass their exams, but for those of us in the real world, it can be terrific for making some simple back-of-the-envelope, head-start calculations that will lead us to ITR and, of course, Yield. However, the inputs, the numbers we’re going to plug in, are highly debatable, so we’re not going to go crazy over the exact figures we use. This is just a guide, to help us understand why, in a market where most participants are pretty well versed in what’s going on, one stock could yield 2.5% while another yields 12%.
The CAPM formula is as follows:
ITR = RF + (B * MRP)
- ITR = Ideal Total Return
- RF = Risk Free Rate of Return
- B = Beta (a measure of the volatility of an individual security compared to that of the market)
- MRP = Market Risk Premium
Let’s put this to work:
- For RF, the risk-free rate, it’s standard to use a Treasury rate. There is considerable difference of opinion as to which rate should be used. The bad news is that the debate is unresolvable; there is no universally correct answer. The good news is that we can come up with something that’s good enough for our purposes. I’m going to use a ten-year rate since I have data for it in StockScreen123.com, the platform I use, and can therefore reference it directly in income models if I wish. (When you have an unresolvable issue like that, resorting to practicality is a good solution!) As of this writing, I’ll assume it’s 3.5%.
- For B, Beta, we’re supposed to use 1.00 if a security is expected to be exactly as volatile as the market (I’m assuming that means the S&P 500; others may use different measures). If we expect the security to be 70% as volatile as the market, we’d set beta to 0.70. If we expect 15% more volatility, then we’d set beta to 1.15. etc., etc., etc. If I look at Betas for typical income stocks as of this writing, I’ll find that the average is about 1.00. But the data, which is based on history, reflects considerable volatility in recent years in financial stocks, a long-time staple of income investing. What happened there was likely a once-in-a-lifetime experience. I prefer to go forward with an assumption of a more normal environment. Based on pre-crisis StockScreen123.com observations, I think 0.60 is more representative of a normal income-stock universe.
- MRP, Market Risk Premium, is very hard to estimate. It’s the difference between the return on the market and the risk-free return. This is the annual return investors expect to receive in order to entice them to bypass risk-free treasuries and accept equity-market risk. If you look at historical data, you can find risk premium numbers all over the place (even negative numbers) depending on the time period you examine. This is why it’s so important to view CAPM as an approximate starting point and not a prescription for absolute truth. There are many studies out there purporting to calculate risk premiums. I’ll avoid the debate and just pick a number that others have cited as being a long-term average: 5%. (Feel free to plug in your own assumption if you wish.)
Notice how I came up with the numbers I need. None of these are absolute. They are all guesstimates at best. That’s OK. Notwithstanding a lot of high-brow rhetoric tossed around by gurus, experts, etc., guesstimates are the best any of us can ever do when we invest; after all, we’re dealing with the future, and nobody knows what that will bring. That inspires our second important mantra:
- Reasonable approximation is superior to false precision!
Now that we have reasonable guesstimates for the numbers we need, let’s calculate ITR (Ideal Total Return):
ITR = 3.5% + (0.60 * 5%)
- ITR = 6.5%
That’s it. The starting point for my evaluation of equity-income investments is an annualized Ideal Total Return of 6.5%.
So what about those other yields we considered? That’s easy to decipher. Knowing as we do that Total Return is Dividend Yield plus capital gain/loss, we can assume that if a stock yields 2.5%, that’s reflecting a market assumption that capital gains will average 4% per year over the long term. Conversely, if a stock yields 12%, that’s reflecting an assumption of annual capital losses amounting to 5.5%.
Let’s not get crazy over the exact numbers. Stocks bounce around a lot and for all we know Microsoft could be 15% lower this time next year, and some double-digit yielding stocks could be up. Models like CAPM (and others such as dividend discount, discounted cash flow valuation, Back Scholes option pricing, etc.) are theoretical starting points. However, when we use them in that spirit, they can be great. When we take the results literally and commit money, things can get ugly.
Here is what we want to learn from our brief CAPM exercise:
- The lower a stock’s yield, the bigger our capital gain expectations should be. This sounds like a truism, but all too often, we let it recede too far into the background. We’re so willing nowadays to tolerate zero dividends or very low yields, we too often fail to hold corporate executives to account for their failure to produce the growth that’s needed to induce us to forego the income we can so easily get elsewhere.
- The bigger the yield, the more vigilant we need to be in examining risks, including the potential for the weak fundamentals to cause the dividend to be reduced or omitted.
- The closer a yield today is to 6.5%, the more likely it is that we can assume no significant stock-price movement one way or the other, absent a change in overall market conditions (if the risk-free rate jumps to 5%, the Ideal total Return will move up to 8%, which means stocks yielding around 6.5% will have to fall nearly 20% absent a quick and sustainable increase in the dividend; conversely, if the risk-free rate falls to 3%, stocks yielding 6.5% should appreciate about 8% all else being equal).
We need to distinguish between company risk and market risk. (The CAPM is one of the concepts that taught investors to do this.) For this article, I’m assuming market conditions will not change.
There are certain academicians who’d be happy to end the discussion right here. They assume the market is efficient and that there’s no room for anybody to consistently do better, thus raising converting the no-free-lunch mantra to a much more formal doctrine (the efficient markets theory). Others, including myself, won’t go that far. I want to introduce one more mantra: Mr. Market should be respected but he’s no more perfect than we are; still it’s OK to disagree so long as you do so based on research rather than a knee-jerk response.
Dividend-growth investors can and do look for situations where actual growth is likely to be better than the ivory-tower rate of growth implied by a stock’s yield and CAPM. Many contributors to Seeking Alpha’s Investing for Income area aim to do this very thing.
Yield hogs, or at least those that legitimately address the inherent risks, can and do seek out situations where reality is likely to be less grim than the market expects. My Prudent Yield Hog series aims to accomplish this.
Both are exciting approaches. But income seekers should never underestimate the importance of core middle-of-the-road strategies that focus on stocks whose yields come reasonably close to the Ideal Total Return. One example of this is the middle-component of my Triple Play Income strategy, the one that lies in between a growth-oriented protocol and a reach for yield.
This isn’t to say that aiming near Ideal Total Return can’t give us gains. Indeed, based on the attention investors give to the dividend-growth and yield-hog approaches, we might almost argue that the core approach is something of a step child. In market terms, step child translates to “inefficient.” That means if we do a good enough job seeking core income stocks that are likely to stay core (i.e. less likely to deteriorate below that status), we might find some unexpected capital gains. We don’t necessarily look for them, but we won’t refuse to bank them!
Figure 1 (click to enlarge) is a list of stocks that currently make the grade under a variation of the Core portion of the Triple Play strategy, one where yield has been more tightly targeted to CAPM-determined Ideal Total Return. (Details about the strategy and performance test results are presented in the Appendix below.)
The average yield is not 6.5%. But remember, we’re dealing, here, in reasonable approximations. The 6.22% average we see is close enough.
The model begins with a screen that's built as follows:
- Basic liquidity rules: OTC stocks are barred, market capitalization is at least $250 million, and share price is at least $5
- 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
- Eliminate ADRs
- Stock yield is at least 90% of the CAPM-implied Ideal Total Return and no higher than 110% of that ideal
From the stocks that pass the screen, we select the top 15 based on the StcokScreen123 QVG Ranking system, which has three components:
- Quality (return on capital, margin, turnover and financial strength)
- Value (price-earnings, price-sales, price-cash flow, and price-book)
- 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 A-1 (click to enlarge) shows the price-only performance record of the screen assuming that the model is refreshed and the list reconstituted every three months.
We see, here, quite a bit of excess return, positive in most periods but, as with most strategies, negative in 2007-08. As noted, CAPM is a theoretical expectations-oriented framework and reality often deviates.
Some of the capital gain/loss is attributable to market movements and some to the QVG ranking systems I used to select among stocks meeting the target yield threshold. Theory-geeks would, obviously, prefer that the red line be straighter. But I don’t know too many real-world investors who’d turn down excess return if they can get it (at least when it’s positive overall).
Disclosure: I am long NS, UNTD, USMO.