Refining the Triple Play Income Strategy

by: Marc Gerstein

I created the Triple Play Income Strategy a few months ago to help income-oriented investors zero in most effectively on the kinds of stocks that best suit their needs and risk tolerances. (Click here to see the introductory article.) This is not as simple as it sounds. Many assume that saying “I want income” amounts to a clear, unambiguous, statement that should point them or their financial advisers directly toward the right set of securities. That is absolutely not the case. Income investing involves a variety of valid but often contradictory considerations.

The Triple Play approach chooses 15 stocks for each of three separate income-oriented styles:

1. A Core Income Strategy

This is for investors who want a decent yield and as little bother as possible (preferably none at all) with other issues such as the safety of the payout, the risk of loss due to fundamental deterioration, the potential for dividend growth, or the need to supplement yield with good share price appreciation.

The selection criteria I’m now using for this part of the strategy is the same as that which I introduced recently in a Seeking Alpha article entitled Navigating the Yield/Growth Tradeoff. In that article, I explained that there are no free lunches in the financial markets and that you should not expect to put anything over on anybody. A very high yield is likely to suggest potential losses, typically from poor fundamentals leading to dividend cuts or eliminations. Conversely, very low yields may suggest good potential for extra return coming from growth of the dividend and appreciation for the stock.

Core income holdings are those for which expected losses or extra gains are likely to be negligible, meaning we’re pretty-much depending on yield (and income we receive by reinvesting dividends) to give us all of our return which, for most income investors, is perfectly fine. The down-side is that many such entities are limited partnerships (often involved in energy distribution). Business-wise, that’s OK and many find the returns they realize to be quite satisfying. The downside is administrative: Ownership of such entities involves extra tax-related paperwork (Form K-1), forcing many investors to bear grunts and snarls from their accountants.

Here’s a review of the core strategy as presented in the Yield/Growth Tradeoff article:

  • Preliminary factors: No OTC stocks; no ADRs; no stocks classified as Financial Services (Miscellaneous) since such stocks are often closed-end funds; market cap at least $250 million; and stock price greater than or equal to 5
  • Stock’s yield must be at least 90% of what I define as “Ideal Total Return,” and no higher than 110% of that ideal. I define Ideal Total Return with reference to the Capital Asset Pricing Model, which is the risk-free interest rate (I use the 10-year treasury rate, which is now 3.3%) plus the equity-risk premium (a bonus investors seek for taking on the risk of equities for which I assume 5%) multiplied by beta, a measure of a stock’s volatility. I assume a beta of 0.6, based on what’s typical under normal market conditions for the kinds of stocks income-seekers usually favor. In an ivory-tower world, the price of a stock whose yield is equal to Ideal Total Return should not move materially up or down
  • Sort the passing stocks from best to worst on the basis of the StockScreen123 QVG (Quality-Growth-Value) ranking system I created on StockScreen123, thus targeting the most fundamentally appealing among the stocks in the target yield range, and select the top 15

Figures 1 and 2 show the results of a StockScreen123 back-test of this strategy (it’s assumed all securities are held for three months, long enough to collect each quarterly dividend).

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Figure 1

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Figure 2

As noted, in an ivory-tower world, we should see no meaningful share price increases or declines. There is, however, often a gap between theoretical ideals and day-to-day realities. We saw in Figure 2 that share prices rose quite nicely giving us returns well above our targets.

Obviously, anyone who invested this way would feel great. So much the better if we can come close to replicating that experience going forward. But as much as we appreciate the back-test numbers we see, we have to remember the mantra about past performance not assuring future outcomes. Frankly, we should be happy if we can wind up with just the 6%-7% annual total return we’re targeting, which is a heck of a lot better than what’s available on most alternatives income seekers are seeing nowadays.

Figure 3 shows the current list of stocks.

Figure 3

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2. A Dividend Growth Strategy

Authors and gurus tend to favor this approach because it brings us into areas that are very familiar and intellectually comfortable; use of fundamental analysis to identify good situations, those least likely to find it necessary to reduced dividends and most likely to be able to raise their payments in the years ahead.

For many income investors, this group can be perplexing. Yields are low, meaning (i) there’s less income to spend or reinvest (ii) a bigger portion of investment success depends on realization of favorable, but uncertain, expectations about the future, and (iii) we’re unable to brag to friends about the great yields we discovered.

On the plus side, dividend growth is a vital element of equity valuation theory and goes to the heart of why any income-seeker should ever consider equities at all, as opposed to fixed income, where yields will almost always be higher assuming comparable credit/payment risk. If, in the future, we find ourselves faced with rising inflation and/or interest rates, we may need dividend growth to help us avoid or mitigate capital losses.

Since having introduced the Triple Play, I revised the dividend-growth component to relay a lot more on Mr. Market to point me in the right direction. There’s considerable intellectual romance to the idea of creating exotic tests or rules in order to outthink the Wall Street herd. But that sort of thing is often unproductive (burdening a strategy with more baggage than it needs impedes, rather than helps it).

In today’s information age, you have to assume the market knows the basic facts. You can interpret them differently, but assuming mass ignorance often comes more from hubris than insight. So in that spirit, when I see a stock yielding, say, 2%-4%, I’ll recognize that the market is assuming that dividend cut is not on the table. Given that, I won’t burden my model with tests involving payout ratios, cash flow coverage, etc. (which would be more appropriate to a yield-hog strategy) and focus on a demonstrable propensity to raise dividends and generally-good corporate fundamentals.

Here’s the Dividend Growth Strategy I’m now using:

  • Preliminary factors: No OTC stocks; no ADRs; no stocks classified as Financial Services (Miscellaneous) since such stocks are often closed-end funds; market cap at least $250 million; and stock price greater than or equal to 5
  • Yield is at least 50% but no more than 125% of the 10-year treasury yield (such a range assures something high enough to be plausible as an income candidate while remaining low enough to indicate Mr. Market has little concern over dividend security and also has healthy expectations regarding dividend growth prospects)
  • The divided must have experienced a positive rate of growth over the past year, the past three years and the past five years
  • The stock must rank at least 75 (on a scale of zero to 100) under the QVG (Quality-Value-Growth) ranking system, thus providing objective support to Mr. Market’s aforementioned assumption of fundamental merit
  • Sort the passing stocks from best to worst on the basis of a Dividend-Growth Combination ranking system I created on StockScreen123 (40% of the score comes from a ranking of the stocks’ yield, 30% from a ranking of its latest annual dividend growth, 20% from a ranking of its three-year dividend growth, and 10% from a ranking of its five-year dividend growth) and select the top 15 stocks

Figures 4 and 5 show the results of a StockScreen123 back-test of this strategy (it’s assumed all securities are held for three months, long enough to collect each quarterly dividend).

Figure 4

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Figure 5

Interestingly, performance here trailed by a bit the results we saw (in Figure 2) for the Core model. But if we’re wondering about the probability of future results resembling what we see in the historic back-test, I’d say there’s a better chance of success with this strategy because we are likely to be exposed much more heavily to companies capable of delivering reasonable growth. That could be important if we get into a market environment characterized by rising interest rates.

Figure 6 shows the current list of stocks.

Figure 6

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3. A Yield-Hog Strategy

When I was in school, I assumed investors wanted to maximize returns (and, minimize risk, or at least so they said in the upper-level courses). Thirty years in the real world has taught me that this view is naïve, and the recent popularization of “behavioral finance” indicates others have come to feel the same way. Human emotion is part of the process and will remain so no matter what anybody says. I couldn’t begin to discourse on the full scope of this field, but for now, suffice it to say that “bragging rights” are important.

For income investors, this means very high yields. Actually, though, a successfully-executed yield-hog strategy can also work pretty well in conventional finance terms since it will produce a larger flow of here-and-now funds that can be spent or reinvested.

The hard part is execution. Recalling that Mr. Market offers no free lunches, we have to understand that higher yields are associated with lower-quality situations that involve greater risk of loss. This is where a lot of authors and gurus throw up their hands and say “Don’t do it.” I don’t run away from situations like this. Quite to the contrary, the initial version of the Triple Play proposed using high-yield (“junk”) bond ETFs for this high-risk, high-reward component.

Based on what I perceive to be a preference to stick with equities, I’m now substituting the Prudent Yield Hog strategy I introduced a few months ago on Seeking Alpha, wherein I seek the 15 highest-yielding stocks drawn not from the equity market as a whole but from a sub-set that has been carefully pre-qualified based on factors I believe can moderate the risk of loss.

Here’s the Prudent Yield Hog strategy:

  • Preliminary factors: No OTC stocks; no ADRs; no stocks classified as Financial Services (Miscellaneous) since such stocks are often closed-end funds; market cap at least $250 million; stock price greater than or equal to 5; and average daily volume over the past 60 trading days must be at least 50,000 shares
  • The yield must be at least 2/3 that of the 10-year Treasury but no higher than five-times the Treasury rate (exceptionally high yields suggest exorbitant risk of dividend reduction or elimination
  • The stock must rank 50 or better (on a scale of zero to 100) under a rating system I developed for StocjkScreen123 specifically for the purpose of evaluating higher-yielding stocks. This ranking system has three equally weighted components: (a) Growth Profile (based 60% on dividend growth, 30% on EPS growth and 10% on sales growth); (b) Dividend Security (trailing 12 month payout ratio sorted relative to industry peers, the lower the better); and (c) Investor Sentiment (based 30% on price signals, 30% on technical signals, and 40% on indicators of investor comfort); StockScreen123 subscribers can, if they wish, adjust this threshold between 40, a more aggressive approach, and 70
  • Sort the passing stocks from highest to lowest based on yield and select the top 15.

Figures 7 and 8 show the results of a StockScreen123 back-test of this strategy (it’s assumed all securities are held for three months, long enough to collect each quarterly dividend).

Figure 7

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Figure 8

Interestingly, this strategy produced the lowest 10-year total return among the three strategies, confirming that there is, indeed, no free lunch in the financial markets. The yields we saw were pretty impressive. But we paid for that in the form of weaker share price performance. Note, too, that the 2007-08 financial crisis, troublesome for pretty much all strategies (income and otherwise) was especially dreadful here, which comes as no surprise given the high-risk nature of the companies with which we deal.

But there’s a bright side to Figure 8. An ivory-tower onlooker would have anticipated annual share-price declines in the neighborhood of 5% (to bring total return closer to the ideal level computed in the manner described above). We actually experienced an average annual gain of about 1% suggesting there really may be merit to the approach used by the screen to pre-qualify the stock list before sorting based on yield.

That’s important. As discussed above, humans aren’t like statistical data points. There are behavioral factors that push us toward the highest yields we can plausibly get. Hence there’s much to be said for a strategy that helps us actually do that without getting our heads handed to us.

Figure 9 shows the current list of stocks.

Figure 9

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Putting It All together

These income styles are every bit as distinct as the value and growth styles are for other equity investors. No style is inherently good or bad. All have pros and cons. What’s most important is that you understand these styles and recognize what’s best for your needs.

An investor could pick any one of these strategies to follow, or could mix and match, as I do for asset-management clients. I allocate 15% to the Dividend-Growth strategy, 55% to the Core strategy, and 30% to the Prudent Yield Hog approach (for an overall average yield of 6.82%). (By trading at FolioInvesting,com, I need not worry about number of positions or commissions.)

Obviously, if I were to blindly follow the back-test results, I’d want to put 100% of assets into the core strategy, since that’s the one that performed best. But that’s not a reasonable way to proceed. It’s easy to nod off when we hear the tired, boring, “past performance does not assure future outcomes” legal boilerplate. But unlike many other kinds of legalese, this is something we really need to take seriously. The easiest way to damage a portfolio is to naively assume we’ll always see a continuation of what we saw in the past.

Longer term, I’d expect the Dividend-Growth allocation to rise given that interest rates and inflation are likely to climb. I believe the economy can live with higher tallies in both than many realize. But fixed-income would undoubtedly suffer, as would stocks inclined to imitate fixed-income by offering more of their total return in the form of dividend yield.

I’d also expect to maintain a decent stake in Prudent Yield Hog. A longer-term good economy not only boosts interest rates but it also improves corporate creditworthiness and for equity holders, dividend security. That could make high-yielding stocks less prone to interest-related declines than might be the case based on interest rates alone.

Ultimately, this means the 55% allocation to Core is likely to decline going forward.

But I’m not yet ready to position the strategy around these longer term expectations. High oil prices are apt to put near-term pressure on the economy, suggesting that, right or wrong, the Federal Reserve might be a lot more aggressive when it comes to supplying liquidity than they’ve let on so far. Higher interest rates may be in the offing, but I don’t envision much, if anything, in this regard during the next three months. So for now, I’m still comfortable having a large position in the Core strategy.