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Is income investing always a game of low, but slowly accumulating, dividends that compound for a reasonable return over a very long period of time? Is it possible to achieve high capital gains while padding the account with abnormally large dividends?

I outlined such an income investing system recently that targeted dividend stocks whose yields were jumping as prices were compressed. This allows investors to lock-in at very high yields while simultaneously providing a strong upside for capital gains.

Income investing expert, David Fish, asked that this strategy be performed with more than the utility sector, that it should include lower yields in the 3-5% range, and exclude MLPs. Fair enough. This ‘high dividend spike’ strategy will be run again using the S&P 500 with the following set-up ...

S&P 500 Dividend Buying Without Strategy (A Benchmark)

  • S&P 500 stocks excluding the financial sector and REITs
  • 5 year dividend and EPS compounded annual growth rate > 10%
  • Dividend Yields > 2.5%

This test cover from January 2008 until today. The results of our benchmark?

  • The max drawdown (from peak to bottom of portfolio value) is 43.96%. At some point we lost almost half of our worth – which is a bitter pill to swallow.
  • Over 3 ½ years we experienced capital gains of 11.38%.
  • We also beat the S&P 500 benchmark by a total of 30.86%.

All shares were purchased on exactly January 2nd, 2008 and held until today. The average current yield sits at 3.5%. Based on our entry price, the effective yield could be a smidgen higher than that. Our annualized capital gain return is at 2.97% and, if you add dividend gains, this is probably just below 7%. Not great, not bad.

Dividend
(Click to enlarge)

The stocks initially invested in 2008 were:

Ticker

Company

CCL

Carnival Corporation

DRI

Darden Restaurants, Inc.

HD

The Home Depot, Inc.

HOG

Harley-Davidson, Inc.

HSY

Hershey Co.

MAS

Masco Corporation

MAT

Mattel Inc.

MCD

McDonald's Corp.

PAYX

Paychex Inc.

RAI

Reynolds American Inc.

VFC

V.F. Corporation

WM

Waste Management, Inc.

S&P 500 Dividend Buying With High Yield Strategy

We are allowing in very low yields with this strategy as has been requested. As such, we will need to increase our relative yield when compared to long-term averages. It is not nearly as meaningful if a 25% spike brings a 2.5% yield up to 3.125%, as if a 6% yield jumps 25% higher to a 7.5% yield. Therefore the added rule will require the current yield to be twice (2x) the 5 year yielding average as we allow a broad range of yields 2.5% and higher.

  • New Rule: Yields must be 2x the 5 year average

Strategy
(Click to enlarge)

Over the three and a half years we see the following:

  • Annualized return 11.78%
  • Total return 50.64%
  • Max drawdown 31.33%
  • The average dividend yield is 2.7% (your yield is over 4% based on entry price)
  • Combined annual returns (price plus dividends) 15.78%

Improving Our Market Timing Ability

It is true that asking for a high dividend yield will provide some measure of market timing – however, we should have better policies in place than simply buying on large yields.

For instance, should we not sell at the beginning of the next down market to lock in large capital gains and have a surplus of cash for new bargains? What about when dividend yields start to drop - either from price growth exceeding fundamental growth or simply from a loss or earnings which may lead to a cut in dividends? We will use two timing techniques to enhance our profits.

Market Timing With the S&P 500 EPS

One simple market timing method uses the S&P 500 earnings per share. When the 5 week moving average crosses below the 20 week moving average (of S&P 500 earnings) – you sell all of your holdings. The theory behind this technique assumes that you are near a market top and are locking in your gains. You are thus sitting on a pile of cash awaiting your next basket of high yielding stocks.

  • This simple strategy improves our annualized return to 14.82%
  • Total Return 66.26% over 3 years
  • Max draw-down 26.78%
  • Average dividend yield is 2.5% (your yield is 4.15% based on entry price)
  • Combined annual returns (capital gains plus dividends) 18.97%

market timing
(Click to enlarge)

Individual Stock Timing Using Average Yields

If buying a dividend stock when the yields are double the 5 year average targets an undervalued stock, then perhaps selling when yields dip below the 5 year average would have us selling when the stock is overvalued. Thus, we have a greater chance of buying low and selling high – in theory.

  • In place of the market timing rule we will add this rule: sell when current yields fall 25% below the 5 year average

The result?

  • Annualized capital gain returns of 12.31%
  • Total return of 53.29%
  • Max draw-down of 30.33%
  • Yields are similar to above
  • Combined annual returns (capital gains plus dividends) 16.5%

Yield
(Click to enlarge)

This is comparable to the market timing system although it has slightly less returns. However, it is able to drop stocks individually - which the market timing system is not able to do.

What would happen if we combine the systems? We essentially revert back to the same ratios as the market timing system despite both signals being actively used.

A Quick Test on the Broad Market

As a quick and final test I run the above rules on the broad market over the past 5 years of data. I want to see if this strategy will work on more than the S&P 500 stocks. Too many stocks come in for my program to handle so I quickly raise the yields to a minimum of 5%, thus filtering out many picks. The results on the broad market (excluding OTCBB) hold up.

  1. Using the "sell when yields fall 25% below 5 year average" rule, I maintain 9.45% capital gain per year. At the end of the 5 years, my average yield - based on my entry price - is between 8 - 9%. Total annual gain of around 18%.
  2. I now use the market timing rule of the S&P 500 earnings trend on all stocks except those in the S&P 500. The annualized return over 5 years is 12.37%. If you add in dividends your yearly return is closer to 20%. Turnover is incredibly low and all but one stock is purchased before 2009 – largely from the summer to fall of 2008 and not simply cherry picking from the lows of 2009.

Wrap-up on Another Battery of Tests

As I go over and over this system I realize that the testing and variety of scans necessary may be beyond the scope of this format of 'actionable article writing'. I’ve enjoyed sharing my work thus far and will test it further to be brought out in a more comprehensive format at a later date.

What are some stocks making the cut right now?

  • GRMN (Garmin Ltd.) – They are offering a 5% forward annual dividend yield. According to this system it is still rated a buy.
  • STM (STMicroelectronics NV) – A forward yield of 5.4% and a PEG ratio of 0.53 make this a candidate. Of course, you need to be comfortable with a share price that has more than fallen in half since March.
  • PTNR (Partner Communications Company) – This company has also seen prices drop in half over the last several months. Still, the forward annual dividend rate is 10.90%. A bad quarter and slashed future earnings estimates have brought prices to their knees. Again, this system in not for the weak at heart.

As an alternative you can always target lower yields, or wait for the market to correct further so as to pick up strong stocks with fewer fundamental issues.

Well, there you have it, David Fish, this system appears to hold up under a variety of sectors using lower yields. I tip my hat in your general direction, you have led me down a productive path of robustness checking.

Source: How To Get Huge Yields Plus Large Capital Gains In Dividend Stocks