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Triple-Play refers to a three-pronged equity-income strategy I developed based on the three main approaches to income stocks selection.

The Core Strategy: This is for investors who are truly serious about emphasizing income and want a strategy that aims to achieve a decent yield with as little exposure as possible to share price gains and losses. That is, of course, an ideal; we almost never actually experience stocks that flat-line for prolonged periods. But we are, at least, aiming as best we can for companies whose dividends seem secure enough to push concerns about dividend reductions or cuts to the background and stable enough that the yields aren’t depressed by investors bidding up share prices in anticipation of superior dividend growth. The stocks currently making the grade under this strategy are shown in Figure 1.

Figure 1

The Dividend Growth Strategy: This approach tends to be heavily favored by investment commentators and educators, perhaps because from the standpoint of equity theory, it’s the most appealing. Equities in general tend to be chosen over less-risky bonds because equities, unlike bonds, allow investors to participate financially in growth achieved by companies. An on paper, i.e. when things work well, this is probably the best strategy. You sacrifice yield (sometimes by a lot) on day one, but over time, can wind up with a lot more as the dividend stream grows.

The downside is that we cannot be sure the growth expectations will pan out. That’s why many equity-income investors are less partial toward the strategy. (“If I wanted growth, I’d invest in growth stocks, but I want income, so stop bothering me with all the talk about growth.”) The stocks currently making the grade under this strategy are shown in Figure 2.

Figure 2

The Prudent Yield Hog Strategy: This is the strategy most likely to cause income investors to salivate. It’s where we really reach for yield, sometimes eye-catchingly high yields. These are the income stocks about which we brag to our friends, especially since it’s likely they’ll forget the specific names we’ve mentioned five minutes after the conversation ends, making it unlikely they’ll check the share prices a month or so later to see how well we really did. That’s a big factor.

Mr. Market is a lot more rational than many Buffett wannabes assume, and is rarely, if ever, going to give you something for nothing. If he’s offering you a double- or high-single-digit yield in today’s interest-rate environment, you have to assume there’s going to be a catch. Indeed, there is one: dividend security. These situations are characterized by above-average risk of difficulties that will cause companies to reduce or eliminate their payouts.

The “Prudent” label in this strategy refers to a screening and ranking process I use to attempt to pre-qualify the universe of eligible stocks in such a way as to weed out situations where the risks seem too darn high even for aggressive income investors. The stocks currently making the grade under this strategy are shown in Figure 3.

Figure 3

Details of each strategy are spelled out in the Appendix below. For a discussion on the testing of these strategies, see my August 5 article.

Choosing a Flavor

When it comes to specifics, there are, needless to say, countless variations on each theme. But if you look at other income-investing articles, you will probably be able to recognize each as an example of one of these flavors of equity-income investing. I consider all three approaches equally valid and present all of them leaving it for each interested investor to decide for himself or herself which one, or what sort of combination, to use.

The last time I rebalanced my Triple-Play portfolio (in early August), I allocated 15% to Dividend Growth (average yield as of today: 1.76%), 55% to Core (average yield: 5.00%), and 35% to Prudent Yield Hog (average yield: 9.34%).

Speaking for myself, I’m not going to rebalance my positions until early November. Most U.S. dividend-paying companies make their payments quarterly, so I hold each for at least three months to make sure the timing of trades does not cause me to miss any payments. But if I were going to re-balance today, I would re-consider the allocations.

We are in an exceptionally low-interest-rate environment based on choices made by the Federal Reserve in its response to our persistent economic weakness. The yields we see in the Core and Prudent Yield Hog strategies, although low by historical standards, are not shocking given what we know about the current environment. The yield for the Dividend Growth strategy seems another matter. It’s very low because my threshold is based not on an arbitrarily chosen number (say 2% or 2.5%) but based on a required spread above the ten-year Treasury. Although the result is correct and intellectually defensible (if I were to simply raise the threshold by increasing the required spread, I’d necessarily be increasing the risk of the portfolio), it still seems unsatisfying.

On paper, we can still anticipate strong dividend growth from this group. But the exact same economic weakness that motivated the Fed to clamp down on interest rates and, by implication, yields, has to make us wonder how much expected dividend growth we’re actually likely to see in the near term. For that reason, if conditions remain as they are now when I rebalance next month, I’m going to eliminate the Dividend Growth strategy (not permanently; I’ll undoubtedly bring it back in a subsequent rebalancing) and allocate 65% to core and 35% to Prudent Yield Hog, which would imply an overall portfolio average yield of 6.52%.

Hedging With TZA

Back on August 5, I decided to hedge my Triple Play Income holdings with a 10% position in the Direxion Russell 2000 3X Bear ETF (TZA). For me, this was a no-brainer given that I’d still have a pretty decent portfolio yield given the low-interest-rate, low-yield environment (the expected average yield on the full portfolio was 6.14%, but because TZA pays no dividends, I’d be earning 6.14% on only 90% of the portfolio, causing the overall yield would drop to 5.53%) and the fact that I did not want to continue to subject myself to the extreme volatility we had been anticipating and which I expected to persist. TZA uses derivatives to target daily price changes equal to three times the inverse of the Russell 2000’s daily change; i.e. if the index drops 4%, the ETF would rise 12% more or less (we’re talking about a targeting, not an outcome that is precise to the penny).

For others, however, such a move seemed preposterous. Although leveraged ETFs have been out for a while (about five years), investors continue periodically to be subjected to rants about their being toxic. Although the assets these ETFs (actually, they might better be labeled ETPs, Exchange Traded Products) have attracted considerable and given that they are a runaway commercial success, it is necessary, every now and then, to counter periodic rhetorical hysteria.

The indictment of leveraged ETPs centers primarily on the fact that targeted performance is based on a presumed one-day time horizon. It’s been correctly shown again and again that if one holds these ETPs longer than a day (as most probably do), the overall return is not likely to match the desired ratio viz. the index. In other words, if the index drops 4% in a day, there’s a good chance TZA will rise about 12%. But if I hold for year and the Russell drops, say, 20% over that span, TZA may rise 65%, it may rise 90%, it may rise 5%, it may decline 40%, etc.

We really can’t say, because it will depend on the pattern of daily zigs and zags that occurred throughout the holding period. Note, though, that the market does have a general long-term upward bias, so if one buys a leveraged short ETP and “locks it away in a drawer,” that could prove disastrous, since the big trend in the value of such a holding would be downward.

I’m not going to address every possible point in detail here; I’ve written much about the topic in recent years. For now, here’s a quick summary of some key points.

Use of TZA (or a similar ETP) as a hedge vehicle does not imply a long-term buy-and-hold. As a portfolio is re-balanced periodically, the purchase price of the ETP would be continually averaged upward or downward, meaning the plot you see in a traditional price chart (which is oriented to a single start price and a single end price) would not be representative of your results. This is huge. Much of the critical commentary regarding leveraged ETPs is rendered irrelevant by failures on the part of the authors to appreciate this scenario. (They write exclusively for the buy-and-lock-it-in-a-drawer crowd.)

Nothing in the equity market preforms as expected (for example, there’s a reason why a rather large cottage industry has grown up around earnings guidance and surprise and associated share price movements) and all things considered, these leveraged ETPs actually seem better than most equities when it comes to delivering what holders expect under a particular set of market conditions.

Holding a leveraged ETP for more than a day is best thought of, not in terms of daily targets (which become irrelevant after one day) and instead, as a security having a life of its own. In this context, I think of TZA as a security having a high degree of volatility (triple that of the high-volatility Russell 2000) and a general upward bias during bearish market environments. That’s enough. I don’t feel any more compelled to quantify the expected return here than I do to put a target price on a share position (a ridiculous exercise, since market trends often trump company-specific factors).

Figure 4 shows the performance of my Triple-Play income portfolio since August 5, the day I implemented the 10% hedge. (This is a screen shot taken from my brokerage account at Folioinvesting.com. The data reflects the 10/7/11 closing prices.)

Figure 4

Based on the position-change information in the holdings data for my account, I can say that without the hedge, and adding back the income I estimate I forfeited, my return would have been minus 0.38%. So basically, the hedge added 1.0% over about two months. That doesn’t seem earth shattering. But for income investors, it is meaningful.

More important is the pattern. It’s not as if I was right about the market’s overall direction. From start to finish, the S&P 500 was down just trivially and it was modestly higher when we factor in dividends. The problem investors have been having has been with volatility which has been, to put it mildly, ridiculous. TZA’s main contribution has been to mute the impact of the market’s volatility, by a lot.

That doesn’t seem so meaningful in terms of Figure 4, given that on a start-to-finish basis, things really haven’t been so bad. But we can’t always judge these things after the fact, when we know how the story ends. (When I was a kid, I often was intrigued by the nostalgia adults felt toward the World War II era which, by any rational measure, was horrifying; but by the time I was growing up, everybody knew how the story ended and such knowledge heavily colored perceptions of the period.) How might you have felt about the portfolio and the hedge on August 19, in late September, or early October? Reduction in volatility is not necessarily about end-to-end performance, when the final outcome is known. (Maybe it will be a plus. Maybe it will be a minus.) It addresses issues that arise when the final outcome is not known.

By the way, Figure 4 has one other interesting aspect. Because I rebalance income portfolios every three months, I have not yet had occasion to average up or down on my TZA position. So here, you are seeing the impact of the sort of buy-and-hold about which the commentators speak. And even this has not been toxic, as they suggest. Commentators presume every unexpected price movement a leveraged ETP makes will be adverse to you. That is false. Some will go against you. Some will work in your favor. And some will be benign. The variables are largely unpredictable. So again, it’s best to learn to see leveraged ETPs as securities that have lives of their own, as discussed above.

Appendix

Here are the details of the three components of the Triple Play Income strategy.

The selection rules for the Core 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; and stock price greater than or equal to 5
  • Stock’s yield must be at least 90% of “Ideal Total Return” (click here for background on this concept) and no higher than 110% of that ideal. Using the Capital Asset Pricing Model, I compute Ideal Total Return as 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.

The selection rules for the Dividend Growth strategy are as follows:

  • 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 the 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 StockScreen123.com QVG (Quality-Value-Growth) ranking system, thus providing objective support to the 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

Here are the selection rules for the Prudent Yield Hog (click here for more on how this model works):

  • 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 StockScreen123 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.

Disclosure: I am long AEP, ARG, ARLP, BGCP, DTE, EXC, LEG, MAIN, MMLP, OHI, RLI, SDRL, SXL, TGT, UNH, VZ.

Source: Triple-Play Income Strategy Update