Positioning Your Equity Portfolio For High Yield With Moderate Risk

Includes: CL, KO, MCD, PEP, PG, T
by: Monty Spivak

Although high-yield is typically associated with high-risk, this series of articles will propose an approach to moderate the risk component. In the series, I will suggest that income investors should buy small amounts of many, higher-current-yield, smaller-cap stocks in order to substantially increase return while mitigating risks.

This contrasts with the more accepted strategy of a relatively small number of large-cap, dividend-growth or share-price-growth companies. Although some may believe that ETFs or mutual funds provide a more convenient (and occasionally, cost-effective) solution, my definition of appropriate risks and yield would likely differ from those of the fund manager. Moreover, this approach proposes that you choose sectors, portfolio composition and geographic diversification, and not leave this to others.

Investors seem to have 1 of 3 philosophies:

1. Seek capital gains for return.

2. Invest for long-term dividend growth and capital appreciation (total return).

3. Seek current yield (exclude capital gains).

I subscribe to the 3rd option, and propose that this will provide you a better total return with a lower-risk. I want to be paid early and often. As a reminder, my investment models always exclude capital appreciation. I believe that this is an issue of timing, and requires excellent domain knowledge, skill and luck could help. If you treat your investment as a 5-7 year certificate of deposit, then you can ignore market volatility and focus on the sustainability of the yield.

Additionally, this is not a strategy which proposes that one blindly chase yield – the goal is to develop an approach where high-dividend-yield through a portfolio of smaller-cap securities is the investment goal, and introduces risk moderation by investing in defensive industries, geographies, and companies.

The recent volatility demonstrated that dividends are a much more dependable income stream than planning for a stream of capital gains. Uncertainty has many investors turning to holding low-yield cash for capital preservation. So, what is next for investors? Inflation? Deflation? Stagflation? Who knows where the wind blows? We know with certainty that financial and economic conditions for the next few years are uncertain. Therefore we need to structure our investment portfolios to mitigate the risks and generate an above-market return.

My previous article with Seeking Alpha proposes that one can receive a higher present-value of returns from higher current yield, rather than through dividend growth. The question that I am now addressing is how could one increase his/her target yield, but continue to manage the risks?


Here are my assumptions. You may not agree, and if so, your portfolio decisions should diverge from mine.

1. This investment model is for investors with a 5 -10 year time horizon, but positions you for a bumpy ride in the next 1 or 2 years. My disclaimer is that I am not an investment advisor, so this is not advice – it is just an investment strategy for you to consider. You should consult with your own, qualified investment advisor.

2. For the next 2 - 5 years, bond market yields will be relatively static. For the long-term, the bond market has nowhere to go but down, as interest rates have nowhere to go but up. The timeline is up for discussion, but the long-term direction is clear.

3. The US equity market is probably fully valued (if not overvalued). With 9% official unemployment, huge deficits at all governmental levels, Quantitative Easing, a shaky housing market, US government and other future sovereign downgrades and/or defaults, and artificially-low interest rates, how can one buy any securities with confidence?

4. The US dollar will decline and may be in trouble. Forget government-legislated debt ceilings and downgrades – what happens when nobody wants to lend to the USA (either before or after state and municipal bankruptcies)? The US government is “too big to fail” and nobody is big enough to bail them out. The world economy runs in USD and every local economy is dependent upon the US’ economic health.

5. The debt problems in Europe (for the PIIGS) will not go away. They have bought time, but no debt has been repaid, and many of the problem countries are not “walking the talk” of reducing spending. Perhaps global, European-domiciled corporations will be better risks than their sovereign debt?

6. Developing countries are not the solution to problems in the developed countries. Within the last 20 years, Mexico, Brazil, and Argentina (MBA) have experienced debt and fiscal fiascos – unable to pay the interest or principal on their respective debt. China has not fully transitioned to a market economy, and what will happen to India if/when their off-shored industrial and service costs become too high? Moreover, do you really want to commit your wealth to their immature governance structure?

7. I remain optimistic that the developed countries will recover. It may take a full seven-year business cycle, but we have the democratic institutions, entrepreneurial culture, intellectual capital, governance structures, and financial capabilities, to lead the global economy. The developing economies may grow to become a larger share of the global pie, as their higher proportion of youth become middle-class consumers, but they have a long way to go before people earning $1.00/day will be buying cars and refrigerators. “More than 1.2 billion people—one in every five on Earth—survive on less than $1 a day”, and one can be fairly certain that they are not the populations of the advanced economies – it is impossible to believe that these destitute people will lift us out of a global recession. The question is therefore, what to do until the developed economies can regain fiscal strength and move forward, and what should we do as investors to improve our odds of coming out ahead of the game?

To summarize, the market is uncertain and volatility will be high. With these assumptions, a lower-risk model would be to seek immediate income, and an established stream of income, rather than a higher-risk approach of waiting for share-price appreciation.

Although I have some gold and commodity securities, I have not exchanged my assets for bullion and food and gone to live in a cave. My assumptions are not optimistic, but they are not catastrophic; they just propose uncertainty and volatility – there may be inflation, a double dip, or some other unfavorable event.

So, what should one do? Perhaps start by “playing defense” with your fixed income portfolio, and only going out for 2 years, and only with low-indebted countries’ (e.g., Canadian and Australian) government-guaranteed investments. The opportunity for gain and yield is largely in the equity market, and this article is about positioning your equity portfolio for high yield with moderate risk.


Let’s first identify the big-picture strategy. I am not proposing that this strategy should appeal to everyone, and sought to identify a counter-balancing opinion (from SA authors) for each:

1. Substantially increase the equity component of your portfolio (rather than bonds) to increase yield. This may magnify certain risks, but you will be compensated with a higher return. In a low interest rate environment, this strategy proposes that we need to substantially overweight stocks. This thoughtful article suggests otherwise - that we remain balanced and diversified between stocks and bonds and avoid yield at any cost. …realize that dividend stocks are stocks not bonds and have volatility characteristic of stocks not bonds because they are stocks. There is a reason why most people have some sort of mix of stocks and bonds; they tend to react and behave differently.

2. Do NOT consider capital appreciation as a core part of your return. This is an income-oriented return strategy. I recognize that this is not a widely accepted investment approach. There are many SA articles that propose that all investors (including dividend Investors) should care about capital appreciation – in fact, an excellent one demonstrates that even in the case of dividend stocks, barring extremely long holding periods, capital appreciation will comprise the larger portion of an investor's total return

3. Focus on attaining your return based upon a (high dividend) yield on investment. Take high-dividend yields now, instead of dividend growth or capital appreciation in the future. Accumulators of wealth and capital tend to be a group which defers financial gratification, as demonstrated by their exceptional savings rate. This approach reflects immediate gratification – grab your high-yield, immediately. There is an enjoyable and well-thought-out, tongue-in-cheek article about the “Bird in the Hand” theory which competes with this perspective.

4. There are other aspects, including that one invest mainly in very defensive sectors; be careful in your use of options; and to limit debt/leverage, but the previous three are core to the strategy.

Now, the cards are on the table – there have been, and will be detractors to this approach. Although not for everyone, this should be particularly attractive to retirees, as the focus is immediate, high, recurring income. I am not proposing that the high-yield strategy is for everyone, or that we will gain a consensus opinion on an investment model. Rather, I propose that the high-current-yield strategy can provide a higher and more dependable return than other strategies, and that the risk can be managed.

Comparison to Dividend Growth Stock Strategy

First, I would like to differentiate this strategy from a dividend-growth strategy. The basics are that dividend-growth stocks pay a steady and growing dividend, and the total return increases over time, as the dividend grows and the shares appreciate in value. I am not proposing that one divest all of these securities. Rather, I am proposing that one should allocate a smaller portion of his/her portfolio to these stocks, as they provide a lower current yield. I consider dividend-growth stocks a baseline – low risk plus capital appreciation and a growing dividend yield. As part of this strategy, the goal is to materially outperform this baseline.

Let’s start our assessment by examining a small sample of dividend-growth stocks, and look at the risk and return, in order to create a benchmark of what I suggest is the lowest risk (but lower-return) approach to equity investing.

Sample Dividend Growth Securities*

(Industries: Consumer / Beverages; Consumer / Personal Prods; Restaurant)

Security Name (Ticker)

5-Yr % Return

5-Yr Div Grow

Div Yield

Mkt Cap

36 Mo Beta

52 Week High

52 Week Lo

Coca Cola Co (NYSE:KO)








PepsiCo Inc (NYSE:PEP)








McDonald's Corp (NYSE:MCD)








Colgate Palmolive Co (NYSE:CL)








Procter & Gamble Co (NYSE:PG)
















Click to enlarge

* Data is from www.barcharts.com on 2011-11-07 after markets closed.

Overall, we see that the dividend-growth stocks are less volatile than the market (the 50% betas demonstrate that they are one-half of the market variability). The bottom line is that the risk is lower. We also see that a substantial portion of the return is based upon the share price increase – in other words, it your return depends on when you buy and sell. The impact is that the published annual growth rates (that are included as part of your total return calculation) can differ from what you actually receive when you sell you security.

Let’s take a more detailed look at Pepsi (PEP) in order to understand the impact of market timing and total return. Again, as part of the return is from capital gains, timing is everything. For example, what if you bought PEP at the 2011 high price ($71.89) and sold at the 2011 low price ($58.50)? For that matter, what if you bought it at the 2010 high and sold at the 2011 low? The share prices and respective betas bring into question your return on PEP, depending on when you bought/sold the security. That said, regardless of the price at which you bought or sold the shares, you would have received the dividends for that period.

I would also like to point out that the assumptions that the mega-cap companies can continue to grow their dividends is an “assumption” – not a fact. These are over-represented in Consumer Products, which may be challenged to continue to grow return and dividends with the stagnation of personal income and employment. In other words, the champions of the past may struggle to qualify for the next “race”. Rising input costs, currency fluctuations, debt at all levels, and fickle consumer taste, can change the risk and return models for this class of investment.

McDonald's (MCD), is a good example of how changing circumstances may impact the return of a dividend-growth and total-return stocks. A recent article, McDonald's: Dividend Champ Facing The Prospect Of Slowing Dividend Growth identified how the changing economic environment may impact the shareholders by reducing the future dividend growth rate. As one can read in almost any related business news article, the share price for McDonald's fluctuates substantially, depending upon the quarterly financial results and forecasts. The last quarterly results announcement created a price spike, but the previous (and perhaps the next?) negatively impacted the share price. The impact is that it could take many more years for McDonald's’ shareholders to reach the equivalent of high-current-yield stocks, and that future capital appreciation is not dependable.

This should not be interpreted as “dividend growth equals bad, and high-yield equals good”. The information in the table supports that dividend-growth stocks are great, “sleep well at night” shares to own. The only problems are that the dividend yield is low, and the total return is dependent upon growing low dividend yields over a long period, plus share-price appreciation – neither of which is certain in this market. Instead of the low yield and hope for capital gains, I am proposing an alternative which provides more immediate return through high yield, and excludes the additional return derived from capital gains. This would be particularly attractive to those who are retired or approaching retirement, but applies to investors of all demographics.

To assess and describe the proposed high-current-yield option, I have structured a series of articles which will be published over the next weeks, to explain the approach to creating a high dividend yield rather than dividend growth or capital appreciation stocks:

Part 1 – Positioning Your Equity Portfolio For High Yield With Moderate Risk: Introduction and Comparison to Dividend Growth

Part 2 - Increase Yield and Manage Asset Allocation Risk

Part 3 - Global and Industry Diversification

Part 4 – What to Buy and what to Sell

This article, which is Part 1 established the groundwork for the strategy. I propose that this still leaves many questions unanswered. Part 2 (which will be posted in the near future) will identify how to attain the goal of increasing your portfolio yield while mitigating risks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.