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High dividend yielding stocks have outperformed lower yielding products, as well as the broad market, between the years 1926 and 2000 in the US (Tweedy Browne paper). A Credit Suisse paper, High Yield, Low Payout, further adds that the combination of high yield with a low payout ratio delivers even stronger gains when testing up to 2006. Has this effect persisted until today?

Testing, Testing, and Back-Testing

Just to make sure we can replicate the positive high yielding results, we run a similar test on the S&P 500 between April 2001 and January 2006. I start on April because this is when my back-testing service began collecting data. We track the 30% highest yielding stocks with monthly re-balancing. The test shows that these high yielding S&P 500 stocks returned the following:

  • Annualized 8.15% in capital gains
  • Over 3% dividend yield annually
  • Combined annualized return of roughly 12%
  • Combined return for S&P 500 over same period is roughly 3% annually

Our results are in harmony with the paper thus far. Will these gains persist?

Running the test from January 2006 until today we have the following results:

  • Annualized 0.75% in capital gains
  • Over 3.5% dividend yield
  • Combined annualized return of over 4%
  • Combined return for S&P 500 over same period is less than 2%

While there is some slight out-performance of the strategy, the gains have plummeted. While some of this may be due to the 2007/08 crash – the Tweedy Browne paper suggests that these high yielding products should be more resilient following a crash. As you can see in the chart below (click to enlarge), there is very little difference between the S&P 500 index and the high yielding constituents from 2006 until today (chart compliments of Portfolio123).

Can we improve upon this by choosing among the lower payout ratio products? For this test, I simply add a filter that keeps those companies that are in the bottom half of payout ratios of the S&P 500. Interestingly, this results in significant under-performance. The compound annual growth rate (excluding dividends) is now negative 5.57% with a deep portfolio draw-down of 79%! What was the problem since 2006?

What Went Wrong?

If we simply remove the financial sector from the mix we immediately spring back into positive territory with a 4.23% annualized capital return (excluding dividends) as opposed to 0.05% annualized capital gain from the S&P 500 from 2001 until Nov 15th, 2011. Next, we change the way we screen for low payout ratios. Our new formula requires the trailing 12 months of payout ratios to be at least 25% less than the industry average. This pops our annualized capital gain to 5.29%.

Which of these stocks currently make our list in the S&P 500?

Ticker

Name

MktCap (mil)

Industry

Yield

(NYSE:CNP)

CenterPoint Energy, Inc.

8199.21

Electric Utilities

4.1

(NYSE:EIX)

Edison International

13195.35

Electric Utilities

3.16

(NYSE:ETR)

Entergy Corporation

12152.03

Electric Utilities

4.81

(NYSE:GCI)

Gannett Co., Inc.

2697.42

Printing & Publishing

2.83

(NYSE:HCP)

HCP, Inc.

15508.18

Real Estate Operations

5.05

(NYSE:LXK)

Lexmark International, Inc.

2544.03

Computer Peripherals

2.96

(NYSE:NU)

Northeast Utilities System

6098.76

Electric Utilities

3.19

(NYSE:OKE)

ONEOK, Inc.

8054.78

Natural Gas Utilities

2.86

(NYSE:PM)

Philip Morris International Inc.

123690.5

Tobacco

4.33

(NYSE:PSA)

Public Storage

21043.68

Real Estate Operations

3.09

(NYSE:SE)

Spectra Energy Corp.

18814.49

Natural Gas Utilities

3.87

(NYSE:SPG)

Simon Property Group, Inc

36722.48

Real Estate Operations

2.88

(NYSE:SRE)

Sempra Energy

12775.14

Natural Gas Utilities

3.6

(NYSE:TAP)

Molson Coors Brewing Company

7377.18

Beverages (Alcoholic)

3.14

(NYSE:VNO)

Vornado Realty Trust

14353.79

Real Estate Operations

3.55

(NYSE:WEC)

Wisconsin Energy Corporation

7537.02

Electric Utilities

3.19

Does this mean that we simply go ahead and buy all the stocks on this list? If there is one thing that we have learned, it is that the rules change. You cannot simply ignore what is happening in the broad economy and buy high yielding stocks with lower than average payout ratios. In fact, if you focused on this strategy with financial stocks alone, your $10,000 of capital in 2006 would be worth $1,740 today.

It is beyond the scope of this article to go into which sectors and industry groups may be of higher risk going forward; the lesson is that if you trade this quantitative strategy, you must have the broad economy in mind or you will find yourself sitting with a very small pile of pennies after many years of using a highly touted system by reputable companies with published back-testing.

Source: How High Yield Investing Can Make Or Break Your Portfolio