Triple-Play Income Stocks: Going Conservative

by: Marc Gerstein

Triple Play refers to the three main varieties of equity income investing.

The Three Income Styles

It may seem odd to think in terms of there being three income strategies, instead of just one, but just try saying “I want to emphasize yield” in front of a room full of experienced investors, investment teachers, authors, commentators, etc., and watch how thoroughly you’ll be pummeled, especially if it gets out that you looked at a web page containing information on something like Annaly Capital Management (and its 15.5% yield), and then browbeaten into favoring such names as Microsoft (NASDAQ:MSFT) or Wal-Mart (NYSE:WMT), with yields of 2.3% and 2.8% respectively.

Actually, it is possible that you could be right in considering Annaly, while at the same time “they” can be right for preferring Microsoft and Wal Mart. There is no single correct way to approach income investing. There are sharply divergent styles, much the way there are differing, and often opposing, styles for other kinds of investing (i.e. value versus growth). It’ll be easiest for you to make sense of the equity income arena and zero in on ideas most relevant to you if you recognize and think in terms of three income styles: (i) Core Income, (ii) Dividend Growth, and (iii) High Yield which I’ve colorfully renamed Prudent Yield Hog.

The Dividend Growth approach is the one most often favored by gurus, etc. probably because it deals with tasks that are intellectually comfortable; use of fundamental analysis to identify “good” companies. The idea, here, is that the stronger firms are the ones most likely to deliver higher rates of dividend growth, thus making it well worthwhile for investors to accept yields much lower than initially contemplated.

At the opposite end of the spectrum we have the Prudent Yield Hog. This is the strategy you really want, but after having been beaten up by experts, are reluctant to openly espouse. Indeed, as much as I want you to own the kinds of income stocks you want, I do have to acknowledge that the experts make good points. No matter how neurotic Ben Graham and Warren Buffett think Mr. Market is (i.e. no matter how irrational some may think the Wall Street “herd” may be), there’s no way he’s going to hand you a 15.5% yield unless he knows the stock is loaded with a lot of baggage, far more baggage than anything you can or would dare imagine with Microsoft or Weal Mart. The baggage typically relates to weak fundamentals which increase the likelihood the dividend may be reduced or eliminated altogether. The Prudent Yield Hog strategy addresses this risk by reaching for the highest yields not within the market as a whole, but within a carefully pre-qualified subset defined by factors designed to identify fundamental, respectability, or at least tolerability, as opposed to excellence.

The Core Income strategy is pursued by investors who simply want a decent yield, and as little bother as possible regarding other issues such as the safety of the payout, dividend growth potential, etc. We accomplish this by targeting something I refer to as “Ideal total Return,” which relies on the Capital Asset Pricing Model to tell us what sort of yield we can find on stocks whose share prices are expected by Mr. Market to remain stable (e.g., investors see nothing that prompts them to worry about dividend security, or salivate over future growth potential).

You can find detailed stock selection criteria for all three strategies by checking the Appendix in the lower portion of this article.

These income styles are every bit as distinct as the value and growth styles are for other general equity investors. None of them are inherently good or bad. They all have pros and cons. What’s most important is that you understand these styles and recognize what’s best for your needs.

The Stocks

Figures 1, 2 and 3 list the stocks currently spotlighted by each of the models. (The lists should be refreshed every three months, a period short enough to keep you on top of changes that warrant replacing some stocks, and long enough to allow you to collect the quarterly dividend payment.) 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 55% to the Core strategy, 30% to the Prudent Yield Hog approach, and 15% to the Dividend-Growth strategy, and (for an overall average yield of 6.14% as of this writing).

Figure 1 – The Core Income Strategy

Figure 2 – The Prudent Yield Hog Strategy

(Click to enlarge)

Figure 3 – The Dividend Growth Strategy

(Click to enlarge)

By trading at FolioInvesting,com, I need not worry about number of positions or commissions, I need not worry about commissions and am perfectly comfortable rebalancing a 45-stock portfolio every three months. If you trade at a conventional firm and need to watch your trading costs, I suggest you bypass the Dividend Growth strategy (fundamental strength is all well and good, but you really need to be well diversified to make this approach work in the real world) and as to the others, you can get by limiting yourself to the top five stocks (as per the sequence set forth in the tables) assuming you’re willing to jump out more quickly if a potential problem surface (your cue to look for one will be an episode wherein a stock significantly underperforms its list-mates). Click here for more on a low-trading-cost version approach to Triple Play.

Today’s stock lists are noteworthy in their conservatism. The Dividend Growth group looks a lot like lists of “defensive” equities one might compile even without reference to income. While few, if any, companies are truly non-cyclical, many tend to be less cyclical than others. I’m referring here to those that sell small-ticket products (i.e. those for which purchase price tends to not be overly burdensome) and, often, everyday necessities. Table 3 gives us substantial exposure to businesses like these.

The Prudent Yield Hog is especially conservative (by its standards). It has, in the past, tended to reach for very aggressive firms, such as real estate investment trusts that lend, rather than own, properties. There are still plenty of these around and they sport double-digit yields. One actually did make it into the list, but most other have, in this wobbling economy, fallen too far down in the ranking system I use to pre-qualify the list from which I’ll select. Interestingly, several of the stocks we see now in Table 2, well exposed to energy pipelines, are typical of what we usually see in the Core strategy.

Meanwhile, the yields in all three lists are now lower than we usually see. This obviously reflects today’s low-interest rate environment. But there is also some impact from general corporate fundamentals, which are working to push the more aggressive selections downward and out of the range of my models. This is an important consideration for those who, in the past, may have been put off by the riskiness of some selections, particularly those have that appeared in the Prudent Yield Hog. This strategy does not ask that investors marry their stocks. It has an air-tight Sell discipline. The models are refreshed every three months, and if a name no longer appears, it gets jettisoned; no excuses, no tears. With risk in general having been ratcheted upward lately, we see in Table 2 that most mortgage REITs, those most exposed to damage from a renewed downturn, are gone. Buy-and-hold, even for income investors, is dangerous. Use the term buy-and-review instead. (This is why it’s so important even for income investors to think about trading costs, whether that means use of a very-low-cost brokerage firm like, or limitations on the number of stocks one will hold and the bypassing of any strategy that requires broader diversification, such as Dividend Growth).

Considering Potential Future Returns users can backtest these models individually (the screens are saved under my name, but I set them such as to make them visible to and copy-able by all StockScreen123 users), or download test results to Excel and combine them, to produce a simple picture of a unified portfolio (using the allocations mentioned above), as I did and present here in Figure 4.

Figure 4

(Click to enlarge)

The above Figure reflects share price change only. Based on further analysis of performance data, I estimate that the average annual yields, and share price gains were as follows:

Figure 5

(Click to enlarge)

I wish I could suggest that the results you see here could be deemed representative of what you could expect in the future. Unfortunately, I can’t.

While I am willing to infer general sustainability of the strategy’s ability to outpace the market (as least as much so as I’m willing to do with any other model), I have to recognize that market conditions today are not nearly as friendly for income investing as they were for much of the test period (aside for 2008, which, it seems, was hostile to all investing strategies). Interest rates now, as we all know, are incredibly low and that’s driving yields to the lower end of the historical range and eliminating the capital-gains we investors usually enjoy as rates fall. And given the way rising rates pressure prices of financial assets, share prices for income stocks are likely to be under much more pressure.

Particularly interesting in Figure 5 is the average annual 9.85% share price appreciation for the core strategy. That’s aberrant; remember, this model aims at zero price change. But we recognize that much of the last decade was characterized by epic declines in interest rates that were often not anticipated much in advance by the market. Today, I’m more inclined to adopt the market’s assumption that the 5.7% average yield for stocks that now pass the core model is reasonable in a zero-gain/loss scenario.

The Triple Play average yield is, as noted above, likewise very low (compared to historical standards), as the ranks of the higher yielding (riskier) stocks fell shy of the threshold I’m using. Using the average yield today of 8.7%, I’m willing to assume a modest annual capital loss that could bring annual total return to, say, 7.5%.

As to the Dividend Growth model, here, too, the current yield is lower than usual at 2.7%. But at least its low for the decent reasons (aside from the low-interest-rate environment): good quality among the companies listed. If I cut the historical annual capital gain in half, that means I’d be assuming future annual returns of about 7.7%.

If these assumptions pan out, we’d be looking at annual returns of around 6.5% for the portfolio as a whole (given the way I’m weighting the three strategies). That’s not the greatest prospect we’ve ever seen. But in today’s market environment, it would be hard for income investors to do much, if any, better without taking a lot more risk than we’re getting here.

Bear in mind, too, that to get even 6.5%, we will need to see the market pull out of its recent tailspin. As we learned in 2008, we have to be alert for crises that cannot be avoided anywhere in the equity markets. With my low-priced stock portfolio, I hedge with a small stake in the Direxion Russell 2000 3X Bear ETF (NYSEARCA:TZA). Given the economic uncertainties ahead, which won’t vanish even if the market rallies soon, I’ll be studying the feasibility of some sort of similar hedging program for the income-stock portfolio. If I come up with workable ideas, I’ll share them with the seeking Alpha community.


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 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 CLMT, CODI, ENP, FLO, PDLI, PG, RLI, SPH, TWGP, USMO, VLCCF, WAC. I expect to own a lot more of the stocks mentioned in this article when I re-balance the model for my own account.