Are You Paying Attention?

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Includes: ADI, CALM, CMI, COH, CSCO, HON, HUBB, INTC, MMM, MSFT, PH, QCOM, ROK, SLB, TKC, TXN, VBMFX, WDC, WDR, XLNX
by: Backroom Analyst

Summary

It is not enough to simply buy the stocks that one finds on a screen. One must listen to the data, and act prudently when there is no data.

No data is data. When the screens tell you there is nothing to buy, one has to take that as an indicator of potential problems in the near future.

This piece will show you an example of how one can use their screening data to allocate a responsive portfolio.

One should always research good stock screening ideas to construct effective portfolios that will yield a nice return over time without knocking themselves from their strategy. In researching the Dividend Strength Portfolio Screen, which I modified from First Trust Portfolios, I found something very interesting that needs to be asked. When you run your screens, are you paying attention to the results? What do you do when your screen yields few or no stocks?

Dividend Strength Portfolio

The Dividend Strength Portfolio, according to First Trust, is a portfolio "that seeks above-average total return through a combination of capital appreciation and dividend income by investing in a portfolio of companies with strong balance sheets and a history of dividend payments with the ability to generate dividend growth." First Trust is more than willing to share its screening criteria, so I will use it as a base, with some personal modifications, to construct this screen:

  • Easy to Trade
  • Market Capitalization > $1 Billion
  • Long-Term Debt/Equity < 40%
  • Return on Equity > 15%
  • Dividend Yield > 2%
  • Dividend Payout Ratio < 50%
  • Current Ratio > 1.5
  • Quick Ratio > 1.0
  • Positive Free Cash Flow
  • Inventory Ratio < 1.25

These are the current candidates which make up a pretty nice portfolio:

Ticker

Name

ADI

Analog Devices Inc.

CALM

Cal-Maine Foods Inc.

CMI

Cummins Inc.

COH

Coach Inc.

CSCO

Cisco Systems Inc.

HON

Honeywell International Inc.

HUB.B

Hubbell Inc.

INTC

Intel Corp.

MMM

3M Co.

MSFT

Microsoft Corp.

PH

Parker Hannifin Corp.

QCOM

Qualcomm Inc.

ROK

Rockwell Automation Inc.

SLB

Schlumberger Ltd.

TKC

Turkcell Iletisim Hizmetleri

TXN

Texas Instruments Inc.

WDC

Western Digital Corp.

WDR

Waddell & Reed Financial Inc.

XLNX

Xilinx Inc.

How has this screen performed in the past? Quite well. Since 1999, the annualized return, assuming a one-year holding period, is 11.92% (±22.30%). It has a low beta (0.76) with a decent correlation (r^2 = 0.68) and high alpha (8.13%). It's a good way to invest. Figure 1 shows how it compares to the S&P 500 since 1999.

Figure 1

Are You Paying Attention?

Normally, I end things here, but I found something interesting when I ran a rolling backtest to check for the robustness of the screen. What I found was a highly significant (p<.01, n = 799) correlation (r = 0.365) between the number of qualifying equities and the return for the S&P 500 during the subsequent year. Simply, the more stocks that passed the screen, the better the returns for the market. For example, the periods where no stocks passed the screen, the S&P 500 lost an average of -25.2% in the following year. Years where there were at least 26 passing, companies consistently averaged positive returns for the overall market. Figure 2 shows the relationship between the number of passing stocks and the annualized returns of the S&P 500.

Figure 2 (Note: White Box/Whisker bars indicate average returns were negative. Black Box/Whisker bars indicate average returns were positive)

I have some personal experience with this that I shared in July 2007. I posted how my screens resulted in no passing companies that would outperform the market. Subsequent to that post, the market lost 17% the following year and it got worst from there.

Table 1 shows how the Dividend Strength Portfolio would have performed since 1999, with annual rebalances. It also compares the results to the S&P 500 and shows the results in dollars to make the outcomes more tangible. Notice how the years with few passing companies tended to have negative years, while the years with more passing companies had more robust returns.

Passing Stocks

Start Date

End Date

Dividend

Strength

Return (%)

S&P 500

Return (%)

$100 Investment

Div Strength

$100 in S&P 500

6

1/4/1999

1/2/2000

1.70

19.53

$ 101.70

$ 119.53

3

1/3/2000

1/1/2001

-3.95

-10.14

$ 97.69

$ 107.41

2

1/2/2001

12/30/2001

2.03

-12.06

$ 99.67

$ 94.45

3

12/31/2001

12/29/2002

1.13

-24.60

$ 100.80

$ 71.22

4

12/30/2002

12/28/2003

28.43

25.44

$ 129.47

$ 89.33

5

12/29/2003

12/26/2004

31.42

10.42

$ 170.14

$ 98.64

3

12/27/2004

12/26/2005

1.52

4.75

$ 172.72

$ 103.33

6

12/27/2005

12/25/2006

31.50

11.00

$ 227.13

$ 114.70

11

12/26/2006

12/23/2007

10.08

5.45

$ 250.02

$ 120.95

11

12/24/2007

12/21/2008

-40.00

-40.25

$ 150.01

$ 72.27

40

12/22/2008

12/20/2009

68.24

24.43

$ 252.38

$ 89.92

20

12/21/2009

12/19/2010

30.43

12.71

$ 329.18

$ 101.34

19

12/20/2010

12/18/2011

0.51

-2.09

$ 330.86

$ 99.23

22

12/19/2011

12/16/2012

13.30

15.89

$ 374.87

$ 114.99

26

12/17/2012

12/15/2013

36.01

25.75

$ 509.86

$ 144.60

22

12/16/2013

12/14/2014

19.07

12.80

$ 607.09

$ 163.11

18

12/15/2014

04/24/2015

2.96

5.62

$ 625.07

$ 172.28

Table 1

How Can We Use This to Maximize Returns?

I suggest that you backtest your screens and compare the results to the subsequent periods to see if they indicate how the overall market will perform. Then, use this to create an allocation strategy that will maximize your returns in up markets and minimize your losses in down markets. What does Warren Buffett do when he cannot find anything to buy? Nothing. Treat your screens the same way.

So what does one do? One needs to find that tipping point that seems to indicate high positive expectations for gains. With that, allocate your portfolio to reflect that confidence. With that in mind, I looked back to find that sweet spot, that perfect allocation strategy that will maximize my gains and minimize my losses.

Table 2 shows what I mean. Instead of an all-equity focus, the strategy focuses on a more balanced approach where the investments are weighted between equities and fixed income based on the number of available passing stocks. For each passing stock at the beginning of the period, 5% is allocated for the equity portion of the portfolio. Obviously, if there is more than 20 passing companies, the entire portfolio is dedicated toward stocks. The remaining portfolio is invested in Vanguard's Total Bond Market Index Fund (MUTF:VBMFX) as a proxy for the fixed income allocation. The portfolio does not take into account fees, loads, or carry costs. You will see how this strategy would have performed since 1999 using the same time frames. The average annual return from reallocating the portfolio based on the number of passing companies is 12.2%. This compares favorably with the all-equity portfolio annual yield of 11.89%. The S&P 500 averaged 5.34% since the initial starting date.

Passing Stocks

Start Date

End Date

Equity Allocation

Vanguard Bond Allocation

Total Return

$100 in Portfolio

6

1/4/1999

1/2/2000

30%

70%

0.02%

$ 100.02

3

1/3/2000

1/1/2001

15%

85%

9.11%

$ 109.13

2

1/2/2001

12/30/2001

10%

90%

7.27%

$ 117.06

3

12/31/2001

12/29/2002

15%

85%

7.66%

$ 126.02

4

12/30/2002

12/28/2003

20%

80%

10.86%

$ 139.71

5

12/29/2003

12/26/2004

25%

75%

10.76%

$ 154.74

3

12/27/2004

12/26/2005

15%

85%

2.24%

$ 158.20

6

12/27/2005

12/25/2006

30%

70%

12.64%

$ 178.20

11

12/26/2006

12/23/2007

55%

45%

8.21%

$ 192.83

11

12/24/2007

12/21/2008

55%

45%

-19.40%

$ 155.43

40

12/22/2008

12/20/2009

100%

0%

68.24%

$ 261.50

20

12/21/2009

12/19/2010

100%

0%

30.43%

$ 341.07

19

12/20/2010

12/18/2011

95%

5%

0.89%

$ 344.10

22

12/19/2011

12/16/2012

100%

0%

13.30%

$ 389.87

26

12/17/2012

12/15/2013

100%

0%

36.01%

$ 530.25

22

12/16/2013

12/14/2014

100%

0%

19.07%

$ 631.38

18

12/15/2014

04/24/2014

90%

10%

2.83%

$ 649.27

What is nice about the results is that it is a strategy one can stick to. It would have kept one out of the disastrous dot.com bust in 2000-2002. It also minimized losses for the debilitating 2008 fiasco. It cannot be underestimated how important it is to have a strategy that one can maintain when the markets go crazy.

Conclusion

What does the screen tell us now? Currently, 19 companies pass the screen. If one uses this approach, it indicates the S&P 500 will average 8.06% (±18.9%) in the next 12 months. That is still a healthy market, but the potential for loss is greater than it has been since the recovery. Given that, this indicator shows that one needs to slowly allocate 5% toward fixed income.

There are many more indicators to predict how the market will perform over the next 12 months, this is just one tool. The important lesson is listen to your data and act accordingly.

Happy Investing!

Disclosure: The author is long CMI, WDR, INTC, QCOM.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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