Seeking Alpha

Top High-Yielding Low-Value Buys During These Volatile Times

by: Mario Glogović, CFA

With bond interest rates at record lows, investors will have to search for yield in the equity universe.

After Trump's positive comments on the U.S.-China trade talks, stocks are back to the upbeat mood. However, be prepared for a continuation of the wild price swings.

The most important thing is a clear, long-term strategy, which holds emotions firmly under control.

Equity positions from this article are a part of the Enhanced Shareholder Yield strategy.

This strategy is grounded in logic, rationality, and long-term market outperformance, which stack the odds in an investor's favor.

During the last weekend, positive comments came from the White House, and the market immediately followed with an upbeat mood. Nonetheless, we should brace ourselves for continued volatility as the trade war saga progresses.

The recent market environment is the best reminder that in investing, the most important thing is a clear and unambiguous strategy, which holds our emotions firmly under control.

As I pointed out during the last weekly update, I still see opportunities in the U.S. equity market. First, I expect that Trump will be highly motivated to reach a trade deal. The reason is that a prolonged trade war would probably lead to a recession and sharp market correction. Both would be severe impediments for his reelection.

Second, interest rates have extended their freefall. During the last week, the 10-year yield briefly touched the 1.50% mark. With interest rates at record low, investors have a strong incentive to seek higher yield in the equity universe.

10 Year Treasury Rate. Source: Macro Trends

However, despite the medium-term supportive environment, to be successful in the long-term, an investor needs to pay attention to two crucial things. First, one needs to choose the right strategy for his personality, and second, an investor needs to take calculated risks only when the odds are in his favor.

One method that offers calculated odds in an investor's favor is the shareholder yield strategy.

This approach offers precise stock selection, percentage allocation, and rebalancing guidelines, which are grounded in the long-term market outperformance. The basics of the strategy coupled with historical research are available in the following article: "Enhanced Shareholder Yield: Time Tested Market-Beating Strategy."

Equities included in this strategy provide exposure to deep value, dividend yield, and repurchase yield factors. Throughout history, these factors have substantially outperformed the broad market. However, one needs to be prepared for the possibility of significant deviations compared to the market returns.

This strategy offers sustainable performance because it systematically exploits market participants' expectation errors. Quantitative analysis of historical data shows that investors using this strategy could achieve annualized returns of up to 17%.

Intense volatility that we experienced during the last three weeks opened some new equity opportunities, which are listed in the updated Enhanced Shareholder Yield Portfolio. The updated list of the U.S.-based mid-cap and large-cap companies with a market cap above $4 billion is available in the following table. These companies provide a combination of the highest dividend and buyback yields, coupled with lowest valuations.

Source: American Association of Individual Investors; proprietary research

Changes In The Model Portfolio

As the equity market was highly volatile, there were a lot of changes in the Enhanced Shareholder Yield Portfolio. The following calculations are based on equal equity weightings (2% per position).

Since last week, shareholder yield decreased from 8.72% to 8.63%. This rise was due to a combination of an increase in the average dividend yield from 3.43% to 3.56%, and the fall in the buyback yield from 5.29% to 5.08%.

On the valuation side, the median price to earnings fell further from 10.20 to 8.90, and the median EV/EBITDA decreased from 6.02 to 5.61.

Source: American Association of Individual Investors; proprietary research

The changes in portfolio characteristics were due to three factors:

  • Market movements
  • Earnings reports
  • Changes in the companies included in the model portfolio

Regarding the company changes, four companies were excluded:

  • Nordstrom Inc. (NYSE:JWN)
  • NetApp Inc. (NASDAQ:NTAP)
  • Ingredion Inc. (NYSE:INGR)
  • Sinclair Broadcast Group Inc. (NASDAQ:SBGI)

The following four new companies were included:

  • Tapestry Inc. (NYSE:TPR): 6.8% dividend yield and -0.6% net repurchase yield
  • Cummins Inc. (NYSE:CMI): 3.5% dividend yield and 3.9% net repurchase yield
  • Reliance Steel & Aluminum Co. (NYSE:RS): 2.3% dividend yield and 7.3% net repurchase yield
  • Spirit AeroSystems Holdings (NYSE:SPR): 0.7% dividend yield and 6% net repurchase yield

Percentage allocation in different sectors. Source: American Association of Individual Investors; proprietary research

The highest sector allocation under the GICS classification is capped at 25%. If one sector represents more than 25% of my portfolio, I would remove the least appealing stock from the overrepresented sector and include the next best investment.

Why Yield Investors Should Look Beyond Dividend Yields

Source: S&P 500 - NYU Stern

The equity market has gone through a structural change because companies currently pay out a lower percentage of their earnings in cash dividends than they have historically. During the end of the 1960s, the average dividend payout ratio for the S&P 500 companies was approximately 55%. However, the payout ratio declined significantly and currently is around 35%.

Due to the falling dividend payout ratio, dividends have lost a part of their significance. Because of this, it is crucial to incorporate buybacks in any strategy focused on yield investing. Additionally, research has shown that compared to the dividend yield, the shareholder yield provides much better insight into the expected future returns.

The following table shows dividends and buybacks for the S&P 500 as a percentage of the market cap and net income. This table confirms the findings from the first graph, which are that both stock repurchases and dividends should be considered in any strategy that focuses on yield investing.

Source: Aswath Damodaran Blogspot

Numerous studies confirmed that historically a portfolio that invested in the highest dividend-paying companies beat the overall market on an absolute and risk-adjusted basis.

However, the predictive power of dividends has declined. The biggest reason is the surge in buybacks, which dividend investors usually ignored. The holistic way to approach the topic of yield investing would be to take into account both ways of returning cash to shareholders.

The question remains: does including data on stock buybacks improve the ability to forecast investment returns in the stock market? There have been numerous studies that have positively answered the previous question. While dividend yield has lost a part of its predictive power, the shareholder yield remained a robust indicator for excess stock return.

Enhanced Shareholder Yield Model Portfolio: Disciplined & Structured Investing Using The Time-Tested Market-Beating Strategy

Companies from the model portfolio have above-average dividend yields coupled with above-average buyback yields. Such combination leads to exceptional cash returns at below-average valuations.

For its investment universe, the model portfolio uses all U.S.-based companies with a market cap above $4 billion. After controlling for size, all stocks with negative EBITDA are removed. Additionally, excluded are ADR securities, financials, and all other companies for which the calculation of the EV/EBITDA ratio is not possible.

Following these steps, I take the top quartile consisting of companies with the highest shareholder yield. I arrange the remaining stocks from the lowest to the highest EV/EBITDA ratio and then select the cheapest 50 companies. The last step is a quality check for companies that pay unsustainable high dividends or conduct massive repurchases, which are not supported by profitability.

These top 50 stocks, which present the best combination of the highest cash distributions coupled with the lowest valuations form the Enhanced Shareholder Yield Portfolio.

Risk Management

If you plan to use this strategy, you must adjust percentage allocation to equities, and the number of equity securities in your portfolio according to your willingness and ability to tolerate risk.

As I have a steady income and monthly ability to invest, every month, I buy four to five new investments. These stock picks are from the Enhanced Shareholder Yield Portfolio and consist of the cheapest companies included on the list. If I already own the best investment on the list, I move down the line and buy the second best that I do not own.

After one year passes, if a company is still on the list of the top 50 investments, then it stays in my portfolio. If it is not on the list (either for the price increase or for deterioration of fundamentals), this security is sold, and the next top investment is included.

Monthly purchases are one possibility for the utilization of this strategy. The second option would be to invest immediately in the 50 top companies included in the Enhanced Shareholder Yield Portfolio and rebalance after a year according to the updated portfolio list.

Using this strategy, I continuously buy mid-cap and large-cap U.S. equities, which have the highest cash distributions coupled with the cheapest valuations.

Weekly, I will provide an update of the top 50 companies. Single constituents will be discussed in separate articles. In this way, readers will be able to follow and utilize the same robust market-beating strategy tested through history.

If you would like to follow weekly updates of this simple, yet powerful strategy, please hit the "Follow" button on the top.

Until my next update, be patient with your investments and give them time to grow!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I do not have positions in the new entrants to the Model portfolio. However, I am long the largest part of equities previously present in the Enhanced shareholder yield portfolio.