Sweet-spot equity income

What This Strategy Aims To Do

 This equity income strategy aims, quite literally, at what we deem the “sweet spot” of the overall dividend yield hierarchy. It seeks yields that are higher than what non-speculators typically achieve in the dividend-investor arena, but which carry risks that are no more than what mainstream equity-income investors accept. The key to this strategy is a tendency on the part of the investment community to overestimate how much cash-receipts risk can be prudently assumed.

Why It’s Worth Considering

 As of this writing, a strategy like this is worth considering because interest rates and yields are so low, many investors and savers will be unable to achieve a satisfactory yield by favoring the more conservative end of the risk scale.

In past generations, yields available on Treasury securities, investment-grade corporate bonds, and blue-chip income stocks were adequate to meet one’s needs. That is not so today. Now, one must work, and work hard, for every “basis point” of yield one can get. That means one must really scrutinize risks. Naive folklore (e.g., “I insist on debt and payout ratios no higher than such-and-such.”) is a luxury we cannot afford.

How We Do It

 There are many ways to measure cash-receipts risk for dividend-paying stocks. The most popular is the payout ratio (dividends paid as a percent of net income). We believe, however, that this is a very limited metric. Different kinds of companies in different types of businesses can afford different kinds of payout ratios, and payout ratio data can be “noisy” (influenced by temporary aberrations involving net income).

We have found market sentiment to be remarkably effective in evaluating dividend risk. (While there is much debate regarding market efficiency, we believe the market is more efficient than usual in assessing this particular risk. The higher the yield, the less likely the company is to generate good (or even any) dividend growth and the more likely the company is to cut or eliminate the dividend. Such assessment is enhanced when combined with analyst sentiment (which can and does address hard-to-quantify considerations) and core company-quality factors. Our equity income strategy aims to invest in high yielding stocks consistent with reasonable risk as determined by the combination of company quality and sentiment.

We start by defining a universe of large-capitalization stocks that meet our liquidity requirements. Then, we filter to eliminate stocks whose yields are below the 75th percentile of the investment universe and above the 98th percentile (that being the range that produces yields of interest to income seekers without taking on undue risk, as per the market’s assessment). The 98th-percentile-ceiling is a test not typically seen elsewhere, but we believe it’s important. The easiest way for cash-receipts risk to rear its ugly head is when the investor gets too greedy when it comes to yield.

We then eliminate shares of companies that do not pay or have cut dividends, as well as shares of Mortgage REITs (higher-risk quasi banks). We also impose thresholds based on our “Classic Quality” ranking system. In so doing, we establish a lower, more lenient threshold for utilities and REITs to account for the characteristics of those businesses, where quality metrics of lesser magnitude can be accepted without increasing cash-receipts risk as we assess it.

From this good-yield good-quality group, we choose the top 20 stocks according to a Sentiment-based ranking system.

The model is refreshed weekly and stocks are sold (and replaced) if or when they no longer qualify under yield or quality standards we establish. Stocks may also be sold based on criteria relating to performance or diversification (i.e., to prevent excessive sector concentration).

Is It Suitable For You?

Interest-rate risk is present, but in contrast to the situation with fixed-income, the prospect of dividend growth can offset some of this, as can the higher yield which provides a stream of cash that can be reinvested at rising rates.

Equity income strategies are typically assessed on the basis of prospects for current income and/or dividend growth. This strategy aims directly at the current income need. This is not to say it won’t or can’t benefit from dividend growth (the link between equities and business trends makes such a prospect inevitable), but expect less dividend growth here than in our lower-yielding “Expecting Dividend Growth” strategy.

You can follow the model here.

Risk Notes

• By overall equity standards, risk is low due to the use of quality-oriented fundamental factors.

• By income standards, however, it is high due to (i) the non-contractual nature of dividends, which can be skipped or reduced with fewer consequences than an interest-payment default, and (ii) our pursuit of yields at the higher range of acceptability

Trading Notes

• Although turnover is likely to be low relative to most strategies that hold stocks, it is likely to be high relative to what many see from ETF-based income strategies.

• Even so, the strategy is suitable for most brokerage-cost arrangements