Quantitative Investing – Enhanced Dividend Yield

Today I want to cover the Enhanced Dividend Yield quant strategy from What Works On Wall Street.  This strategy is a bit more complicated to implement than the others I’ve covered (see previous posts), especially for individual investors. Its performance results are much better than other dividend based strategies. While not as good as the strategies I’ve presented previously it still could be of quite some use to investors. I present some ideas on how it could be made easier and why it could be attractive.

Dividend yield is a popular value metric. High dividend yielding stocks do outperform the market over time. But not by as much as many people think. The table below shows how different dividend strategies perform over time.

Good performance, definitely better than the S&P500. Decile 1 of dividend yielders from the All Stocks universe gives you about 2% a year outperformance over All Stocks and almost double the risk adjusted return but with higher drawdowns. Sometimes high yielders are value traps. The Enhanced Dividend Yield screen tries to get rid of these value traps in two ways. First it limits the stock universe to market leading companies defined as non utility stocks in the large stock universe (market cap > average) with shares outstanding greater than average, cash flow greater than average, sales greater than 1.5 times the average. It then ranks those companies based on EV/EBITDA and eliminates the 50% with the highest EV/EBITDA ratios (most expensive).  Then it ranks the remaining list by dividend yield and invests in the top 50 stocks on a weighted basis as follows; 25% of stocks with highest yield get 1.5 times the weight, the next 25% by yield get 1.25% the weight, the next 25% get 0.75 the weight, and the final 25 get 0.5 times the weight. Now, we’re done. Phew! This weighted list of 50 dividend stocks had a yield of 3.6% when I last ran the screen on June 10, 2013. Now, I think 50 stocks is too much for most individual investors to implement with reasonable fees unless the portfolios are quite large. A reasonable modification for individual investors would be to limit the list to the top 25 stocks and weight them equally. This portfolio of cheap market leading dividend payers yields 4.12%. Just for reference below is the list of top 25 stocks.

So far we have a screen that requires more work for less results. Why continue? Well, one of the many nice things about dividend stocks is the potential to live off the dividend income. It lessens the reliance on capital gains and sure makes an investing style easier to stick to. Potentially we have a strategy that allows us to do this “automatically”. O’Shaughnessy looked at this in detail a while back. You can access the study here (free registration required). Starting in 1963 a portfolio of $250K in the Enhanced Yield Strategy generated an income of $11K (4.4% yield) which grew to $815K in annual income by the end of 2009. That’s an average income growth of over 10% a year. The ending portfolio value was $14M as well. The worst decrease in income was 7.8%. Even during the worst decade for stocks since the great depression (2000 to 2009) a $250K portfolio, with a starting yield of 3.87%, would have generated income growth of 12.5% per year and finished at $473K. Not bad. You could also do this with the Combined Consumer Staples/Utilities strategy I’ve already presented. While not specifically a dividend strategy these two sectors are basically filled with dividend paying companies and would accomplish similar things.

In summary, the Enhanced Yield Strategy is a better dividend paying strategy than traditional dividend yield alone. An income investor could use this strategy and potentially the Combined Consumer Staples/Utilities strategy to construct a portfolio of significant income with great prospects for inflation beating growth. Compared to the effort of building, monitoring, and maintaining a portfolio of individual dividend paying companies this is a worthy alternative to consider.