Using dividends to cushion against market gyrations

Early in 2013 I presented a quantitative strategy based on dividend paying stocks from OShaughnessy’s What Works On Wall Street. The Enhanced Dividend Yield strategy. The strategy provides market beating returns, higher sharpe ratios, and a healthy dividend stream. One of the best things about this strategy is it’s high stick-to-it-iveness. That’s a highly technical financial term that means that it is one of the easier quant strategies to adhere to and implement because of the high income stream from the strategy. The income stream provides a cushion that helps investors weather the tough times. Now, about 22 months after I first presented it I thought it would be good to go back and look at the strategy in some detail to point out it’s strengths and weaknesses. Also, we’ll look at the different results of this strategy for an investor pre-retirement who is focused on building wealth and for a retired investor spending the income from this strategy.

The Enhanced Dividend Yield strategy basically takes cheap market leading stocks and ranks them by dividend yield. An investors buys the top stocks from this ranked list and holds them for one year. Rinse and repeat. For details of the implementation of the strategy see my earlier post. Lets look at the recent performance of the strategy. The table below shows the performance of the Enhanced Dividend Yield strategy from the beginning of 1999 through Oct 19, 2014. I also list several other metrics which I’ll discuss below.

The strategy returned 17.4% a year over the last 15 years and 10 months. That compares to the 4.6% a year for the SP500 over the same time period. Not bad. As the dividend yield column shows the starting yield of the portfolio varies quite a bit every year. This is really a value strategy first, then a dividend strategy. The potential dividend income from the portfolio rises at 15.5% a year as well. An investor who is trying to build an income stream as retirement approaches would have been well served with such an approach. But what about a retiree? A retiree would maybe like to spend the dividends instead of re-investing them in the portfolio. The table below shows that analysis along side the previous one.

For a retiree, who is not re-investing the dividends into the portfolio the results of the Enhanced Dividend Yield strategy are quite impressive as well. Without re-invested dividends the portfolio grows at 9.9% a year plus the dividend income stream grows at 8.6% a year. That’s still a lot better than the SP500 and the income stream handily trounces inflation as well. Sounds like a great strategy to consider for a retirement portfolio. It is one of the core strategies I use in mine. But it’s not all roses. There are two negatives. One, is the strategy does not limit drawdowns. This is typical of all quant value strategies. You get higher returns in the long run but still suffer large drawdowns. The Consumer Staples and Utilities Value strategies do a better job of limiting drawdowns while still providing some level of income, all be it lower. The other downside, in particular for retirees, is the fluctuating level of dividend income from year to year. As the last column in the table shows, from year to year the level of dividends can decrease quite a bit, even though it is rises quite strongly over the long run. A retiree using this strategy could apply a smoothing approach to the income stream over a 3-5 year period to avoid this downside. Also, an allocation to bonds in an overall portfolio can accomplish the same thing.

Finally, what is the Enhanced Dividend Yield strategy telling us today. I ran the screen this weekend and the top 15 stocks are shown below.

The portfolio above yields 5% as of last Friday. That’s on the low end of the yield range for the last 15 years (compare to the first table in the post) which is to be expected in the current valuation environment but still a robust yield. We’ll see how it does over the next year compared to the market. I have a tracking portfolio set up in FINVIZ to monitor its progress.

In summary, the Enhanced Dividend Yield quant strategy is a great strategy for investors in the wealth building part of their lives and for retirees in the withdrawal phase. The high level of dividends not only enhances returns but also makes it easier to stick with the portfolio during rough times knowing that at least that income stream is there.