Quantitative investing: enhanced yield system update

Time to update quant system #3 in my series. See my previous two posts for the first two system updates (here and here). Today I’ll update the enhanced dividend yield system which I originally posted on almost 2 years ago. Let’s dive right in.

The enhanced dividend yield strategy originally appeared in What Works On Wall Street. In its original form its is a bit complicated to implement with an unequal weighting of the individual holdings. In my modified approach I use an equal weighting of the top 25 stocks. The strategy basically screens for large profitable popular dividend paying companies that are trading at a discount to the average (as determined by EV/EBITDA)  and ranks them by their dividend yield. As I said in the original post, the strategy is a good performer, not as good as the other strategies, but still impressive. From 1965 through 2009 the strategy returned 14.3% per year vs the SP500’s 9.3% per year. How about since 2009? Let’s take a look. Below are the results for my slightly modified enhanced yield strategy from Jan 1 2009 through Dec 31 2009. Results are Portfolio123.

Great out of sample performance and still handily beats the SP500. There is one downside to this strategy. During times of market stress the enhanced yield strategy has the same or larger drawdowns than the market. This is clear in the results shown above. From the peak in 2007 the strategy has a 52% drawdown vs the SP500’s 51% drawdown. This usually runs counter to the tenets of dividend investing but probably one of the reasons for the strategy’s continued outperformance.

What really makes this strategy attractive is it’s appeal to ‘income’ investors, investors seeking to live solely off the income generated from the portfolio without having to sell to generate capital gains to fund spending. While a total return approach generates better results investors need to account for the behavioral component in investing. Dividend strategies allow many investors to stick with stocks when times get rough and that is invaluable. I discussed this  income approach with the enhanced yield portfolio in the original post so I’ll just re-print it here. I think it is a very important consideration.

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.

Now let’s see which stocks the enhanced yield system would pick if we ran the system today. First, my usual caveat emptor. My preference is to run these systems at the beginning of the year vs any other time of the year. The quant systems work in all months tested but their effect and performance has been more powerful in January than any other month. Just like the January effect for the general stock market. These are not investment recommendations at all. I have also not checked the stocks for compliance to the quant system rules I’ve discussed before. This is just an example.

Below are the top 25 stocks in the enhanced yield screen as of the close of 4/26/2015. I also listed the screen parameters used to rank the stocks.

That’s it. That’s the updated enhanced yield portfolio. You can enter the stocks in to a simple free portfolio tracker, like the one at finviz, and see how the portfolio does over the next 12 months.

In the next quant post I’ll update the trending value portfolio.