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.
9 thoughts on “ Quantitative Investing – Enhanced Dividend Yield ”
Very interesting! Sorry, I’m new here. How do you pull the screen with matching stocks? Is there a popular program?
Also, would you (in theory) begin investing now, or perhaps try to wait for a larger market correction?
Nevermind! Got around to reading your earlier posts. Sorry!
Thanks for your great site. I’ve been doing a little “comparison shopping” by comparing your list here, the holdings of a hedge fund I like (GMO LLC), and the list of dividend champions. AFLAC matches all these, so went ahead and picked some up 🙂
Is the software you use from AAII what lets you pick specifically stocks that have a market cap > average? I’m not seeing this on the free site, unless one manually picks something like greater than 200B market cap? Sorry, still a newbie.
I am just curious how you discovered “What Works on Wall Street” and why you chose it from all of the investment books out there? I am having trouble with the “too good to be true” feeling and why doesn’t everyone implement it. Is the only caveat that past performance doesn’t guarantee future returns? It seems like O’shaughnessy’s strategies change from each edition and I am not sure if it is from new data or fine-tuning the methods.
I’ve always been into quant investing a bit. Way back from when I first discovered the Dogs of the Dow strategy. Of all the quant books out there, I find O’Shaugnessy’s work to be the best in terms of methodology and historical data that is actually made available to the reader. The book talks a lot about methodology, why most people will fail (due to behavioral issues mainly) even with quant strategies, etc… While the best strategies have changed from edition to edition the fundamentals of what outperforms has not, i.e. value, small cap, and momentum. For example, the latest issue EV/EBITDA was the best performing single value metric, which was new, but P/S the previous top factor, was still quite high on the list. Then to address this issue of the varying performance of single factors, he introduces multi-factor strategies. This is an evolution of the work, fine tuning as you say, and something I’m glad to see.
Do you include the dividends in the returns and drawdown calculations (not only in this article but in general)?
Yes, dividends are always included.
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