The portfolio manager of a large, active dividend fund was recently interviewed by Morningstar. (“What Active Management Can Bring To Dividend Investing” http://www.morningstar.com/cover/videocenter.aspx?id=716392). The portfolio manager argues that simply looking for stocks with high dividend yields is insufficient because so many of those very high yielding stocks go through dividend cuts. She says that using fundamental analysis and looking at things like cash flow generation can help a dividend investor avoid some (not all) of the stocks that eventually have dividend cuts. That is certainly sound advice, and avoiding stocks that undergo dividend cuts is really the key to a successful dividend strategy.
Another way to help find stocks that might have a dividend cut is to use relative strength. There is often a lot of selling pressure well before a dividend cut as more and more people figure out a company is not going to be able to maintain its current payout. Like good fundamental analysis, using relative strength to screen out weak dividend stocks doesn’t mean you avoid every stock that has a dividend cut. But it does help you avoid enough of them to add value over the long-term.
The following two models draw stocks from the same universe. The universe is the top 1000 domestic stocks by market capitalization (a mid and large cap universe similar to the Russell 1000). Each model is rebalanced at the end of each calendar quarter with 50 stocks. The Dividend model simply selects the top 50 yielding stocks from the universe at the rebalance date and then weights those securities by their yield (i.e., higher yielding stocks get a larger percentage in the model). The Dividend+Momentum model takes the top 50 yielding stocks from the universe that are also on a Buy Signal and in a Column of X’s on their Point and Figure RS chart. The only difference between the two models is the Dividend+Momentum model adds the PnF RS filter to the yield screen.
The chart above shows how using an RS filter can enhance a dividend yield strategy. Over the entire test period from 12/31/1989 through 9/30/2015 the added RS screen adds a tremendous amount of value. Some of that outperformance comes from avoiding the stocks that have very high current yields that are unsustainable. Also keep in mind that relative strength is not predictive so it isn’t necessary to try to “get out in front” of every dividend cut. The market tends to recognize these situations well before the cut actually happens.
The article also addresses the financial crisis when a lot of dividend strategies were heavy in financials that eventually cut their payouts. Just about every fully invested strategy had difficulty during that period, but the RS screen on the dividend portfolio did help to cut the drawdown versus a yield only portfolio:
The Dividend+Momentum definitely had a rough 2008, but was much better than not using the screen. There are a number of periods during the test where the relative strength screen really improved performance. This year is no exception. We have seen this across the board with some other factors we track. Things like Value+Momentum are doing much better so far this year than just Value alone. The exception is Low Volatility where the relative strength screens aren’t adding as much value, but they are still outperforming their counterparts that don’t use the relative strength overlay.
The downside of using a relative strength screen with dividends comes in big mean reversion years. This should be expected in any type of strategy that adds a momentum overlay. Years like 2001 and 2009 are much better on a raw dividend yield basis. However, if you are willing to deal with those periods of relative underperformance then adding a momentum screen to a yield strategy has the potential to add a tremendous amount of excess return over time.
The portfolio manager in the article is 100% correct about needing to find companies with high yields that are sustainable. There are number of different ways you can accomplish this. Most methods involve using some sort of fundamental data to ascertain if the company’s payout is sustainable or not. Another effective way to do this is to use a relative strength overlay to fund stocks that are outperforming the market with high yields. Using a RS overlay might cut down on the current yield of the portfolio, but testing shows that the gains from capital appreciation can make up for this. Making sure your portfolio of high yielding stocks remains on a buy signal and in a column of X’s versus the broad market is another way to filter out stocks that might have unsustainable yields.
The performance above is based on total returns, inclusive of dividends, but does not include all transaction costs. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value.