After I finished yesterday's column, I spent some time contemplating income investing. I am convinced this is the hardest form of investing. This is especially true of those who have been forced into equity and alternative-assets markets in the last decade because of extraordinarily low interest rates. They tend to be more inexperienced investors and those they turn to for help our often their worst enemy.
Wall Street has ginned up some very interesting income products over the last 10 years. These products have sexy, easy-to-sell stories and income investors have snapped them up. They have rewarded the brokers and their firms pretty well, but I am not so sure we can say the same for the investors.
I have spent a lot of time looking for income strategies that work. Equity REITs below book value have been a winning strategy over my career. Electric utilities purchased below book value and then held for a very long time have also been winners. The problem is that if you are bringing new money to the market today, there are no utilities at bargain levels and very few equity REITs below book value. After six years of steadily rising prices, there are simply not enough income investments at bargain prices.
As I contemplated the matter, I recalled the work of folks like Cliff Asness of AQR and Wesley Gray of Alpha Architect. They have had a great deal of success combining value and momentum. They put half the money in value stock and half in momentum strategies, and it has worked very well. Value and momentum are the two surviving market anomalies and complement each other very well. When value is working, momentum is not and vice versa.
I fired up my tester and built a dual momentum-income model. I looked for stocks with a yield of 4% or more that have positive returns over the past year and are also outperforming the market over the past 52 weeks. All three factors had to be true to hold the stock. This dual momentum-income model works very well, according to my quick test of the last 16 years. The only real rough patch the model experienced was from mid-2008 to mid-2009 when pretty much everything hit a rough spot and there was no place to hide. In the bear market of 2001-03, the portfolio did very well and protected capital while delivering a consistent dividend flow.
I ran the results next to a value income model and found that value income did really well in the 2008-09 time period as the model went to cash due to a lack of investable opportunities. In 2001-03 it was almost entirely in cash. In the worst two bear markets in recent memory, the combination of momentum income and value income did a fantastic job of preserving capital and still delivering needed income.
When I look at the momentum-income portfolio today, you have some high-yield REITs like Apollo Commercial Real Estate (ARI) and Annaly Mortgage (NLY). There are some utilities including PPL (PPL) and Pepco (POM). The trade of the decade is represented with smaller banks like People's United (PBCT), Park National (PRK), Trustmark (TRMK) and Northwest Bancshares (NWBI). Equity REITs like Inland Real Estate (IRC), EPR Properties (EPR) and Cedar Fair (FUN) are high-yielding momentum names. So are some of the red-hot health care REITs like Health Care Realty Trust (HR) and Physicians Realty Trust (DOC). There are insurance companies and operating companies in industries like tobacco and telecom that have been traditional income sectors.
No one sector really dominates the portfolio, so there does not appear to be too much concentration risk to the current momentum-income portfolio. There are 37 stocks now and the average income at current prices is 5.37%. The dual momentum factor should help prevent any disasters, as when one of the two momentum factors is absent, the stock is sold from the portfolio.
Income investing is a difficult task. I have seen yield chasing destroy more investors' portfolios and advisors' careers than any other action. Wall Street is no help as unsophisticated, income-hungry investors are the most likely to buy high-fee, low-return packaged products. Investors are probably better off combining simple value and momentum income strategies and rebalancing the mix once a year.
