One of the hardest quant systems to develop over the years has been one for dividend investing. We have developed some successful portfolios that throw off income, like the EV/EBIT growth and income system, but the portfolio's current yield really is not that high. It's decent, but if you are primarily investing for income it might not get the job done all the time. Last night, I decided to keep things as simple as possible and developed a system on just a few factors. It turns out that sometimes simple really is best.
I wanted to find a mix of stocks that would throw off above-average income. I wanted to be able to avoid most of the dividend blow-ups we occasionally see in higher-yield stocks. Since dividend investing is by its very nature conservative, I needed to eliminate as much financial risk as possible, as well. I ran several tests and found that limiting my search to those U.S. stocks trading with a yield of between 3.5% and 8% and where the company earned an F-score of 6 or higher worked pretty well.
I only included those stocks with a market cap of $1 billion or higher, so we didn't have a portfolio comprised of primarily illiquid stocks. Although I might not mind owning all illiquid stock, and would in fact prefer it, most income-oriented investors will probably prefer more liquid stocks for their portfolio. To keep costs low I only rebalanced the portfolio once a year.
This simple combination works very well. It outperforms the market over the five, 10 and 15-year time periods and plays pretty good defense in bad markets. I limited purchases to the 50 highest yielding stocks so this approach does stay fully invested all the way through but the dividend yield and conservative nature of the stocks leads to less volatility. There is no approach that can fully protect you from market meltdowns so you have to have the discipline and faith in the future to stay with system through the full market cycle.
When I run the screen today, I find that you own a lot of REITs. The current portfolio holds 15 Real Estate Investment Trusts, with a slight bias towards the out of favor hotel sector. The upside dividend cutoff keeps out of the more volatile mortgage and financing REITs and emphasize equity REITs. I think that commercial real estate has several decent years ahead, so I am comfortable with owning REITS that hold hotels, offices, shopping centers and other CRE properties.
The economy is not going to grow rapidly, but I don't think it is going to collapse anytime soon either, so CRE-related investments should continue to throw off a reliable stream of dividends. Only buying those that yield more than 3.5% or more does a nice job of keeping us away from those that are overly focused on the overheated segments of the market.
There are currently eight energy-related MLPs in the portfolio. Again, the upside of dividend cut off keeps us away from some of the more risky energy-related income investments that have double digit yields that are vulnerable to selling related to a dividend cut. The Piotroski F score requirement also helps to make sure that the MLPs we buy are in decent financial condition and have improving fundamentals. The MLPs have been battered over the past year and could have decent upside price potential form here in addition to the dividend payout.
The rest of the portfolio is a solid mix of companies across several sectors including insurance, retailers, utilities, telecommunications and media. The average market cap is $13.5 billion, so it's a lot larger-cap oriented than a typical Melvin portfolio. The average dividend yield is 5.45%, so the dividend investing portfolio compares very nicely with other income alternatives. The average F-score is 6.21, so the stocks in the portfolio have strong financial conditions and are seeing fundamental improvements.
Income investors have had a tough time of it the past few years. Traditional fixed income investing does not exist right now, as bonds and bank products have very low yields. Investors who have traditionally relied on these products for income have found themselves pushed into the equity and alternatives markets, without a reliable tour guide, with the expected unsatisfying results.
Using a simple quantitative model to own and manage a portfolio of dividend-paying stocks may be a better solution for those searching for yield.