Saturday, December 10, 2011

Thoughts on Investing from Curtis Hammering

Can you really boost your long-term dividend rate by 25 - 500% without engaging in ridiculously high-risk tactics? 

A recent SeekingAlpha article (How to Get Sustainable 7% Dividends in a Market Crash) says, yes you can! *(but maybe not 500% unless you are lucky)

The article outlined the following strategy: buy quality dividend-paying stocks when market sell-offs temporarily generate high yields. The mechanics of such a strategy are simple and plainly outlined in the linked article in the above paragraph.

The rationale for this strategy is two-fold:

1. When yields jump high, share prices are often compressed - such as during a major market crash. This can provide you with quality stocks at a deep discount for a margin of safety and the potential for high future capital gains.

2. When you buy a quality stock with high dividend yields during a falling market, you effectively lock-in at that high yield as a minimum for life - provided the company has a policy (and the means) to increase yields, instead of cutting them.

One of the criticisms of this strategy is that it ignores share price movement - which is related to market timing. Buying quality companies when yields are high could prove to be a value trap. The risk of large capital losses associated with bear markets or shoddy stocks would nullify the high dividend effect. The high yields might simply be an 'efficient market' indicator of a fundamentally bad stock. The complaint was a valid one which I quickly sought to test and report on. (Please note that this strategy includes MLPs and ADRs)

Putting The Theory to Test

I felt it fair to put the dividend strategy to the test to see whether this technique would create large capital losses or whether it would improve returns from inherent market timing. To test this we need to create a simple dividend strategy and calculate the returns. Next we add our "high yielding dividend strategy" filters to see the effects on capital gains/losses.

First, we buy dividend utility stocks without trying to capture high yields in falling markets. We look for:

• Utility stocks
• 5 year average yield > 3%
• No OTCBB stocks
• 5 year dividend and EPS compound growth rate > 0%
• Currently paying a dividend

We build a portfolio with a maximum of roughly 30 stocks, we have $500,000 starting capital and we re-balance monthly. We will use the past 5 years of market data for this test.

This is how our regular dividend portfolio fared:

• Annualized Return 3.92%
• Total capital gains over 5 years = 21.14%
• The capital gains on this strategy beat the S&P 500 benchmark by 30.86%
• Average current yield based on entry price is roughly 5% - 5.5%

How did the high dividend capture strategy fare compared to our basic dividend strategy? To find out we need to introduce 2 more rules.

1. Current yield(when purchased) > 7%
2. Current yield(when purchased) is at least 25% higher than 5 year yield average

This system only purchased 13 stocks starting in the fall of 2008 up until last month. Despite sitting on cash for the first 2 years due to unsuitable circumstances we have the following 5-year statistics:

• Annualized return 6.03%
• Total capital gains over 5 years = 34.02%
• The capital gains on this strategy beat the S&P 500 benchmark by 44.62%
• 12 out of 13 stocks were winning picks
• Max drawdown was only 9.16% despite the S&P 500 dropping by more than 50%
• Average current yield based on entry price is 9.6%

Targeting decent companies when yields are high generates excess gains as to share price and to yield. If we isolated the 3 years that this strategy was actively buying companies - the returns would be much higher. As well, we didn't even consider the value of realized dividends into the total 5 year gains. The compound annual growth rate over the previous 3 years, including dividends, would be much higher around 17 - 18% CAGR.

This first round of testing provides some evidence that buying quality high-yielding dividend stocks will provide some market timing ability with superior dividend payouts. What if there are too few stocks or some claim the arbitrary 7% yield was purposely data-mined to take advantage of the previous drop?

Then lower your entry requirement to a 6% target yield. We would then achieve 48.18% capital gain return (or 57.89% better than the S&P 500 benchmark) in 5 years with an annualized return of 8.2%

Lowering our entry yield helps with one of the problems which is that too few stocks meet the 7% criteria for a fast portfolio generation. Then again, this test was limited to utility stocks only. With a few modifications, we could open up other sectors for an increased selection of 7% yielding stocks.

What are your views of this work in progress? While I do not claim it to be the "perfect income strategy," it does appear to be a simple and effective way to potentially beat the market and sit with high yields. One further refinement that I would add - use a market timing technique that looks for trends in the S&P 500 earnings to know when to sell your holdings. Thus you can also lock-in at high capital gains and arm yourself with cash for more potential deals in the succeeding drop.