The Low-Risk Yield strategy has returned 19% since September 2017.
June was another great month for this strategy with a 5% increase in value.
Despite the headwinds expected for dividend stocks this year has seen an 8.3% increase in the strategy’s funds.
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Since September I have been investing in a strategy that I researched and documented in Building A Low Risk Dividend Strategy. This strategy used a simple set of criteria to identify dividend stocks that were likely to be undervalued and showed backtested returns of 16% annually over the last 20 years together with a low annual turnover of stocks
I’ve been trading the strategy with a small investment since September 2017 and am now kicking myself that I didn’t invest my normal stake in it. I reasoned that with the market expectations of three interest rate hikes over the next 15 months, dividend stocks as a whole would show below average gains for the greater part of 2018.
While the strategy’s volatility did increase in the latter part of 2017, the strategy has returned 18.7% since I started trading it, with capital gains making up two-thirds of the gains and dividends the balance.
Results Since September 2017
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You can see from the above graph that the strategy initially tracked and has now started to accelerate away from its S&P 500 benchmark, recovering from the recent market correction in the first quarter within 2 months. When analyzing performance I always look at a strategy’s drawdowns in addition to the top line returns to see if I could live with the volatility – in this case the drop in value of 9.8% was an improvement on the benchmark, which dropped by 10.5% in the same period.
The monthly returns show the strategy produced strong gains in September, December, April and June whilst October, January and February showed losses. The Market Cap exposure graph shows the companies that the strategy selects are largely valued between $250m and $2bn, which is exactly the profile we are targeting.
Why The Strategy Works
I always advocate simplicity when designing and refining trading strategies – my low-risk dividend model focuses on the highest dividend-paying stocks with the lowest payout, debt to equity and price to free cash flow ratios, as can be seen in the below:
The most obvious factors that work together are selecting companies with low payout and debt to equity ratios. This combination focuses the strategy toward companies whose dividends are the safest as they are both covering their dividend with earnings and have relatively low debt levels to service.
Similarly, a company’s free cash flow tells us as investors how much cash a company generates to invest or pay out as dividends. A low price to free cash flow ratios tells us that a company could be undervalued by the market and could be poised to increase in value. Alternatively, it could show the company has underlying problems and issues – in this case the combination of this factor with low payout and debt to equity ratios seeks to minimize the number of junk stocks selected.
As of 4th July 2018, the strategy held the following positions:
Wingstop Inc (WING)
Advanced Emissions Solutions (ADES)
HP Inc (HPQ)
Cohen & Steers Inc (CNS)
Enduro Royalty Trust (NDRO)
New England Realty Associates (NEN)
Capital Southwest Corp (CSWC)
Buckle Inc (BKE)
Tailored Brands Inc (TLRD)
Hi-Crush Partners (HCLP)
Positions Closed On 2nd July 2018
The strategy sold three positions to make way for the newcomers:
National Presto Industries (NPK)
Ennis Inc (EBF)
Insteel Industries Inc (IIIN)
A key risk that I always examine with mechanical investing strategies is that the data phenomenon that I am exploiting will simply stop working. To combat this, I look to see if a strategy intuitively makes sense – my model invests in companies with relatively safe dividends and that are undervalued based on the levels of free cash flow they generate. To me, these are all logical and understandable factors as to why our system works and should continue to be profitable.
The average company my strategy invests in has a market capitalization of $250m-$2.5bn, leading to potential problems exiting positions at the lower end of our range in a market downturn. Risk appetite is an individual thing – for me the enhanced returns that come from focusing on smaller companies more than compensate the liquidity risk we take on. If this is a concern, operating the strategy with a higher market cap threshold would have still resulted in substantial historical profits.
Finally, a risk specific to this strategy is in its concentration. The portfolio has seen some large losses in a small number of its investments, including BCRH (an insurer that took losses from hurricane Irma) and NTIP (losing a patent-infringement trial) which could have been mitigated by electing to hold more positions in the portfolio. One of the beauties of being able to backtest these strategies is being able to refer to history – the model I researched last year would have experienced losses of greater than 30% in 29 of its 598 positions, and increasing the number of positions entered at any one time acted as a material drag on performance.
My original research showed that historically you could have earned 16% returns investing in small, dividend-paying companies without taking on too much risk. The proof in the pudding, they say, is in the eating – over the 10 months since September the strategy has shown returns that are above expectations.
This review has shown me that my original stance of not materially investing in dividend stocks as a whole was flawed, and reminded me that you can almost always find opportunities in any market. This strategy has done a good job of identifying one of them, and I see no reason to believe that it will stop any time soon.