The Idea Of The Model
The concept of the model is exactly what it's title, Prudent Yield Hog, suggests.
The yield-hog aspect refers to an odd quality where the final stock list is compiled by sorting, not on the basis of a ranking system, but on the basis of yield (a descending sort). The default setting, the one incorporated into the model as pre-defined on Portfolio123, assumes 15 stocks will be chosen.
Sorting based on a factor like yield isn't necessarily odd in and of itself. The availability of the Quick-Rank feature in Portfolio123 assumes many will want to go that route. What's strange, here, is that we actually do rely heavily on a ranking system (quick-rank is typically used when there is no ranking system). But in this case, rather than using the ranking system to help us identify the top stocks, we use it only as one of our filters.
The leads us to the other aspect of the strategy; the prudence. Part of this comes from a rule setting a minimum rank threshold as per the system developed specifically to accompany the screen, and part from a rule setting an upper limit to the allowable yield. Use of a ranking system to identify merit is business as usual for Portfolio123 users. But use of an upper yield limit in an income screen, may strike some as odd. Actually, though, it may be the single most important factor that allows us to chase yield; it eliminates the riskiest situations up front. This is not to say stocks yielding 20% or so (in today's interest-rate environment) are inherently bad. Some may present terrific opportunities, but not for income investors. Ideas like that fall into the category of "cigar-butt value" and would best be addressed by strategies designed for that sort of thing.
Selection Criteria In Detail
Figure 1 shows the Prudent Yield Hog screening rules.
Figure 1
The ADR exclusion is a matter of convenience. The tendency of many issuers to pay semi-annual rather than quarterly dividends can lead to some screening oddities. If you are working with a model like this with the idea of generating ideas for one-at-a-time review as opposed to an automated portfolio, you may want to consider suppressing this rule. Another convenience rule is the exclusion of companies classified by Thomson Reuters, our data provider, as Miscellaneous Financial Services. Many of these are closed-end mutual funds for which all of our fundamental data is really irrelevant. If you're willing to consider these anyway (as you'll soon see, the ranking system has a healthy does of dividend-growth and sentiment exposure that could be used), you may want to modify this rule as well.
Notice that the yield boundaries are set with reference to the 10-year treasury rate. Doing it this way spares you the burden of constantly changing the screen as the interest-rate environment shifts. For example, a 20% yield would be a red flag today, but who knows what things will look like five years from now. If the world changes such that it would be reasonable to seek yields at or even above 20%, the screen will adapt automatically. Note, too, that the lower limit is below the Treasury rate. I'm not suggesting anyone should accept lower returns from stocks than risk-free instruments; it's simply an acknowledgement that with stocks, part of the return is expected to come from growth.
The last rule, the rank threshold, is the one you'll most likely want to modify based on your own preferences. My own experiments suggest you can go down to 40 if you want to dial up the risk-reward action, but I wouldn't go much lower. Performance tests on the ranking system, when confined to an income-oriented universe, suggest its main virtue is to eliminate the worst potential situations (as opposed to the bar graphs with the 45-degree upward slopes we like to see). So going too low would wipe out the main benefit we expect to get from use of the ranks. I'd also be leery about setting the threshold too high, say above 75. That will push yields down. We'd expect to compensate for that with more capital gain, but if we're going to go that route, that's really not a yield hog approach and there are probably are better ways to do it.
Figure 2 shows a summary of the ranking system, referred to as Special: Income Stock Selection Group. The name may be a bit over the top, but I do want to emphasize the intended use for this system, as a way to pre-qualify a broad field form which we'll select as we chase equity yield. A standard performance test may suggest the system has promise for stocks in general, but it's the sort of test upon which we should not over-rely. For non-dividend-paying stocks, a little more than 50% of the rank will be based on NA factors, and stocks that pay modest dividends (below the levels an income-seeker would want), will often find themselves pushed toward the bottom.
Figure 2
Not surprisingly for an income model, payout ratio figures prominently. Note, though, that I use the trailing 12 month figure only. I'm looking to ferret out immediate threats to the payout. I don't want this to morph into a general test of financial strength, as often happens when we build screens and ranking systems addressed to income stocks. As long as the immediate risk to the payout seems tolerable, we should be prepared to accept companies whose finances may be less than sterling. After all, we are being yield hogs. Note, too, that I'm sorting payout with reference to industry; I don;t want to penalize firms in industries normally characterized by high payout ratios.
The growth portion of the model emphasizes dividend growth, as might be expected. But sales and EPS growth are considered as well, since these ultimately increase the pace at which dividends can grow. Figure 3 provides a close-up of the Growth component.
Figure 3
The EPS and Sales growth components should look familiar. They're based on Growth modeling used in the pre-defined Basic: Growth rank. Note, too, that the dividend-growth component, while, looking at the longer term (as is often done in income models), places greater emphasis on immediacy. Healthy recent dividend increases can be good for near-term share price performance. I want to feature that idea conspicuously; yield-hog approaches often don't outperform well in terms of share price changes, so I want to try as best I can to fight that tendency.
Finally, we have investor Sentiment, which is shown up close in Figure 4.
Figure 4
The top two sub-categories, Price Signals and Technical Signals, should also look familiar. These comprise the pre-defined Basic: Momentum ranking system. What's interesting is their inclusion, with prominence no less, in an income-oriented ranking system. The idea, here, is to let consensus market opinion help us assess risk. Within the context of the high-yielding group created through the screening filters, it seems reasonable to assume companies in trouble, most vulnerable to dividend cuts, will fare poorly under such ranking factors. This theme persists in the third sub-category, which mostly looks for moderate and/or falling short interest. The 50%-factor, yield signal, assumes a danger signal if a stock's yield, relative to industry peers, jumps to high-by-historical standards, levels and vice versa.
Odds And ends
The strategy presumes that about 15 stocks will be held and that rebalancing will occur once every three months. In terms of testing, it looks like we can accept a shorter re-balancing period. But this is an income strategy and actual receipt of dividends is important. With companies typically paying quarterly dividends, it's important that we make sure all stocks are held long enough to actually collect a payment. You can't always count on that happening if you rebalance more frequently.
