Quant Concepts: U.S. High Income Portfolio

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Phil Dabo: Welcome to Quant Concepts' working from home edition. As interest rates went to all-time lows last year during the pandemic, it has become increasingly challenging to find yield in the United States. Today, the U.S. 10-year bond and the S&P 500 yield are very close to each other at 1% to 1.6%. This hasn't always been the case as a 10-year bond used to be close to 5% in 2006, while the S&P 500 yield was a lot closer to 2%.

Now, investors may be looking at stocks to get income that they need in their portfolio, and that they can use to pay for daily expenses, and they can also get the additional benefit of participating in an upward trending equity market.

Today, let's take a look at a strategy that offers a yield that's over 3%, which is twice the amount on the S&P 500 and the 10-year bond. Let's start by selecting our universe of stocks, which includes all 500 stocks in the S&P 500. Next, we're going to rank our stocks according to five key factors. The first factor is the market cap, except we've done something a bit different. We're going to rank the stocks from low to high in order to capture more mid-cap stocks. Next is our 3-months earnings revision because we'd like to see companies analysts have a positive outlook for. Next is our industry relative yield, which puts more emphasis on stocks that have a higher yield compared to others in the same sector. Next is our return on equity, which is a good measure of financial performance and profitability. Our last factor is return on total assets because we'd like to see companies that are reinvesting in their business, but we want to make sure that they are generating a good return from their investments.

Now that we have our stocks ranked from 1 to 500, we can start going through the screening process. We're only going to buy stocks that are ranked in the top 20th percentile. And we're only going to buy stocks that have a market cap above $500 million. The yield on the stock has to be above 2%, which is higher than the yield on the S&P 500, and they can't pay out more than 100% of their income because we would like companies to reinvest some of that income back into the business. We want to avoid companies that have a negative quarterly earnings momentum, and we don't want companies that rank in the bottom third based on the debt-to-EBITDA, because we want to make sure that companies will have enough income to manage their liabilities while paying out a good dividend at the same time.

Now, let's take a look at our sell rules, which are quite simple. We're going to sell stocks if they fall out of the top 40th percentile of our list. And if their yield drops below 1.06%. We're going to sell stocks if their payout ratio goes above 100% because it will not have enough money to reinvest in their business, and they might not be able to maintain the dividend. We're also going to sell stocks if their quarterly earnings momentum drops below negative 5%. And if they start to have too much debt in relation to EBITDA.

Now let's take a look at performance. The benchmark that we used is the S&P 500 Total Return Index and we tested the strategy from January 2006 to June 2021. Over this time period, this strategy has generated a very strong 15.1% return which is 4.7% higher than the index, with only a 32% annualized turnover.

We can see by looking at the annualized performance that this strategy has generated a very good long-term track record over the 3, 5, 10 and 15-year periods with slightly lower price risk, as you can see by the standard deviation, which has contributed very nicely to risk-adjusted returns, which has beaten the index over every significant time period. It's also important to note that this strategy has had lower market risk, as you can see by beta.

I really like to look at this chart because you can see very good outperformance by the strategy over time. And when looking at the market capture ratios, we can see that this strategy has participated a little bit in up markets, but it has really performed well in down markets, which contributes to a very good overall market capture ratio.

This is a great strategy to consider for investors that are interested in U.S. stocks that have a higher income than the S&P 500 and also provide an opportunity to grow their investment over time. It's also remarkable that this strategy has a downside capture ratio showing that it outperformed the S&P 500 over every quarter that the index was down since January 2006. This would support the idea that the strategy is suitable for conservative clients that also want a distribution of income while their money is tied up in the stock. You can find the buy list along with a transcript of this video.

From Morningstar, I'm Phil Dabo.

A larger version of the table is available here.