Building A Low Risk Dividend Strategy

We show you how to build a profitable, low risk income-producing strategy.

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Written by Liam Flavelle on 11 August 2017

Summary

  • Our last article analyzed often used factors used to select dividend stocks.
  • We have taken this research and designed a trading strategy that would have returned 18% annually.
  • Our final design would have yielded 3.7% a year and total returns of 1,800% over a 17 year period.

Our last dividend article (How to Build a Better Dividend Strategy) analyzed the typical factors used to differentiate 'good' dividend stocks from 'bad' ones, and ended with some surprising conclusions - our models showed that including traditional dividend growth or debt factors in our decision making process actually acted as a drag on total returns.

This final article in our Building a Dividend Strategy shows the results of our research - a trading system using 8 simple, readily available factors that has worked well over the long term and also over the last few years.

As usual, we have used the InvestorsEdge.net platform to backtest our trading ideas. Further graphs, charts and statistics, including position data, can be found by clicking here, or by clicking on one of the graphs in this article. To access the other versions of the model mentioned in this article, simply click on the history button in the left menu and select the desired version to view.

Here is a chart showing the simulated performance of our dividend model from 2000 until 2017:

Best Dividend Strategy Equity Curve

You can see that our average returns would have been 18.3% a year, with a maximum drawdown in 2008 of 60%:

Drawdowns

Apart from the financial crisis, the model's returns weren't really affected by the dotcom bubble, the 2011 Euro crisis or the 2016 oil price plunge, which is exactly what we want from an income strategy - low volatility. So, the headline 60% drawdown figure looks bad, but the strategy's behaviour outside of the great financial crisis is pretty good.

Market Cap

The strategy also focuses on small-cap companies (between US $300-2,000 million), meaning that the model doesn't typically open positions in tiny, illiquid stocks).

How Did We Do It?

I always advocate simplicity when designing and refining trading strategies - our new model consists of just 8 factors.

First, the universe of stocks that our strategy will consider opening positions in is built of companies that meet the the following criteria:

  • All US shares and depository receipts with a market capitalization greater than US $100m and a closing price greater than $1.
  • A trailing yield greater than 2%.
  • A payout ratio less than 80%.
  • A Debt To Equity ratio of less than 0.4.

Over the years of our backtest the universe would have typically consisted of between 20-70 stocks. Next, the strategy then ranks our stocks by:

  • Payout ratio (lower is best)
  • Yield
  • Price to Free Cashflow ratio (lower is best)

At the start of each month we rebalance our portfolio of stocks by buying or holding the top 10 ranked companies in our list that meet our minimum liquidity threshold.

Recent Performance

One way of identifying if a strategy is robust is to examine the rolling 3 year returns - this tells us how profitable the strategy would have been if we had run it for each of the 15 3-year periods going back to 2000:

Period

CAGR

2000-2

23%

2001-3

29%

2002-4

25%

2003-5

20%

2004-6

14%

2005-7

5%

2006-8

-11%

2007-9

1%

2008-10

13%

2009-11

26%

2010-12

18%

2011-13

22%

2012-14

25%

2013-15

23%

2014-16

16%

What this table shows us is that if we had started using the system at any time in the last 17 years it would have made money, with the one exception of investing at the start of the financial crisis (2006-8).

Would We Trade This Strategy?

For us to execute a trading strategy in real life, we need to have good reason to trust that it will continue to be profitable. To help us decide the likelihood of this, we have four-high level tests that our model should pass:

  • Investable - The strategy should be tradeable in real life and should scale. Our backtests include trading fees, so frictional costs are already taken into account. From a liquidity point of view, changing the starting cash to US $100,000 slightly reduces profitability down to 17.7% per annum, whilst setting our initial funds to US $1m sees 14% annual profits. Pass.
  • Intuitive - There should be logical risk- or behavioral-based reasons why the strategy works. We have attempted to create an income-producing strategy and have focused on factors that affect the payment of distributions to shareholders, namely Debt, Equity, Free Cash Flow, Yield and Payout Ratio that identify companies that are likely to continue paying distributions and increase in value. Pass.
  • Persistent - The factors involved should work over long periods of time. Our tests have concentrated on the 2000-17 period. From an academic point of view, this would not be long enough to prove persistence. However, from our point of view at InvestorsEdge, we consider going through two major market shocks and a series of smaller downturns as enough to convince us the strategy works on a long-term basis. Pass.
  • Pervasive - Pervasiveness is more an ideal than a hard rule - our model should work across countries, regions and sectors. Whilst running our strategy on companies from other countries didn't result in the same returns, we consider that a strategy that works across multiple time frames running in the country with the largest and most liquid set of exchanges in the world is acceptable. Pass.

Current Holdings

We started tracking this strategy is running in real time on the InvestorsEdge system on 1st August - here is the initial portfolio of stocks that the system invested in:

Company

Ticker

Entry

Supreme Industries

STS

14.38

Insteel Industries

IIIN

26.76

NTT Docomo

DCM

23.58

West Corp

WSTC

23.51

Sinopec Shanghai Petrochem

SHI

58.06

FutureFuel Corp

FF

14.79

Brinker International

EAT

35.3

Just Energy

JE

5.3

Harmony Gold Mining

HMY

1.78

Buckle Inc

BKE

17.27

Your Takeaway

Over the last few articles in this series we have designed and developed a trading strategy that in backtests would have historically returned 18% gains a year. Taking the financial crisis of 2007-8 out of the equation, volatility was low with average drawdowns of 10% over the 17 year test period.

We have now got to a point where we are happy to test our strategy in the real world. Our portfolio is set to rebalance at the start of each month, so from here on in we'll be writing a follow up article once a month charting the system's performance and transactions.

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