Written by Liam Flavelle on 13 June 2018
- What are the best factors to analyze in order to successfully invest in dividend-paying companies?
- I research the effects of earnings per share on US income-generating stocks.
- The result of my investigation is a strategy that would have returned 26% annually for the last 8 years.
- I find that the quality and consistency of a company's earnings are just as important as its earnings growth.
Dividend strategies have always been a popular way to invest your money, never more so than in the low interest rate environment that has existed now for a decade. A simple google search for 'Best way to invest in safe dividend stocks' reveals a deluge of opinions that are often at odds with each other.
As seasoned dividend investors we know we should be looking at earnings and dividend growth rates, consecutive years of dividend growth, low payout ratios, high yields and low debt levels to name just a few factors. But how do we really know what makes a dividend stock a good investment opportunity?
This is the first in a series of articles researching what effect these factors have on the stocks we invest in, with the aim of identifying the ones we should be using and those that we should be avoiding like the plague. Today we will focus on the effects of earnings per share on a portfolio of dividend stocks, and how we can use different methods to measure it to identify companies we should be investing in.
As usual, I've used the InvestorsEdge.net platform to perform my research - clicking on an image will take you to the strategy results in question, from which you can take a copy and play with the model yourself.
Starting Point - Reaching For Yield!
To start with, let's see how the average investor who reaches for yield would have fared. Below is a strategy that at the start of each quarter buys the top 50 yielding stocks in the US with a market capitalization greater than $50m.
So that is one piece of prevailing wisdom confirmed - simply chasing the highest yields doesn't work and if we had been investing in this strategy over the past 8 years we would have lost 20% of our starting capital. Possibly the bigger surprise is that the loss was so small, as I was expecting a bigger drop in equity value before I pressed the button to perform the backtest. Digging behind the headline data, the strategy would have returned an average income of 7.8% a year, but would have lost 8.5% annually in price depreciation at the same time.
So yes, you can create an income from investing in higher yielding stocks - you just have to find a way of sorting the gems from the junk so that your capital appreciates at the same time.
Does Earnings Growth Matter?
It seems logical that dividend-paying stocks that grow their earnings the fastest will be able to pay higher dividends in the future and their share price will appreciate faster than slower-growing enterprises, so let's see how the our strategy works if we limit our universe to stocks that are growing their Earnings Per Share.
I have researched over 60 different combinations of earnings growth ranging from 10-35% over the previous 3-8 periods and found the sweet spot is to prefer stocks to have shown between 10-35% growth in earnings over the previous 3-4 periods. The best returns came from selecting stocks with at least 25% growth in EPS over the previous 4 quarters:
While an 19% annual return isn't bad, few investors would stomach the 50% loss that occurred during the taper tantrum at the start of 2016, so we need to find a way of dampening our strategy's volatility.
Ranking by Earnings
One way to select less volatile stocks is to rank them by more than one factor. Our initial model ranks companies by their dividend yield and selects the top 10 each quarter, but when you add EPS growth and consistency as additional factors an interesting pattern forms:
Adding both the actual growth in EPS and the standard deviation (StdDev) in the earnings numbers makes a big impact on volatility whilst improving returns. Standard deviation measures the volatility in a series of values, and allows us to prefer stocks that have shown consistent levels of growth over those that saw stellar increases in one quarter and sub-optimal ones in the others.
The above chart shows the best combination I found, ranking stocks by their Yield, % Eps Growth over the last 3 quarters and the standard deviation of EPS over the last 6 quarters. Returns from our latest attempt would have increased by 0.5%, but more importantly our strategy now would have 'only' lost 33% in January 2016 - still too high but definitely heading in the right direction.
I made one last change that made a big difference in our strategy's performance; screening on stocks that had the most consistent earnings numbers - if you also limit your universe of stocks to those with a low volatility in earnings growth you would have seen the following returns:
I found that while limiting the standard deviation of EPS over the last 6-12 periods to any value below 1.5 produced enhanced returns, the best performance came when limiting the volatility to a maximum of 0.9.
This final iteration shows a dramatic increase in our strategy's performance whilst keeping volatility level, returning an average annual yield of 6.8% with a 600% increase in our starting investment over an 8 year period.
On the downside, the volatility is still too high for a non-recessionary environment and the win rate (the number of winners divided by the number of losers) is a bit low for my tastes. The next stage is to look at other factors to improve the strategy's performance.
This article was written to understand if earnings are a big factor to consider when investing in dividend-paying stocks, and the answer is a resounding 'Yes'. The key takeaway from this research is that the quality and consistency of a company's EPS history is just as important as its growth in EPS. Our final strategy looks like this:
The next part of this series of articles will move the focus away from earnings and analyze what part debt plays in successful dividend investing.