Research Affiliates Screens for Smart vs. Dumb Dividends

Research Affiliates may perhaps be best known for the 2% return advantage by which its smart beta strategy is said to outperform cap-weighted indexes.

Now the data-driven investment firm, in its June newsletter, is proposing a dividend investing strategy that also coincidentally results in a 2% per year advantage over a more basic high-yield stock portfolio in a simulation looking back over the past 50 years.

The near zero interest-rate environment that has prevailed since the financial crisis has heightened interest in stock dividends as a potentially more reliable method of generating portfolio income, but one that is nevertheless fraught with its own unique risks.

Migrating from low-yielding bonds to high-yielding stocks might seem a no-brainer since dividends are persistent, less volatile than equity prices and since stock volatility provides opportunities to buy yield cheaply; what’s more, investors can spend the dividends while leaving their principal intact.

Yet as Research Affiliates execs Chris Brightman, Vitali Kalesnik and Engin Kose point out, dividend-paying stocks may resemble one another for their high yield but hidden within the basket containing these equities are “lemons” whose fundamental flaws will give their owners grief.

“As when buying a used car, buying bargain equities can produce nasty surprises,” the authors write.

So while cheap equities (whose dividend yield rises as the price of the stock declines) have historically outperformed expensive equities (and even lowered volatility), high-yield stocks carry the downside of a higher percentage of delisted stocks and slower future dividend growth.

The question Research Affiliates asks is: can an investor enjoy high equity income “cherries” without interference of these occasional, seemingly indistinguishable lemons?

And indeed the Newport Beach, Calif.-based firm suggests three ways to screen out the investment lemons, with each incrementally improving characteristics of the ensuring portfolio.

The first screen is profitability, based on the intuitive notion that a company with poor growth prospects is like used-car lemons that are always in and out of the auto shop.

Citing Blockbuster Video Entertainment as a classic case of a high-dividend-yielding company with poor profitability (after cable, satellite and broadband killed its business), the authors use return on assets as a proxy measure of profitable firms.

Their simulation shows that the high-yield, high-profitability portfolio gained 50 basis points per year (over 50 years) in comparison to a high-yield, low-profitability portfolio. What’s more, the high-quality portfolio had many other advantages: its volatility was lower; the number of delisted companies fell from 8 to 1 (out of 100 companies); and its subsequent five-year dividend growth rate shot up to 18.6% from 10.5%.

Investors only lost 0.1% in dividend yield (from 5.6% to 5.5%) to gain these quality advantages.

The profitability screen fueled the portfolio’s higher performance, not through higher yield (which declined slightly) but through a faster rate of company growth.