On October 24th, I introduced the Smart Alpha Equity Income model. With three months having past since the portfolio was initially put together, it’s time to publish and updated list of stocks (see below) and look in on how the model has fared since it went live.
Assessing Yield Risk
We know that Mr. Market is incredibly averse to handing out free lunches. So if Stock A yields 2% while Stock B yields 5%, hopefully, we’re sufficiently alert not to plow all our money into Stock B. Sure the yield is better, much better. But there has to be a catch.
Usually, there is. There’s a much greater chance that the dividend on Stock B will fall, be eliminated, or at the very least not grow nearly as much as we might expect with Stock A. This is not a black-and-white rule. It’s possible risk and growth prospects may be equal for both. But experience shows Mr. Market is very skilled at evaluating the relative merits of income stocks, insofar as dividend security and growth prospects are concerned, balancing it all out with yield differentials (equivalent to handicaps in golf, point spreads in football, etc.). While I don’t usually like rules of thumb, if someone were to suggest they could sort income stocks based on risk and do so only by lining the stocks up based on yield, I wouldn’t argue.
But here’s another catch, something that provides an opening for income investors looking for an edge. The sort of risk with which we’re most concerned is binary; something (dividend cut or elimination) will or won’t happen. The probability of bad outcomes, however, is not binary. There are infinite shades of grey between zero-risk and hopeless. This allows us to challenge how much of a handicap or point spread (i.e. excess yield) is warranted for a given level of risk.
This model is based on the notion that Mr. Market overdoes it in terms of assignment of handicaps. In other words, plenty of stocks in the intermediate-yield range (in between safe and junk) carry much less risk than many realize. This model identifies intermediate-level yielding stocks that are favorably regarded in the investment community (implying favorable qualitative assessments of their respective futures) and well ranked under a fundamental quality ranking system (in order to provide quantitative support to favorable sentiment). Details were discussed in the introductory post.
