Situation: Some investors are experienced enough to try beating the market, but few tools are available to help them. Business schools professors like to point out that it is a settled issue, with only two routes are available: A stock-picker can either seek information from a company insider (which is illegal) or assume more risk (buy high-beta stocks). The latter route can provide higher returns but those will eventually be eroded by the higher volatility in stock prices. In other words, risk-adjusted returns (at their best) will not beat an S&P 500 Index fund (e.g. VFINX) or ETF (e.g. SPY).
Mission: Develop an algorithm for investing in high-beta stocks. Use our Standard Spreadsheet for companies likely to have higher quality.
Execution: see Table.
Administration: We call the resulting algorithm “The 2 and 8 Club” because it focuses on companies that a) pay an above-market dividend and b) have grown that dividend at least 8%/yr over the most recent 5 year period. Quality criteria require that a company’s bonds carry an S&P rating of BBB+ or better, and that its common stock carry an S&P rating of B+/M or better. We also require 16 or more years of trading records on a public exchange, so that weekly prices can be analyzed by the “BMW Method”. We use the SPDR Dow Jones Industrial Average ETF (DIA) as our benchmark, given that it rarely has a dividend yield lower than 2% or a dividend growth rate lower than 8%. And, we use the US companies listed in the Financial Times Stock Exchange (FTSE) High Dividend Yield Index as our only source for stocks paying an above-market dividend. That index is based on the FTSE Russell 1000 Index. The Vanguard Group markets both a mutual fund (VHDYX) and an ETF (VYM) for the ~400 companies in the FTSE High Dividend Yield Index. The same companies are found on each list, and weighted by market capitalization and updated monthly.
Bottom Line: As expected, this algorithm beats the S&P 500 Index (see Columns C, F, K & W) at the expense of greater risk (see Columns D, I, J & M). Its utility lies in risk mitigation (see Columns R & S), where the cutoffs for S&P rankings make these companies above-average for the S&P 500 Index with respect to the risk of bankruptcy. Only 23 companies in the S&P 500 Index qualify for membership in “The 2 and 8 Club”, and only 5 of those are in the Dow Jones Industrial Average (JPM, TRV, CSCO, MMM, IBM). An additional 5 companies are found in the FTSE Russell 1000 Index but have insufficient market capitalization to be included in the S&P 500 Index (WSO, HUBB, SWX, EV, R; see COMPARISONS section in the Table).
Risk Rating: 7 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, gold bullion = 10)
Full Disclosure: I dollar-average into JPM and NEE, and also own shares of TRV, MMM, BLK, IBM, R and CMI.
Caveat Emptor: This week’s blog is addressed to investors who a) have been investing in common stocks for more than 20 years, b) don’t use margin loans, and c) have more than $200,000 available for making such investments. Most investors are best served by maintaining a 50-50 balance between stocks and bonds, e.g. by investing in the total US stock and bond markets (VTI and BND at Lines 30 & 38 in the Table). That 50-50 investment has returned ~8%/yr over the past 10 years and ~5%/yr over the past 5 years. The same result can be found by investing in a balanced mutual fund where stocks and bonds are picked for you: The Vanguard Wellesley Income Fund (VWINX at Line 35 in the Table). Either way, you’re likely to have no more than 2 down years per decade: VWINX has had only 7 down years since 1970. NOTE: all of the stocks in VWINX are picked from the same FTSE High Dividend Yield Index that we use for “The 2 and Club”.
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