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Brandon Strong: Welcome to Quant Concepts. Income investors have two major goals – to generate a steady income and preserve the capital invested into a company. With interest rates gradually rising, these goals set in place by income investors will become increasingly difficult to achieve using the standard buy and hold strategy. However, not all dividend strategies are built alike. Some strategies place a greater focus on dividend growth. Others look for dividend payers with a steady payout. Some are purely momentum and technical based.
But what if we could get the best of both worlds? That's what we set out to achieve today. We are looking to build a strategy that identifies companies with growth in dividends, steady payout and short-term dividend momentum coupled with a splash of downside protection. You'll see what I mean in a moment. So, let's jump right into the strategy creation process. Today, let's look at a strategy with a focus on dividends.
Let's start by ranking our universe of around 2,000 stocks. In the ranking step, we're going to look at five different factors, each with their own purpose intended to round out the strategy. The first factor is yield on expected dividends. Very straightforward, but it's the estimated annual dividend rate expressed as a percentage of the latest market price of the stock. For our strategy, the higher the yield, the better. The next factor we have is five-year price beta versus the market index. As most of us know, beta is a measure of an asset's risk relative to the market. Low beta stocks tend to be more established, have greater stability of earnings, and so on. Essentially, we want to keep that dividend healthy.
Next, we have five-year normalized dividend growth which measures the annual compound growth of dividends per share averaged over the past five years. Not only do we want a higher dividend yield, but we want growth in dividends as well, as most companies tend to grow their dividend when they are profitable, healthy and positioned well in their sector. The next factor would be the quarterly earnings momentum, which measures the rate of change of quarterly operating earnings per share. This is calculated as the percentage change between the latest four quarters of operating earnings per share and the four quarters of operating earnings from one quarter ago. We use this to see if a company's trailing earnings have increased in the past quarter. And lastly, three-month estimate revision, which measures the percentage change over the past three months in the current fiscal year median earnings estimate. Analysts' sentiment is important, but we don't want to rely heavily on this information. That is why we placed a small DOI on this factor.
Now, let's run through the screening process. As you can see here, we're only going to select stocks that rank in the top 10th percentile of our list. We are going to eliminate any stocks that do not pay a dividend yield greater than 3.5%. We chose to place a buy rule on three-month estimate revisions of a C-. We want our selected stocks to be revised up rather than down to give the best possible chance of future outperformance. Furthermore, we included a market cap screen of a D+ to make sure we have sufficient liquidity.
The number of estimates must be greater than three, as we want our estimate revision factor to be meaningful rather than basing it off of the median estimate of 1 to 2 analysts. And lastly, we included a screen on the MIC 80-day moving average factor. This factor will put our portfolio to cash if the S&P 500 dips below minus 3% of its 80-day moving average.
Next, let's take a look at our sell rules. We are going to select stocks that fall out of the top 40th percentile of our list. We have a larger gap between our buy threshold and our sell threshold than previously seen in other strategies. Essentially, we want wiggle room for these dividend stocks to run their course as they tend to perform better over the long run. We want our stocks for the strategy to have a minimum dividend yield of 1%. As we saw a second ago, we are buying stocks based on their revised estimates. So, we will sell on this factor as well with a value of a D-. If estimates are slashed significantly relative to the universe, the stock will be sold out of the model. And lastly, we need to place a value on the MIC 80-day moving average factor in order for it to actually sell the whole portfolio if the minus 3% value is met.
In our back test we've started the period from Jan 2001, and we've run it until March 2022. Over that time period, we've seen our strategy outperform and underperform in a few different time periods. Since inception our strategy takes the cake. We are rewarded in the form of dividends and steady moderate return. Taking a look at the strategy's downside deviation, which is here, we can see how well we hold up versus the index. Our strategy has anywhere between 2% to 4% less downside deviation per time period. The strategy tends to hold up during market downturns, which is nice to see as we are bracing for higher inflation and a possible economic recession. Furthermore, we can see that this strategy has low aggregate beta over every time period. And we can see that this indicates that we have less market risk, which is ideal for the current climate.
And lastly, we can see significant alpha generated from this strategy. Here we can see that the turnover is quite high compared to a typical dividend strategy. This is mostly due to our MIC 80-day moving average factor, which causes 100% turnover if the threshold is met. If I go into the performance breakdown tab, I can see all the times that our turnover was 100%. This would mean that that factor is triggered, and our portfolio was held in cash during that time.
As mentioned before, we've seen significant outperformance since '01, but most importantly, the strategy holds up in the long run. We are happy to trade safety for excess return as the macroeconomic environment remains shaky. Again, if you're looking for a strategy that identifies companies with strong dividend characteristics and sufficient downside protection, please make sure to check out the buy list accompanying the transcript of this video.
From Morningstar, I'm Brandon Strong.
