Research Affiliates: Elegant Design

December 15, 2015

A Design That Works

"Some people think design means how it looks. But of course, if you dig deeper, it's really how it works."

Steve Jobs5

Designers charged with developing a new product should start by focusing on how that product can work best. For an investment product, that means they should focus on the components of return most valued by a particular type of investor. For many investors, total return is what matters, but some investors prefer to maximize the income component relative to the capital appreciation, or growth, component. Individual investors, for example, use portfolio income to meet their living expenses; defined benefit pension funds use current income to discharge their obligations to beneficiaries; university endowments need income to pay the institutions' operating expenses; and charitable trusts dispense investment income to support their particular cause. Many investors with an income preference turn to high-yield equity products, those with relatively high dividend distributions.

Currently, investors with a greater preference for income have two product options to choose from: dividend yield–oriented products and dividend grower products. Figure 1 illustrates how these two products differ in terms of company quality (vertical axis), as measured by the average Standard & Poor's credit rating of the constituent companies, and the dividend yield pick-up, which is the difference between the current dividend yields of the strategy and the benchmark (horizontal axis). The dividend yield–oriented products seek higher dividend–yielding stocks; that is, stocks with a record of high dividend payouts and a low current price. But the low price relative to dividends paid can signal one of two things: cheap future dividends (that's what investors want!) or distressed and slow-growing companies that may stop paying dividends in the future (that's what investors want to avoid!).

The dividend grower products seek stocks that have a lengthy history of positive, steady dividend growth. This strong historical record is an indirect proxy for quality and typically signals a healthy company. As a result, dividend grower products generally own higher quality companies than dividend yield–oriented products. But because a stock's history of dividend growth is unrelated to its dividend yield (i.e., no bias exists toward higher yielding stocks), the stocks in this category typically have a lower dividend yield, as indicated in Figure 1, than dividend yield–oriented products.


Research Affiliates: Elegant Design

For a larger view, please click on the image above.

The consequence is that dividend-oriented investors often must make a trade-off between quality and yield. Both high- and low-quality companies can have the same dividend yield. Not knowing which is which can introduce poorly performing companies into a dividend-yield portfolio. Some high-yield stocks are cheaply priced equity of high-quality dividend-paying companies. Other high-yield stocks are cheaply priced equity of low-quality companies with unsustainable dividends. Low quality can be explained by one or more of the following considerations: financial distress, unsustainability of profits, and poor accounting practices, sometimes even extending to fraud. Simply paying the lowest price for a given dividend is not an optimal strategy.

We believe the quality–yield trade-off is largely unnecessary. The challenge is to find the high-quality companies among those with high dividend yields. In an article we published in June 2015, "The Market for 'Lemons': A Lesson for Dividend Investors," we showed that introducing company-quality screens in selecting stocks for a high dividend–yield portfolio can help investors avoid this trade-off.

 

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