Stock Strategies - Principles, Policies and Rules – Portfolio123

Executive Summary

Portfolio123 Securities Stock Strategies are implemented through objective rules-based protocols (models) that determine which stocks should be bought and which should be sold. The models are refreshed once per week. However, they are designed for low turnover so more often than not, the model will not signal any trades for that particular occasion.

The models are all designed for the purposes of exploiting inefficiencies (instances of stock mis-pricing) in the equity markets, which we believe and, through research confirmed, are continuously present. Generally speaking, we look to buy stocks that are priced lower than warranted based on relevant fundamental characteristics. This is very different from a naïve value strategy that simply seeks stocks that are priced low (relative to earnings, sales, book value, etc.) without regard to whether other factors justify the low valuations. What we do is also different from naïve strategies such as growth, momentum or quality that simply seek “attractive” tallies under chosen metrics but do so without regard to where such metrics should be.

Simply put, we view the stock valuation in a holistic context; a stock can be deemed correctly or incorrectly priced only based on where it stands relative to key fundamental company characteristics (much the way an automobile can be correctly or incorrectly priced only relative to performance specs, appearance, etc.). For more on the characteristics we consider when we assess valuation, see Portfolio123 Securities White Paper #1.

Since our investments succeed or fail based on the unknowable future, stock selection can never be a true science. Although there are things we can and do learn from scientific approaches, there can ultimately never be any perfect certain-to-work formulation. Our goal is to develop and research clues that we believe can lead us toward stocks for which the probability of (favorable) mis-pricing is higher than average, and this involves the mixture of science with a considerable degree of art. Our approach is explained in White Paper #2.

There are many potential correct answers each of which works with different sets of stock-company characteristics and each of which is more or less compatible with different temperaments, circumstances, and risk tolerances of different investors. We offer, at this time, four different approaches all of which lean in the direction of Quality in order to help investors manage turnover and transaction costs.

The Equity Models

We presently offer four Equity Models all of which are based on the investment philosophy described in White Paper #1 and were structured on the basis of the principles described in White Paper #2. They differ in the way they seek stocks that conform to the ideal, and the reward-risk characteristics of each approach. The four models are as follows:

Enhanced U.S. Market Portfolio

Value Selections

High Quality

Equity Income

As discussed on White Paper #2, ranking systems are an important element of the Portfolio123 approach. We use ranking systems as part of our screening/filtering process (e.g., a rule limiting consideration to stocks with Value ranks above 80). Ranks are also used to sort stocks passing our screening rules with portfolio selections being drawn from those stocks with the highest rank scores.

The following raking systems are used in our models (descriptions of the individual models will state which systems are used in the particular model and how they are used).

Ranking Systems Used in Portfolio123 Invest Equity Models

Classic Quality

This ranking system is based on a core collection of fundamentals relating to the DuPont framework, which established return on equity as the penultimate measure of company quality, and articulates its components; margin, turnover and leverage.

The framework defines return on capital as net margin times asset turnover, and return on equity as return on capital times leverage. For purposes of investing, where we are concerned with expectations about the future rather than an analysis of the past per se, it can be more useful to look at attributes of the DuPont framework that, while not strictly part of the framework, provide a level of visibility into the company that may be more revealing of the company’s future. For example, we consider operating margin (a more purely “business” oriented measure) rather than net margin and supplement consideration of leverage with metrics that measure liquidity.

We also give attention to on Return on Investment (which does not reflect leverage) based on our belief that this provides strong insight into the health of the business separate and apart from corporate financial strategic choices. Time frame for historic data considered is also an issue. The long term is relevant for providing a broader view of the firm; the recent period is relevant for illustrating potential changes and in gauging the market’s potential here-and-now view (including potential investment “noise”).

The components of this ranking system are as follows:

Margins – 25% weight

Trailing 12 Month Operating Margin – 75% of category, higher is better
5-Year Average Operating Margin – 25% of category, higher is better

Turnover – 25% weight

Trailing 12 Month Asset Turnover, higher is better

Returns on Capital – 25% weight

Trailing 12 Month Return on Investment – 30% of category, higher is better
5-Year Average Return on Investment – 40% of category, higher is better
Trailing 12 Month Return on Equity – 30% of category, higher is better
5-Year Average Return on Equity – 40% of category, higher is better

Financial Strength – 25% weight

Latest Quarter Current Ratio – 30% of category, lower is better
Trailing 12 Month Interest Coverage – 45% of category, higher is better
Latest Quarter Total Debt to Equity – 25% of category, lower is better

Classic Sentiment

Sentiment, particularly analyst sentiment, is often very useful in stock selection. Expected growth is a key element of any investment case but expectations can be difficult to derive based on historic data, which tends to show poor persistence when it comes to growth rates. Use of analyst sentiment data can serve as a worthy proxy for expectations regarding the future, not necessarily detailed numeric forecasts but qualitative expectations regarding the adequacy of future growth relative to the stock price. Also, analyst sentiment can cue us to the presence or likely trend in market noise, as well as depict sentiment regarding other factors that are not readily quantifiable.

Analyst ratings (Buy, Hold, Sell, Neutral, Outperform, etc.) are one way of measuring sentiment but are by no means the only way, or even the best way. Even apart from questions that have been raised about the sincerity of these ratings, this is not even necessarily the major component of the job of a “sell side” (Wall Street) analyst. Much of their responsibility entails providing information to institutional clients who ultimately make their own investing decisions based on their own criteria.

Changes in ratings, however, tend to be more useful in that they signal analysts’ beliefs that trends for the company are more or less favorable than previously believed. The same holds true for estimate revision and earnings surprise.

The components of this ranking system are as follows:

Earnings Estimate Revision – 50% weight

Percent EPS Estimate Revision for Current Fiscal Year – 33.3% of category, higher is better
Percent EPS Estimate Revision for Current Fiscal Quarter – 33.3% of category, higher is better
EPS Estimate Range, Current Quarter – 33.3% of category, higher is better

Earnings Surprise – 30% weight

Percent EPS Surprise, Latest Quarter – 65 % of category, higher is better
Percent EPS Surprise, Prior Quarter – 35 % of category, higher is better

Analyst Recommendations – 20% weight

Average Analyst Recommendation – 25 % of category, more bullish is better
4-week Change in Average Analyst Recommendation – 75 % of category, change in the direction of bullishness is better

Comprehensive Value

The aim of any value-oriented ranking system is simple; to identify stocks which are “cheaper.” A single-factor Value ranking system might, for example, sort stocks on the basis of P/E with the idea that the investor will buy the stocks with the lowest P/E ratios (i.e. stocks with the highest scores under the ranking system).

In practice, the task is complicated by the fact that P/E is not the only potentially useful valuation metric. We can measure the relationship between price and sales, price and cash flow, price and book value. We can also use enterprise value (market capitalization plus debt and preferred stock minus cash on hand) and compare it to company fundamentals.

All of these variations derive from the Dividend Discount Model (see White Paper #1, Appendix A), and the reasonableness of each can be judged in terms of growth (of earnings, of sales, of book value, etc.) and company quality.

The components of this ranking system are as follows:

Based on Income-Statement Items – 50% weight

PEG Ratio (using forward PE and Growth rate) - 25% of category, lower is better
Trailing 12 Month Price to Sales - 25% of category, lower is better
Trailing 12 Month Price to Free Cash Flow) - 25% of category, lower is better
Forward PE Ratio (using Estimated E for Current Fiscal Year) - 25% of category, lower is better

Based on Balance-Sheet Items – 50% weight

Price to Book Value – 50% of category, lower is better
Enterprise Value to Estimated Sales for Current Fiscal Year – 50% of category, lower is better

Focused Sentiment

This ranking system is very similar to Classic Sentiment. It’s slightly more confined in that it omits two of the less sensitive factors; the current level of analyst ratings and the quarter-ago earnings surprise. It’s designed for use in situations where we believe analyst sentiment may play a lesser role than elsewhere.

Earnings Estimate Revision – 33.3% weight

Percent EPS Estimate Revision for Current Fiscal Year – 33.3% of category, higher is better
Percent EPS Estimate Revision for Current Fiscal Quarter – 33.3% of category, higher is better
EPS Estimate Range, Current Quarter – 33.3% of category, higher is better

Earnings Surprise – 33.3% weight

Percent EPS Surprise, Latest Quarter, higher is better

Analyst Recommendations – 33.3% weight

4-week Change in Average Analyst Recommendation, change in the direction of bullishness is better

Momentum

Momentum is an often under-appreciated and misunderstood but potentially powerful tool of equity analysis. As with Sentiment, this can be used to detect investment-community beliefs regarding important but not readily-quantifiable issues, as well as market “noise.” Momentum adds to the inquiry by not confining its scope to sell-side analysts; it embraces all of the equity community. Moreover, this measure of sentiment is not based on what investors or analysts say; it’s based on what they actually do.

Suspicion of momentum reflects a belief, at least an implicit belief, in the irrationality of the market, the notion that the herd or mob is always wrong. This is a popular and romantic view. But it’s also naïve. With information as widely and quickly disseminated as it is today, it’s more prudent to presume that all market participants have knowledge of the same material facts. Cynicism aside, it’s also reasonable to presume that all, or at least the vast majority, market participants act in what they see as their own best interests. This does not mean that Mr. Market is always right; we’re still dealing with the unknowable future. But the distribution of information and the logic of self-interest suggest that Mr. Market does, at least, make a good faith effort to get things right. And that means when one disagrees with Mr. Market, one should do so on the basis of clear reasons, as opposed to a dogmatic mob-is-always-wrong belief.

Critics of Momentum correctly point out that we cannot logically conclude that Equity Return in time-1 “causes” Equity Return in time-2. In other words, this is a case where A cannot cause B. However, neither A nor B occur in a vacuum. If both are caused by C (good earnings growth for example), then it can and will look as if A is causing B, as if Equity Return in time-2 can be inferred from what happened in time-1. The essence of successful Momentum investing is use of such A-B patterns to cue us indirectly to the underlying cause C.

Therefore, when a stock exhibits strong momentum, we can often presume the market is reacting to credible expectations regarding future developments, and vice versa.

The challenge lies in defining what constitutes strong momentum. Many presume this refers to technical analysis or very recent price strength, gaps up, moving average trends, and so forth. The temptation to day-trade can be strong. Actually, however, the sort of momentum to which we refer, the sort that can support fundamental investment decisions, unfolds more gradually and persists longer. And it is inextricably intertwined with human behavior which is not a straight-line phenomenon but which instead ebbs and flows. In the stock market, with a strong stock, we often see this manifested as a sustained uptrend trend punctuated by periods of profit taking. For buying opportunities, we therefore look not to peak performance but sustained strength albeit not necessarily continuing up through the moment of buying.

It’s important to note that we do not generally consider momentum alone. Our view of momentum requires that the market be reacting to positive fundamental developments. Hence we typically combine momentum with other fundamental factors.

The sole component of this ranking system is as follows:

120 Trading Day Share Price Change lagged by five days, higher is better

Short-Term Momentum Reversal

This is another aspect of momentum as discussed above. This simple ranking system is used in situations where we wish to look for profit taking opportunities. And to increase the probability that the reversal we’re seeing does, indeed, reflect profit taking rather than deterioration, this rank is used in conjunction with fundamental measures that suggest the former.

The sole component of this ranking system is as follows:

5 Trading Day Share Price Change, lower is better

Stability

Beta and Stability are well-known and well-revered concepts in finance. Beta is a measure of the volatility of a stock relative to the overall stock market. In financial theory (Nobel Prize winning theory!), it’s the measure of company-specific risk. Volatility, meanwhile, is a measure of a stock’s stability in its own right (without regard to market trends).

The world of implementation, however, can raise challenges. Suppose, for example, a stock swings back and forth wildly, more so than most, but does so in directions that are opposite those of the market. This can and does happen if company-specific developments occur without reference to the factors that influence the market as a whole. We could wind up, in such a case, with a very volatile-risky stock but one for which we compute a very low, or possibly even negative, Beta. Episodes of stock-specific volatility also can and do occur based on factors that are not sustainable, meaning historic share price volatility cannot necessarily be counted on as a reliable forecast of future volatility.

That said, in the ordinary course of events, low-risk businesses tend to produce more stable and more predictable profit streams and this tends to translate to relatively stable share price performance. Hence Beta and Volatility are useful often enough that we ought not be quick to discard them because of inevitable aberrations. This ranking system is designed to reduce the probability of aberrant distortions by measuring Beta and Volatility over multiple time periods. That, we believe, is a significant step in the right direction, but even that is not foolproof. Hence we tend to use this ranking system as a component in models that also consider company Quality, an important indication of potential future earnings and by implication, share price stability.

The components of this ranking system are as follows:

Beta – 50% weight

Beta calculated for the past year – 33.3% of category, lower is better
Beta calculated for the past 3 years – 33.3% of category, lower is better
Beta calculated for the past 5 years – 33.3% of category, lower is better

Volatility – 50% weight

Volatility calculated over the last 125 trading-day intervals – 33.3% of category, lower is better
Volatility calculated over the last 52 5-trading day intervals – 33.3% of category, lower is better
Volatility calculated over the last 36 21-trading day intervals – 33.3% of category, lower is better

The Stock Strategies

Portfolio123 Enhanced U.S. Market Portfolio

This is Portfolio123’s core U.S. stock market strategy. We start with a universe consisting of largest capitalization and most liquid portion of the market (the approximate top 20%) and generate a 20-stock portfolio of favorably-valued high-quality dividend-friendly stocks. Although the strategy is refreshed every week to monitor for sell signals and new purchases, we expect the portfolios emphasis on stability will result in low turnover.

The goal of this strategy is, as its name suggests, is to provide basic exposure to the U.S. equity market but to do so in a way that offers an alternative to the many passive index funds available elsewhere such as the S&P 500 SPDR ETF (SPY) or the Vanguard Total Stock Market ETF (VTI) and to do so in a way that offers market exposure plus something more, and enhancement.

The most easily and quickly noticeable differences between our market portfolio and those offered by others is the number of stocks (our portfolio aims to own 20 positions while major holdings of the major passive funds number in the hundreds or thousands) and the position weightings (our portfolio aims at approximately equal weightings while major passive funds tend to be approximately market capitalization weighted). The reasons for these differences are twofold:

The Enhancement for which we aim runs counter to the need to own everything, the latter being the motivating force behind the passive offerings. We pick and choose a portion of the market we believe will provide the general but enhanced exposure we seek.

We share in the liquidity goals of the passive funds; we need stocks that can be widely, easily, and reliably traded. That, however, is amply accomplished for us through our choice of a generally large-capitalization selection from among the universes created in connection with Portfolio123 Securities equity strategies. Beyond that, our strategy does not entail any sort of bigger-is-inherently-preferable belief, something that is an important driver of performance of many other passive funds (including Smart Beta offerings, which differ from the standard funds in that they define bigger in ways other than capitalization, specifically, in ways not tied to stock price movements). Since stocks that pass our model’s selection criteria are deemed equally desirable, we weight them equally (subject to subsequent adjustment based on market movements and the limits we adopt to guard against excessive exposure).

Based on the philosophical considerations discussed in White Paper #1 and the investment styles to which we translate them, as well as the need to control turnover and transaction costs, we define enhancement as benefits that investors can achieve through above-market exposure to the following styles:

Quality: expected future stability
Value: a reasonable relationship between a measure of equity value and measures of company wealth
Sentiment: an important proxy for expected future company growth
Income: a conspicuous portion of total return realized on an ongoing basis through dividends and the associated implications for stability (more emphasis on actual as opposed to expected return) and for those not devoting funds to consumption, opportunities to reinvest, potentially in an escalating-interest-rate environment

Our other three strategies, Value Selections, High Quality and Equity Income, offer focused exposure to the styles we pursue. This core strategy serves as a single-source for exposure to all three.

Strategy-Specific Buy Rules

The stock ranks above a specified threshold on the basis of our “Comprehensive Value” ranking system This implements the value aspect of the strategy and assures that any stock considered for purchase will have valuation metrics that signify that the stock’s valuation ratios are, on balance, lower than for most stocks in the eligible universe (i.e. that they are “value” stocks).

For a 10-position portfolio, the threshold is 80
For a 15-position portfolio, the threshold is 85
For a 20-position portfolio, the threshold is 85
For a 30-position portfolio, the threshold is 88

Purchase of the stock would not cause the portfolio to exceed the maximum allowable concentration in any single sector.

For a 10-position portfolio, the maximum allowable sector allocation is 30%
For a 15-position portfolio, the maximum allowable sector allocation is 20%
For a 20-position portfolio, the maximum allowable sector allocation is 20%
For a 30-position portfolio, the maximum allowable sector allocation is 20%

The Ranking system: Classic Quality-Sentiment-Size

This ranking system combines two systems, Classic Quality and Classic Sentiment, on a 40%-40% basis. The remaining 20% of the model consists of a single-factor rank based on the stock’s market capitalization (larger is better).
Limiting consideration to stocks that are well ranked under this system enhances the likelihood that considerations of growth and risk suggest ideal relative valuation metrics should be higher than those in effect in the market.

Strategy-Specific Sell Rules

The stock ranks below a specified threshold on the basis of our “Comprehensive Value” ranking system.

For a 10-position portfolio, the threshold is 75
For a 15-position portfolio, the threshold is 75
For a 20-position portfolio, the threshold is 75
For a 30-position portfolio, the threshold is 78

Deterioration in this rating suggests the stock is less attractively valued than it was at the time of purchase.

Value Selections

The Portfolio123 Value Selections portfolio owns stocks selected on the basis of favorable valuation and attention to other metrics relating to growth and risk that aim to reduce the likelihood that the stocks are modestly valued because they deserve to be cheap. Put another way, we aim not for stocks that are cheap per se, but stocks that are cheaper than they deserve to be given company fundamentals and prospects. Although the strategy is refreshed every week to monitor for sell signals and new purchases, we expect the portfolio’s additional consideration of quality will result in low turnover.

Value is the most basic and easily understood stock-market strategy. Buy low (when stocks are cheap) and sell high (when they get expensive). Nevertheless, it can be a very challenging strategy to implement. That’s because we cannot measure cheap or expensive only in terms of the price (i.e., in terms of valuation ratios such ass P/E). We must also consider what we get for our money.

We expect to pay more for quality merchandise in most areas of life; a meal at a Michelin-ranked restaurant is expected to cost more – much more – than a meal at a fast-food drive-thru. The same holds true in the stock market. We expect to pay more for shares of a great company than for shares of a weak firm. The quality of the company is measured in terms of the expected growth rate (not the historic growth rate, but the expected growth rate) and expected company-specific risk.

We do not, therefore, seek to buy shares with the lowest valuation ratios we can find. These may be cheap. Or they may be expensive. It also depends on the relationship between the valuation, growth, and company-specific risk.

After we have defined the appropriate investment universe and filtered to eliminate stocks that violate the uniform Buy Rules we use, we identify a subgroup of stocks having modest valuation metrics. From among these value candidates, we select the highest ranked stocks as per our “Classic Quality-Sentiment-Size” ranking system. The number selected is either 10, 15, 20 or 30, depending on the client’s choice.

Strategy-Specific Buy Rules

The stock ranks above a specified threshold on the basis of our “Comprehensive Value” ranking system This implements the basic strategy and assures that any stock considered for purchase will have valuation metrics lower than is the case for most stocks in the eligible universe (i.e. that they are “value” stocks).

For a 10-position portfolio, the threshold is 80
For a 15-position portfolio, the threshold is 85
For a 20-position portfolio, the threshold is 85
For a 30-position portfolio, the threshold is 88

Purchase of the stock would not cause the portfolio to exceed the maximum allowable concentration in any single sector.

For a 10-position portfolio, the maximum allowable sector allocation is 30%
For a 15-position portfolio, the maximum allowable sector allocation is 20%
For a 20-position portfolio, the maximum allowable sector allocation is 20%
For a 30-position portfolio, the maximum allowable sector allocation is 20%

The Ranking system: Classic Quality-Sentiment-Size

This ranking system combines two systems, Classic Quality and Classic Sentiment, on a 40%-40% basis. (See for details.) The remaining 20% of the model consists of a single-factor rank based on the stock’s market capitalization (larger is better).
Limiting consideration to stocks that are well ranked under this system enhances the likelihood that considerations of growth and risk suggest ideal relative valuation metrics should be higher than those in effect in the market.

Strategy-Specific Sell Rules

The stock ranks below a specified threshold on the basis of our “Comprehensive Value” ranking system (assuming, in all cases, complete financial statements were available as of the time when the rank was computed).

For a 10-position portfolio, the threshold is 75
For a 15-position portfolio, the threshold is 75
For a 20-position portfolio, the threshold is 75
For a 30-position portfolio, the threshold is 78

Deterioration in this rating suggests the stock is less attractively valued than it was at the time of purchase.

High Quality

The Portfolio123 High Quality stock portfolio invests in stocks selected primarily on the basis if stability; historical price stability and additionally, perhaps more importantly, fundamental factors that suggest a high probability of continuing relative-to-market stability in the future.. Although the strategy is refreshed every week to monitor for sell signals and new purchases, we expect the portfolios emphasis on stability will result in low turnover.

Company-specific risk is an important element of the investment case for or against a specific equity, as discussed in White Paper #1 and Appendix A therein. All else being equal, the lower the level of risk, the higher the warranted valuation. Much the way one pays extra to insure against catastrophic losses in everyday life (health care, auto usage, home ownership, etc.), so, too, should one expect to do likewise in the stock market.

This does not involve the sort of exotic derivatives-based “portfolio insurance” about which much has been written in the past. In fact, it’s quite the opposite, an approach that is as classically fundamental as can be. Risk, here, is defined in terms of volatility. But in contrast to statistical approaches about which you may have read elsewhere, we do not naively measure historic share-price volatility. While we do not ignore that, we focus heavily on the underlying factors that cause volatility to be what it is, making it more likely that we will successfully identify potential future volatility.

The metrics that help us do this are well known and widely used; margins, turnover, financial strength, returns on invested capital, and the nature of the business itself. This package of metrics is often referred to under the label “Quality” and would be familiar to those who have studies the likes of Graham and Dodd or Warren Buffett.

After filtering all available stocks and narrowing to those included in our investment universe and which pass muster under our uniform Buy rules (we allow up to 30% or the portfolio to be in a single sector), we filter further on the basis of Beta (the historic record of share price volatility relative to the market) and a strong rating our multi factor “Classic Quality” ranking system. We then select the highest rated stocks as per our “Stability” ranking system.

Strategy-Specific Buy Rules

The stock is ranked above 65 in our “Classic Quality” ranking system

This implements the basic strategy by assuring that all eligible stocks will rank favorably relative to the universe under a ranking system based on a constellation of Quality metrics covering return on capital and its components, and financial strength

The stock’s beta is below 0.90:

When calculated on the basis of the latest year . . .
And, when calculated on the basis of the three years . . .
And, when calculated on the basis of the latest five year

This supports the Quality strategy by limiting consideration to stocks that have histories of stability relative to the market. Such stability is typically the result of stable business profiles which tend to be reflected in high quality metrics. Use of multiple periods to measure beta increases the probability that the observed history of relative market stability reflects substantial factors rather than aberrant developments.

The Ranking system: Stability

Use of this ranking system to prioritize among stocks that satisfy all of the Buy rules means the portfolio is investing in the most stable among those stocks it can find consistent based on the assumption that all else being equal, more historic stability (as we define it and conditioned upon the group being sorted) suggests greater probability that the cause of the stability is fundamental and potentially sustainable in the future.

Strategy-Specific Sell Rules

The stock’s rating on the basis of the “Stability” ranking system falls below 60 (assuming it has been held for at least 60 trading days )

This condition would suggest a substantial (as opposed to transitory) deterioration in an important consideration that motivated purchase of the stock.

Or, the stock is ranked below 60 in our “Classic Quality” ranking system ( assuming it has been held for at least 60 trading days )

This condition would suggest a noteworthy deterioration in fundamental metrics relating to the likelihood of future earnings (and share price) stability.

Equity Income

The Portfolio123 Equity Income stock portfolio holds stocks selecting based on their attractive dividend yields, balanced against the need to guard against stocks whose yields are too high; in other words, so high as to suggest a significant risk of dividend reduction or elimination. The universe from which the strategy draws consists of the larger capitalization and most liquid portion of the market. Although the strategy is refreshed every week to monitor for sell signals and new purchases, we expect the portfolio’s attention to quality will result in low turnover.

Many investors seek high yielding equities and there are good reasons for this. Sometimes (including the time of this writing), this is because investors can find shares with yields that are superior to what is readily available in the fixed income market. Income-producing equities offer two important benefits:

Many find them satisfying from a risk standpoint because a meaningful portion of the investor’s expected return is received periodically (usually quarterly) as actual cash and hence immune to the prospect of being eliminated later by adverse market action (investors can continue to shield themselves from such risks by keeping dividend proceeds out of the equity market, or investors can thoughtfully choose to reengage in whole or part with that risk by reinvesting the cash back into stocks).
Relative to fixed income investments, income stocks are attractive because the income can grow, along with profits. This can be very important in times of rising interest rates. The latter must damage fixed-income securities and in the short-term, they hurt income stocks as well. But if rising rates are caused by improvement in economic activity, as is often the case, then better profit growth can be expected to translate to a rising dividend stream.

The downside of equity-income investing is the potential for dividend reductions, or even elimination of the dividend, if business trends deteriorate.

There are many ways to measure the risk of such occurrences and the most popular is the payout ratio (dividends paid as a percent of net income). We believe, however, that this is a very limited metric. Different kinds of companies in different types of businesses can afford different kinds of payout ratios, and payout ratio data can be “noisy” (influenced by temporary aberrations involving net income).

We have found market sentiment to be remarkably effective in evaluating dividend risk. (While there is much debate regarding market efficiency, we believe the market is more efficient than usual in assessing this particular risk. The higher the yield, the less likely the company is to generate good (or even any) dividend growth and the more likely the company is to cut or eliminate the dividend. Such assessment is enhanced when combined with analyst sentiment (which can and does address hard-to-quantify considerations) and core company-quality factors. Our equity income strategy aims to invest in high yielding stocks consistent with reasonable risk as determined by the combination of company quality and sentiment.

After filtering all available stocks and narrowing to those included in our investment universe and which pass muster under our uniform Buy rules (we allow up to 30% or the portfolio to be in a single sector), we filter to eliminate stocks whose yields are above the 70th percentile of the investment universe and below the 98th percentile (that being the range that produces yields of interest to income seekers without taking on undue risk, as per the market’s assessment), shares of companies that do not pay or have cut dividends, and shares of Mortgage REITs (higher-risk quasi banks). We also impose thresholds based on our “Classic Quality” ranking system. We then select the highest rated stocks as per our “Focused Sentiment” ranking system.

Strategy-Specific Buy Rules

The company must have paid a dividend in each of the past four quarters

This rule establishes the first element of the investing strategy; the company pays dividends

The company must not have reduced its dividend in any of the past four quarters

This rule disqualifies dividend payers that have already demonstrated a condition that strategy aims to avoid; reduction in the amount of the dividend

The stock’s yield must rank in the top 70% (at or above 70th percentile) of the appropriate investment universe

This rule establishes another important element of the investment case, the fact that the yield is high enough to be of interest to those who wish to pursue the equity income strategy.

The stock’s yield must rank below top 98% (98th percentile) of the appropriate investment universe

This rule eliminates companies for which the market has determined that the risk of dividend reduction or elimination is high, based on the notion that yields are positively associated with the degree of such risk.

AND, the company must not be a Mortgage REIT

This rule eliminates a small group, Mortgage REITs – i.e. bank-like mortgage lenders that tend to be more aggressive than banks) for which the risk of dividend reduction is high relative to potential return.

AND, the company’s “Classic Quality” rank must be above the minimum threshold applicable to the sector in which it operates:

If the Company is in the Utilities or Real Estate sector, the minimum allowable rank is 30
For companies in all other sectors, the minimum allowable rank is 80

The “Classic Quality” ranking system is based on a constellation of fundamental metrics that suggest business stability and effective financial management, two important indicators of future dividend safety

Different (and lower) rank thresholds for Utilities and Real Estate firms (excluding Mortgage REITS, which were eliminated by a prior Buy rule) reflect the stable dividend-friendly nature of those businesses. That provides latitude for use of the Classic Quality ranking system to exclude the worst firms, rather than seek out the best.

The Ranking system: Focused Sentiment

Use of this ranking system allows the portfolio to benefit from the judgment of analysts regarding the issue of dividend safety. This is an important supplement to our use of the “Classic Quality” ranking system in that it enables the model, to, in effect, tap into qualitative judgments.

Strategy-Specific Sell Rules

The dividend was reduced in the last quarter

This rule eliminates companies that have demonstrated the phenomenon we seek to avoid.

OR, the stock’s yield rank has risen to or above the top 98% (98th percentile) of the appropriate investment universe

This rule suggests the market’s analysis of dividend safety has resulted in a more pessimistic conclusion

OR, the stock’s yield rank has fallen below a minimum threshold level:

If the stock has been held for less than 120 trading days, the stock is sold if the yield falls to less than the 70th percentile
In all other cases, the stock is sold if the yield falls to less than the 60th percentile

This eliminates companies whose shares have rallied to the point where the yield is less attractive to equity-income investors. The threshold is more stringent in the case of stocks held for less than 120 trading days, where such a development would suggest an unusual opportunity to quickly realize a meaningful gain.

OR, the company’s “Classic Quality” rank falls below a minimum threshold applicable to the sector in which it operates:

If the Company is in the Utilities or Real estate sector, the minimum allowable rank is 20

For companies in all other sectors, the minimum allowable rank is 70

This is the reciprocal of the Buy rule that utilized the “Classic Quality” ranking system for purposes of assessing future dividend safety. When that rank deteriorates as specified, we deem the stock no longer worthy of being held.

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