This article looks at an investing strategy for income generation that shows strong returns and low drawdowns in back-testing.

A Simple Strategy For Income Generation – Introduction

Dividend investing ranks as one of the most popular and some would say straightforward stock picking strategies. It’s probably come about this way because dividend stocks are considered by many to be safer companies to invest in.

This is particularly true for large cap, utility, and blue chip stocks, the type of reliable companies that can be relied upon to pay out to shareholders year after year even when market conditions deteriorate.

As such, dividend stocks offer not only capital gains but income too.

As an example, consider an investment in Johnson & Johnson which managed to increase its dividend every year for something like 40 years between 1963 and 2004. An investment in 1963 would have returned an incredibly annual return in reinvested dividends alone.

However, just because a company pays out a regular dividend doesn’t mean it’s a sure thing and buying a stock based solely on a dividend is a flawed strategy.

Some stocks enjoy paying out high dividend yields because it attracts more investors to purchase shares. A volatile resource or gold mining stock is such an example. And since dividend yields move inversely to stock prices, a high yield can actually indicate a company that has been performing badly.

In general then, investors should look for reliable, steady dividends and companies that are able to increase dividends year after year, even through difficult trading conditions.

Furthermore, through historical testing, I’ve found that the most reliable results are found by concentrating on stocks that yield between 2% and 7%.

So, when it comes to stock picking, dividends are very nice to have but they only form part of the story. Investors should consider all the other moving parts that make up a good investment and there are many factors to choose from.

In the strategy that follows, I look for stocks that are paying dividends of more than 2% but I also make sure the company has a decent balance sheet, in the form of a reasonable current ratio and a reasonable amount of cash. This is a portfolio strategy with a hedging mechanism that holds a maximum of 10 stocks at any one time. It is set up and back-tested using the wonderful simulator at Portfolio123 which allows the back-testing of fundamental and technical metrics in stocks.

Our income strategy buy rules

Buy rules

  • Dividend yield > 2%
  • Increase in dividend over last year >5%
  • Current ratio > 2
  • Price-to-free-cash-flow < 10
  • Ranking: Rank based on 52-week performance, choose best performing stocks first

Sell rule

  • Dividend yield < 2%
  • Hedge: If S&P 500 EPS estimates trend lower, move 100% into the iShares 7-10 year treasuries ETF $IEF

Additional Settings:

  • Starting Capital: $100,000
  • Portfolio size: Max 10 positions, equal weighting
  • Commissions: $10 per trade, 0.5% slippage (variable)
  • Universe: All fundamentals (USA)
  • Liquidity: Position size no more than 5% of 20 day average volume
  • Diversification: No more than 30% of portfolio allocated to one industry
  • Rebalance period: Every 4 weeks
  • Trades entered on next day open

Our income strategy in plain language

This is a portfolio strategy that selects stocks from portfolio123’s all fundamentals universe (all US stocks where fundamental data is available).

When a stock meets each of the buy rules specified above, it is bought and added to the portfolio. If there is more than one signal, each stock is ranked by its 52-week performance and the best performing stocks are bought first.

Position size is equal weighting with no margin and no one industry can take up more than 30% of the overall portfolio.

On the rebalance period (4 weeks ahead) any stock whose dividend yield has dropped below 2% is sold and it drops off the portfolio.

The EPS for S&P 500 stocks is monitored and if the 5 week EPS trend crosses under the 20 week EPS trend, the portfolio is moved 100% into the $IEF, the iShares 7-10 Year Treasury Bond ETF. The aim of the hedging mechanism is to keep the portfolio safely in bonds during bear market conditions.

Strategy Results

The simple dividend strategy was first run on an in-sample period between 5/1/2000 and 5/1/2010. The results are shown below: (The green blocks represent periods where the portfolio is hedged).

A Simple Strategy For Income Generation

As you can see, the strategy did extremely well, outperforming the benchmark S&P 500 by some margin. The annualized return was 19.79% with a Sharpe Ratio of 0.98.

Next, the strategy was moved forward and run between 5/1/2010 and 5/1/2015:

A Simple Strategy For Income Generation

Again, the strategy performed well and out-muscled the benchmark with an annualized return of 13.94%.

Finally, the strategy was run through the full sample period 5/1/2000 to 5/1/2015:

A Simple Strategy For Income Generation

As you can see, the results from this simple dividend investing strategy are good over the 15 year period as well. Annualized return is 16.77% with an overall win ratio of 66% and a Sharpe ratio of 0.79. The maximum drawdown is just -20.37% and the strategy recorded only one losing year (2014):

A Simple Strategy For Income Generation

The system represents a smooth equity curve and was able to turn $100,000 into over $1 million during the back-test, much better than the benchmark (S&P 500 Index).

Final thoughts

This is a simple dividend strategy, suitable for capital growth and income generation that has potential. It was formulated in just a couple of hours using Portfolio123 and some simple, standard rules, without optimization. (For a more advanced stock picking strategy see here.)

At first glance, this looks to be a robust strategy with low drawdowns and low risk. One potential problem with the strategy is that it has not performed so well in the last couple of years. This might be a worry and more stress-testing needs to be undertaken.

Underperformance could be because dividend stocks have moved out of vogue. It could also be due to the choppy nature of recent EPS trends which has seen the hedge mechanism come into play on several occasions in recent years. It is advisable to test the strategy on various different start dates and conditions (robustness tests) before taking the strategy live with real money.

Overall, there are enough positives in these reports to suggest that investors are right to seek out good dividends and that the seeking of yield is indeed a worthwhile pursuit.

About Joe Marwood

Joe Marwood is an independent trader and writer specializing in trading systems and stock trading. He began his career trading the FTSE 100 and German Bund for a trading house in London and now works through his own company. He also writes for Seeking Alpha and other financial publications. You can find him at http://jbmarwood.com and http://profitsquawk.com