High yield investing and the ‘Dogs of the ASX20’ strategy tested

The portfolio manager of DNR Capital’s Australian equity income strategy Scott Kelly says investors’ should be wary of simply focusing on dividend yield, in their understandable search for income in this ‘lower for longer’ interest rate environment.

“It’s a headline variable that is easily understood but often a high yield can also be a red flag,” said Mr Kelly.
“The famous, and popular, ‘Dogs of the Dow’ investment strategy developed by US investor Michael O’Higgins in 1991 is based on selecting the top ten yielding stocks on the Dow Jones Industrial Average (DJIA) index as of December 31 and holding the stocks for the following year.
“Dogs of the Dow has proved to be a successful strategy in the US market, showing an average return of 200bps above the market over the last ten years”, as shown below.
Source: www.dogsofthedow.com

But will this approach work in Australia?

“Traditionally, investors looking for yield in Australian equities have concentrated their exposure to the top 10 companies which contribute more than 50% of the ASX200 dividends paid, so it was a worthwhile exercise to consider how the ’Dogs’ strategy might have worked in Australia.

“We analysed a notional ‘Dogs of ASX20’, investing $1,000 into the highest yielding stocks of the ASX20 at 31 December and constructing an evenly weighted portfolio of ten companies each year.

The results were stark.

“The ‘Dogs of the ASX20’ would have underperformed the market by ~60bps pa over the previous 10 years and ~560bps over the last five years.

Source: DNR Capital; Factset
Note: This table presents the average of annual total returns. Fees excluded. Past performance does not guarantee future performance.

What about this current year ?
“On 31 December 2018, the highest yielding stocks of the ASX20 were ANZ, BHP, CBA, NAB, RIO, SCG, SUN, WBC, WES and WPL.

“The ‘Dogs of the ASX20’ strategy clearly underperforming the market over the first nine months of this year by ~2%. Whilst the Dogs has delivered ~3% additional income (including franking), this has resulted in ~5% lower capital growth. Further, the additional income has primarily come from two companies (BHP and RIO) and the special dividends that have been paid in January, April and September.

“DNR Capital believes the ‘Dogs’ high-yield strategy is too simple and fraught with unacceptable risks. For example, consider the following

 High yields can indicate companies are facing structural headwinds and dividends might be at risk of being cut (Eg. Retail REIT’s; Telstra; Banks).
 Yield strategies have become increasingly impacted by interest rate expectations which exposes these stocks to macro top/down volatility (Eg. Bond Proxies).
 Sources of yield shifts over time. Over the last 5 years, yields from Materials and Energy companies has substantially increased, whilst for Consumer Discretionary, Utilities, Telstra and Industrials companies, it has significantly declined.

“Assessing a company’s dividend sustainability is core to the DNR Capital Australian Equities Income Portfolio process. We are primarily looking for quality companies that can demonstrate the ability to sustain and grow dividends over time.

“In our view, an investor needs to consider a substantial number of a factors when assessing a dividend’s sustainability and capacity for growth. Our investment process considers such factors, both quantitative metrics and qualitative features, including: average DPS/CFPS, average dividend yield + relative yield, average DPS growth / trend, franking level, payout ratio, capacity for capital management, capital intensity and capex vs. payout to name a few.

“The following charts show the DNR Capital Australian Equities Income Portfolio performance over the last ten years relative to the ‘Dogs of the ASX20’ strategy.

“It shows that the DNR portfolio has not only delivered better total returns, however it has also generated better income levels for investors.

Every dog may have its day but investing for high yield on the ASX is certainly not a walk in the park.

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