Capital Growth AND Income - the holy grail for investors?

Friday, Jun 01 2012 by
7
The mythical cup itself
The mythical cup itself

Grail quests have never tended to end pretty. Chasing after the mythical biblical artefact with abandon brought the death of many a knight crusader and the history of markets is no different. The terrain is littered with the bodies of those who have dared to suggest they can consistently beat the market at a lower risk - from Long Term Capital Management to Bernie Madoff - but a research paper published this month from SocGen’s famed Global Equity team offers a more modest approach that may just have the answer for investor’s share portfolios.

While flash harry 20-something traders may get a lot of press the average stock market investor is aged 45 and over and grows increasingly concerned about income at the expense of capital growth. Almost all advisors will position the returns from capital growth and income as a trade-off, that you can’t have one unless you drop some return from the other. So if you were to tell these investors that they could indeed get both from the same investments, while lowering their risk and comfortably beating the market return they’d probably bite off your hand and sack a broker or two along the way. That appears to be what Soc Gen have done.

 Meet Soc Gen Global Equity

Dylan Grice Over the years the equity strategy team at Soc Gen, stewarded by the (generally) ultra-bearish Albert Edwards, have built up a formidable reputation in the City. While James Montier has now moved on to GMO his writing set a tone there that has been continued by those that succeeded him - most notably Dylan Grice (pictured) and Andrew Lapthorne - who continue to publish challenging research notes that span our own key themes of behavioural finance and value investing.

Just this month the team introduced their so called ‘SG Quality Income Index’ - an index that aims to track stocks with strong fundamentals and good yields. Many in the market now appreciate that both higher ‘quality’ stocks and higher yielding stocks tend to outperform, but according to the research note, stocks that share both qualities put together standout total returns that have averaged 11.6% per year since 1990, more than doubling the return of the global equity markets at a significantly reduced volatility. But what is more striking is the return of the portfolio since the market topped in 2000 - a genuinely miserable time for all. While the total return of stock markets has actually been negative in that time period, the Quality Income index has almost tripled! Holy Grail indeed?

Soc Gen Quality Income

Defining Quality Income

The research note is tremendous reading. They start by showing that since 1970 dividends and dividend growth have absolutely dominated long term equity returns. There are many strategies such as the Dogs of the Dow (Dogs of the FTSE) which pick the highest yielding 10 stocks in an index, but their research note throws cold water on the idea of building a portfolio in this way by illustrating how the highest forecast yielding stocks actually realise far lower yields due to impending financial distress. (for what its worth the best realised yields (of 6% or so) seem to come from 8–9% forecast yielders). As a result they want to find companies with a sustainable yield.

Finding sustainably yielding stocks is trickier. As the last decade has shown blue chip names such as BP and RBS are just at risk of cutting dividends as any other stock, therefore a consistent dividend history isn’t necessarily the best indicator of dividend sustainability. Their research found that ‘balance sheet quality’ as they define it is a far greater indicator.

Further, much research has shown that ‘quality’ stocks tend to outperform low quality stocks. They define quality companies as those that are ‘financially robust’ - having not only a strong balance sheet but also good underlying business economics.

Why should Income and Quality stocks outperform?

A great research paper by Robert Arnott many years ago showed that contrary to expectations, companies which pay out a higher proportion of their earnings as dividends actually grow faster. The reason for this is basically because company management are generally very bad at allocating capital - wasting resources on empire building or bad acquisitions. Actually taking cash away from the company actually seems to improve the discipline and skill of managers at reinvesting capital. The Soc Gen paper confirms this finding and indicates that high yielding stocks outperform as a result of this better capital allocation.

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Quality businesses on the other hand tend to be steady stalwarts and are often ignored by fund managers as being just, well too boring. Fund managers have to do something from day to day and need a bit of pizzazz to keep them excited about their work and possible bonuses. As a result they’ll tend to pay more money for stocks that have the capacity to double from year to year. Just like lottery ticket buyers, they pay over the odds to play, systematically underbidding quality stocks in the process.

So the idea of bringing both quality and income together into a portfolio strategy has some very sound behavioural foundations - avoiding overconfident managers and avoiding overpaying for lottery tickets.

How investors can ‘roll their own’ Quality Income index on Stockopedia

Of course I was fascinated by the details of how they had put their index together to see whether we could match it using our burgeoning toolkit at Stockopedia in a custom screen. The Soc Gen portfolio itself is drawn from a global mix of ‘eligible countries’ and subject to a few turnover minimisation techniques, quarterly rebalancing and a basket size of between 25 and 75 stocks.

Stock selection criteria consists of three essential metrics - a quality score > 7/9, a balance sheet risk score in the top 40% of the universe and an ‘adjusted dividend yield’ higher than the minimum of 4% or 125% of the mkt-cap weighted dividend yield of the market universe. Financials are excluded and market capitalisation has to be at least $3bn. As we are currently restricted to a UK dataset I’ll be dropping the market cap requirement to >£800m to find eligible companies.

What surprised me when reading their definition of ‘Quality Score’ was that they just seem to be using the Piotroski F-Score but don't appear to have credited it to the Professor himself! I looked through their 9-point scoring system and couldn’t find a difference. Bingo I thought as we publish F-Scores for every stock in our system. The definition of Balance Sheet risk is a bit tougher for us as they use a ‘Distance to Default’ methodology that we plan on modelling but haven’t as yet. As a temporary proxy for this I’m going to use our favoured balance sheet indicator the Altman Z-Score - looking for stocks that at least have an Altman Z1 of > 1.8 - i.e. that have little bankruptcy risk. Lastly I’ll require a forecast yield of greater than 4% and less than 15% to be rid of outliers.

Subscribers can click straight through to see the list of 16 SocGen-esque Quality Income candidate stocks that I’ve put together - (Past performance is no indication of future returns etc)… If you aren’t a subscriber do take a free trial to see the list . You won’t find much excitement there but the truth is that the path to the holy grail of market beating returns is much steadier footed than the knights of yore believed.

Click Here to see the list.


Filed Under: Income Investing, Screening,


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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.


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4 Comments on this Article show/hide all

Edward Croft 1st Jun '12 1 of 4
1

Forgot to add that the median yield of the resulting list is 5.3%. If anyone wants to fork the screen to lower the mktcap threshold or play around with the criteria you can just type /fork/ at the end of the screening url.

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Edward Croft 2nd Jun '12 2 of 4
2

David Stevenson writes up the same SGQI index in the FT http://www.ft.com/cms/s/0/4f40354e-a8e3-11e1-be59-00144feabdc0.html

Investors can buy the global index as an ETN - ticker SGQI

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terryshead11 7th Jun '12 3 of 4
1

I think your site is the best I have come across in fact some times my head gets dizzy with all the information.

When my cheap rate is up come back to me on the annual rate.

I know no one knows what the future is going to do myself I get into a bit of a tis what is going to happen these idiots that run us are stealing are money annuties are a joke the eu is up the swannie what do you do myself I am buying silver etfs the bloody lot is a complete Ponzi sheme.

Terry Shead

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Corsica 21st Jun '12 4 of 4

the SGQI select good businesses ( solid balance sheet) with high dividends. This reminds me Joel Greenblatt's approach good businesses with high earning yield.

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About Edward Croft

Edward Croft

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CEO at Stockopedia where I weave code, prose and investing strategies to help investors beat the stock markets. I've a background in the City and asset management but now am more interested in building great stock selection tools for the use of investors online.   Traditionally investors online have had very poor access to the best statistics, analytics and strategies for the stock market and our aim is to set that straight.  High Quality fundamental information has been prohibitively expensive in the past and often annoyingly dull. People these days don't just want to know the PE Ratio and look at a balance sheet. They expect a layer of interpretation over data, signal from noise and the ability to know at a glance whether a stock is worth investigating or not. All this is possible using great design and the insights gleaned from quantitative research.  Stockopedia is where we try to make it happen ! more »


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