Great growth companies, bought early at cheap prices are highly prized by most investors, many of whom will go to great lengths to find the next ‘multibagger’. But while the search for top quality earnings growth and market-beating performances usually means focusing on exciting smaller stocks that look set to soar, it’s also possible to outperform the market by blending these hallmarks with something that many growth investors might consider (quite wrongly) to be ‘boring’ - dividend income.
On paper, the combination of growth and income aren’t easy bedfellows. Most growth investors are more than happy (indeed expect) to see their companies ploughing all available cash resources into growing further and faster rather than hiving off a proportion to their shareholders. But according to American share analyst Kevin Matras, screening the market for companies with quality growth credentials that still offer above average yields makes a whole lot of sense.
Background to Winning Growth & Income
As Vice President at investment research company Zacks Investment Research, Matras is known in the US for screening strategies that focus on earnings growth. In his book Finding #1 Stocks: Screening, Backtesting and Time-Proven Strategies, he suggests a growth and income screen for those investors that are “looking for good companies with solid revenues that pay a good dividend”. Naturally, this kind of approach can shift the focus away from smaller shares, which are much more capable of spectacular growth rates, towards larger cap companies that have begun rewarding shareholders with dividend payouts. He notes that these larger stocks can often be great companies generating huge amounts of cash but have nonetheless moved beyond the growth opportunities they once had.
To find them Matras uses a screening tool that tracks earnings revisions by analysts and, in this case, looks for stocks that are rated Strong Buys, Buys and Holds. This is simple enough to replicate in the UK market, as are some of his other screening metrics. At Stockopedia we track a screen that’s inspired by Matras’s search for growth and income but which is more appropriate to the shares available to buy in the UK.
It begins by looking for companies where brokers have recently been upgrading their forecasts for the next financial year. It then looks for a few ‘quality’ criteria, such as above average return on equity (signalling that the company is good at generating cash); manageable levels of debt and a valuation (based on price-to-earnings) that’s below average. Each company’s beta (or the volatility of its share price) also has to be low so while our market cap threshold of £20 million is still very much in the small cap range, any stock qualifying here will have to be displaying a stable share price. Finally, shares qualifying must be paying above average dividend yields.
Matras envisages selecting the top 7 by dividend yield, but with no more than 2 in each sector - although it's hard to find 7 such stocks qualifying on the UK market. We list the top 14 but it might make sense to pick 7 from the resulting list with sector diversification in mind (our system can't yet automate sector diverification criteria but we will be able to do so soon).
Does it work?
Matras carried out backtesting of his version of the strategy and found that it produced an average annual compounded return of 20.6% (while taking on about 40% less risk than the S&P 500). Stockopedia’s interpretation of the screen delivered an impressive 61% in the 12 months ending September 2013, outperforming the FTSE 100 over that period by 48%. Interestingly, while Matras originally intended to focus on larger companies with this strategy, the Stockopedia version has shown no such bias, with small cap stocks providing a strong weighting in the portfolio.
Things to think about
The Winning Growth & Income strategy was originally devised with the US market in mind and it’s likely that simply applying the same model to the UK market would yield very few qualifying candidates. As ever with high yielding stocks (particularly smaller companies) there is a risk that dividends can be cut in response to changing business, market and economic conditions. Matras suggests that searching for ‘quality’ first should mitigate against this, giving investors the opportunity to hold these companies from anywhere between three to 12 months and even longer. While the Stockopedia portfolio is rebalanced quarterly and takes no account of trading costs, neither does it account for dividend income generated which, based on a current median yield of 4.0%, is a reasonable kicker to the overall return.
Filed Under: Income Investing,