New Trades In The Smart Alpha Equity Income Portfolio

Another three months, another refresh of the Smart Alpha Equity Income portfolio. There were plenty of trades, 19 out of 20 positions turned over. That’s par for the course and to be expected: The model reaches for yield as far as feasible without straying into the junk-income territory, and that requires that we not allow metrics that lead to purchase to become stale with age.

First Things First: Turnover

I know it’s respectable and expected to consider portfolio turnover. On one level, we do want to hold positions long enough for our ideas to be able to pan out, and many do take time. But many are much more worried about transaction costs.

I trade at FolioInvesting.com, where I pay a modest annual fee and trade for free, yes free, so long as I trade within the firm’s 11 AM (ET) or 2 (PM) “window.” If I were a hard-core trader, that might irritate me. But I’m not. I’m a fundamental investor. I don’t play the “tape” and agonize over whether my trades close at 11 AM, 9:53 AM, 3:14 PM etc. Trading desks aside, that sort of thing plays well in movies but in real life, oh please!

It’s much more important to me that I feel comfortable getting out of a position, not when some guru with no skin in the game thinks I should but based on when the models that got me into a stock tell me it’s time to exit. Holding stocks that should be sold is not a good idea. We had to do it when we paid an arm and a leg in commissions. But now, payment of big commissions is strictly voluntary. Nobody has to do it if they don’t want to do it, and I don’t want to do it.

Recognition of taxable capital gains can also be a concern. I trade this model in an I.R.A. so for me at this time, this topic is off the table. But even with trades in taxable accounts, I prefer to book a gain and pay the tax, rather than not have the gain, or worse, have it turn into a loss because I held even though fundamentals told me that was the wrong thing to do.

So yes, I’m trading 19 out of 20 positions; Guess? Inc. (GES) is the lone holdover. But considering the non-junk yields available in the marketplace today, the 4.4% I’m getting here strikes me as well worthwhile, especially since I only refresh the model once every 13 weeks.

The entire portfolio can be seen, and followed, for free on Portfolio123 (to see the stocks, you’ll need to register, but there is no fee or credit card requirement to “subscribe” to a free Smart alpha model such as this one). But I’ll provide a sample here to show you the kinds of ideas this model pursues pursuant to its goal of using market action in addition to fundamentals to gauge dividend security.

Table 1 lists the five highest-yielding stocks presently in the portfolio:

Table 1

Be warned, with interest rates as low as they are, you aren’t going to get yields like these without having to deal with some sort of corporate baggage. We know that going in. The model is designed to keep the baggage manageable.

Outerwall (OUTR): This is an example of what I think of as a “little elves” stock: “I didn’t know publicly-owned companies were in businesses like that, I thought it was done be little elves.” The company is into self-service kiosks, coin-counting kiosks, Redbox (video game/movie rentals/sales) kiosks, kiosks you’ll see in places like airports that sell serious consumer electronics products. Are these the kinds of businesses that will be huge 20 years from now? I doubt it. But I don’t plan to own it for 20 years; it may or may not be gone in three months, They aren’t even huge now – but that may be a good thing. This is not something that attracts a ton of competitors, but it does allow $OUTR to generate a little more than $300 million in annual cash flow, about triple what it needs for capital spending and its recently-doubled dividend. Management does seem to find new applications for its kiosk competence. Also, management is looking for ways to enhance shareholder wealth, which is not usually a bad thing.

L Brands (LB): This entity evolved from a well-known retailing empire known as The Limited. Strictly speaking, L Brands is a new name for the Limited and its still run by Les Wexner. But there’s been a dizzying array of corporate transactions. For now, suffice it to say the company consists of Victoria’s Secret, Bath & Body Works, Pink, La Senza, and Henri Bendel or put another way, the snazzier parts of the old portfolio of businesses. Evolution is probably not finished since even recent years have witnessed notable share repurchases and special dividends. Way back when I managed junk bonds, I hated companies like this and the “event risk” such moves posed for bondholders. But as a stockholder, I love it. I don’t need to see Bath & Body Works grow its store base tenfold. I’m fine having wealth returned to me, and management seems to be on this same page. With cash from operations running at more than double capital spending needs, we’re good.

Orchids Paper Products (TIS) and Moelis (MC): Actually, these are returning names that I previously introduced on 11/20/15.

$TIS is not involved in the seriously declining part of the paper business (the part that serves newspapers, magazines, brochures, books, business documents, etc. all of which are going digital, which means demand is declining). The company makes “parent rolls” which then become finished products the bulk of which are paper towels and toilet tissue. Fortunately for $TIS, that category of paper can’t be pushed aside by digital alternatives. There are always ups and downs in materials costs but ultimately, stable population-driven demand is the primary driver of the business. Much of what reaches consumers consists of $TIS’ own no-name brands sold through discounters and products made for sale by discounters under their own house brands. Unlike the firms discussed above, $TIS does not generate significant “excess” cash flow. Between dividends and capital spending, the company pretty much spends what it brings in. The key, here, is the stability of the business, and a balance sheet strong enough to make it work (trailing 12 month interest coverage was 37.3, versus 12.8 industry median).

$MC is an independent investment-banking firm – really independent. Its activities are advisory. It’s not involved in sales and trading. It’s not a lender. It doesn’t underwrite new issues. There’s no financial supermarket here. Therefore, the advice MC gives to its clients is free from conflict, free from the pressures of cross-selling any number of other services, and free from the high risk of confidentiality breach that exists in organizations with many moving parts. MC’s advice is also independent of employee self-interest. Compensation is based on “collaboration, client impact, and lasting relationships,” not commission. Equity is a meaningful part of the compensation package, thusly aligning staff interests with those of shareholders (and motivating the company’s tendency to return cash to holders on an ongoing basis, mainly through dividends). Cash flow from operations already comfortably covers the dividend, and it could get better if interest rates eventually rise. $MC is debt free so it won’t hurt. On the other side of the coin, the firm built up its capabilities in debt restructuring, a move that will position it well to advise potential leveraged clients who are not well positioned for future rate hikes.

Pier One Imports (PIR): This well-known retailer of home furnishings is another company that generates a lot more cash than it needs for the business and is open to returning cash to shareholders. Dividends, obviously of interest to us, are part of the package. Ditto share repurchases, even to the point of adding a bunch of debt to the balance sheet. The cash generation here is strong enough to allow the company to nibble away at the debt as time passes, and, hence, further boost income and cash flow. The company uses multiple sales channels but is primarily a brick-and-mortar retailer. Obviously, that’s doesn’t seem very futuristic. But the kinds of wares sold by $PIR, not just furniture per se but lots of decorative wares, are the kinds of things that continue to hold their own in the traditional store setting. As a side note, $PIR impressed investors by significantly beating EPS guidance in the last quarter. That’s not really something about which I usually care, especially in the context of an income model. But it doesn’t hurt.

Performance

Figure 1 shows the basics, model/strategy performance against a standard S&P 500 benchmark since it went live on 10/23/15.

Figure 1

That looks OK. But we really can’t stop there. For all practical purposes, and in the minds of investors if not quants and academicians, income is a distinct sub-market within the overall field of equity investing. So we should evaluate any such strategy with reference to one or more relevant income-oriented benchmarks.

Addressing this is easier said than done because there isn’t much out there to go on. So consistent with work I’m doing in other aspects of this endeavor, I created, here, a collection of indexes, the idea being not just to generate an outperform or underperform statement, but to gain insight into the whys and wherefores of what we see. Here are the benchmarks I created:

• General Equity Income Benchmark: This is an equally-weighted group (rebalanced once every six months) of Russell-3000-type constituents that pay dividends and which have been filtered further to exclude yields too low to be of likely interest to income investors (yields the top half of the group) and to exclude very high yields likely to be of interest only to the most aggressive income seekers (i.e. junk yields), defined here as yields that rank in the highest 10%. Equal weighting is important because that is how the portfolio is weighted.
• Large-cap Equity Income Benchmark: This benchmark is based on the same rules as the General version, except that the universe from which it selects consists of larger-cap Russell 1000-type stocks.
• Small-cap Equity Income Benchmark: This benchmark is based on the same rules as the General version, except that the universe from which it selects consists of smaller-cap Russell 2000-type stocks.

I’m also going to look at three major equity-income ETFs and a hypothetical portfolio that combines all three. The ETFs are Vanguard Dividend Appreciation (VIG), iShares Select Dividend (DVY), and Utilities Select SPDR (XLU).

Table 2 shows performance of the Smart Alpha strategy relative to the benchmarks.

Table 2

The most obvious comparison is with the General Equity Income Benchmark since the model was agnostic regarding market cap. Still, the Small-cap benchmark is worth noting because as it turned out, most of the issues that make it into the portfolio tend to be on the smaller side. Under both standards of comparison, the Smart Alpha strategy looks has been a resounding success during its first five months.

We see, though, that there were things that could have been done in the ETF world that produced better results. $DVY and $XLU, which yielded about a percentage point less, produced greater overall returns.

There are two factors that drove this result.

One was the overall strength of large-caps during the measurement period. That was particularly apparent in the benchmarks I created, where the large caps handily trounced the small caps (both are equally weighted). So the market-cap weighted ETFs had a strong built-in edge.

Second was the particular strength in utilities during the measurement period. The recent period was a perfect storm, in a good way, for the group. The economy has been decent helping demand. And fuel costs plummeted. Utilities were absent from the Smart Alpha strategy. They are the entire focus of XLU. And they comprised about 35% of DVY.