Best High Yield Dividend Stocks - From The 4 Factor Strategy

4 Factor - High Yield Strategy

If you follow me here on Seeking Alpha you may be familiar with the 4 factor dividend growth strategy I published almost a year ago. I came up with this strategy last October, launched the first portfolio on November 1st and summarized the process in this article published on November 24th, 2022. Ever since I've been documenting how this portfolio has performed on a monthly basis, spoiler, it's been doing quite well and sits slightly ahead of the S&P 500 as we approach the 1-year mark.

The objective of the 4 factor strategy is to blend the ease of investing in an ETF with the appeal of holding individual stocks. Humans are emotional creatures and it's difficult for us to not make emotionally driven decisions. When it comes to investing, emotions tend to drive poor decisions that are not based on fundamental data. Therefore, most average investors will often underperform the broad market and not achieve equivalent long-term returns as passively managed ETFs. This conundrum has puzzled me for years and I've spent the past few working on shifting my strategy towards a more passive stock selection approach. While I enjoy holding individual stocks I crave the allure and simplicity from investing in ETFs. I believe the 4 factor strategy is, at the moment, an ideal solution for me and perhaps others who seek to automate their investing strategy.

The beauty of the 4 factor strategy is that it can be tailored to focus towards a specific style of dividend investing. The original strategy focused on high growth, and today I'd like to share another version of this strategy that is geared towards a more attractive dividend yield.

While the 4 factor strategy can have a focus such as dividend growth, a high yield or any other subset of dividend investing. Its main objective is to find high quality companies that look reasonably valued and are poised to generate adequate total returns. The strategy isn't perfect and not all of the stocks it suggests will go on to generate above average returns, but collectively it should design a strong portfolio that in the long run will give investors a market-beating return.

The high yield 4 factor strategy works on the same principles as the original version that focused on high growth, but with a very important addition of a minimum yield cutoff. If you're familiar with the 4 factor strategy you can skip ahead, but if this strategy is new to you, let me summarize the process.

The objective of the 4 factor strategy is to automate the stock selection process by identifying high quality companies with above average dividend yields that should collectively deliver a market beating total return. This is a passive style of investing where the process selects the top 20 stocks for inclusion in the portfolio.

It all starts with building the initial universe of stocks that all meet specific fundamental criteria. The criteria for inclusion in the high yield universe are:

1. A minimum dividend yield of 2.75%.
2. A payout ratio no greater than 100%.
3. A positive 3, 5 and 10-year dividend growth rate.
4. A positive 5-year revenue growth rate.
5. A positive 5-year earnings per share growth rate.
6. A wide or narrow economic moat rating.
7. A standard or exemplary stewardship rating.
8. The stock must trade on the NYSE or the NASDAQ.

These criteria aim to identify businesses that have a history of operational growth, have an economic moat, are ran by competent management teams and have a commitment to paying and increasing dividends. Some of you may think that a 2.75% dividend yield is not necessarily a high dividend yield, and everyone is entitled to their opinion. But as you will come to find out the top 20 lists I will talk about in the following sections had initial starting dividend yields well above this minimum threshold.

The number of companies that pass this initial filter to be included in the universe of stocks varies from month to month. Between May and September there were as few as 65 stocks and as many as 85 stocks included in the screening process.

Once the universe of stocks is set, the following step is to rank all of the stocks using the 4 factor stock selection process. As the name implies the process uses 4 financial factors to seek out the top 20 stocks. These 4 factors are:

1. Free Cash Flow to Total Debt Ratio.
2. 5-Year Dividend Growth Rate.
3. Return on Capital.
4. Forward Dividend Yield.

I borrowed this stock selection strategy from the Dow Jones U.S. Dividend 100 Index, the underlying index for the Schwab U.S. Dividend Equity ETF (SCHD). The Dow Jones Index starts with a much more broad initial universe of stocks and their 4 factor stock selection process includes the return on equity, unlike mine that favors the return on capital.

I started tracking this strategy at the end of May of this year, and I have done so every month since. I am also tracking the performance that each monthly top 20 stock list has attained thus far. And I have included 4 different rebalancing frequencies in the test to see if a more frequent re-constitution of stocks will lead to favorable results. The rebalancing frequencies are as follows:

• Annual (for taxable accounts).
• Semi-Annual.
• Quarterly.
• Monthly.

Under each rebalancing frequency the original list of stocks is rebalanced with the top 20 stocks selected for the upcoming month. Since more frequent rebalancing may create tax obligations it makes more sense to apply such strategies in tax-free or tax-deferred accounts. The primary reason why I am testing 4 different rebalancing frequencies is to see if more frequent re-constitutions lead to better outcomes.

Each month's top 20 list is tracked for a rolling 12-month window, which is the optimal holding period for this strategy. Let me share the initial results with you next.

Summary of Results

The table below shows the performance results for the June 2023 Top 20 High Yield Dividend Stocks.

The return shown for October is a partial price-only return through mid-day Monday October 9th.

As you can see the top 20 high yield stocks chosen for the month of June are thus far outperforming the SPDR S&P 500 Trust ETF (SPY) and SCHD, under every rebalancing frequency. Thus far the monthly rebalanced portfolio is showing the best return, outperforming the 3 other rebalancing frequencies during each month following the initial month.

A full list of the top 20 stocks for each month is shown in the next section.

The table below shows the performance results for the July 2023 Top 20 High Yield Dividend Stocks.

As you can see the top 20 high yield stocks chosen for the month of July are also outperforming both SPY and SCHD, under every rebalancing frequency. And similar to the results for the June top 20 list, the monthly rebalancing frequency is thus far generating the best return.

The table below shows the performance results for the August 2023 Top 20 High Yield Dividend Stocks.

Only one rebalancing frequency for the August top 20 list is performing better than both SPY and SCHD, with the three other portfolios trailing SPY by a single basis point. Thus far it would appear that the monthly rebalanced portfolio is showing the most promise. It is also important to note that all 4 rebalancing frequencies of the August top 20 list are thus far outperforming SCHD.

The table below shows the performance results for the September 2023 Top 20 High Yield Dividend Stocks.

Similar to the August top 20 list, the chosen stocks for September are only seeing one portfolio ahead of both SPY and SCHD. And to no surprise, once again, it is the monthly rebalanced portfolio that is performing the best.

The table below shows the partial performance results for the October 2023 Top 20 High Yield Dividend Stocks.

The October top 20 list did not get off to a good start and thus far it is seeing a negative return while SPY is recovering from the past two months of sour performance. The October list is also the only month thus far that is performing worse than SCHD. Granted we are only partially through the month thus far and things can get much better, or worse, over the next few weeks.

The 4 factor strategy is a long-term strategy with an intended minimum holding period of 12-months. While overall the initial results are promising I intend to judge this strategy's success based on rolling 12-month returns.

Here are the initial success rates for the first 4 full months plus partial October, for each rebalancing frequency.

Top 20 Stocks by Month

Each month I follow the same process to update the list of the top 20 high yield dividend stocks for the upcoming month. From month-to-month, the list does not change by much but I have observed turnover on the list in each of the last 4 months. This is expected, as the 4 factors are updated each month stocks move up and down in the rankings. Below are the top 20 stocks selected for each month thus far, in the original rank order, with new stocks bolded.

During the last 4 months there have been on average 3.25 new stocks appearing on each months top 20 list. This equates to roughly 16.25% turnover from month to month. While this may appear high, the market in general has been rather volatile recently and perhaps that is driving the high turnover rate.

Starting Dividend Yields

Given that the focus of this strategy is to generate an attractive dividend yield it's prudent we take a look at the average starting dividend yield from each monthly top 20 list thus far. Below are the average metrics for each of the 4 factors, for each month:

The average starting dividend yield has ranged from a low of 4.26% in October to a high of 4.61% in June, with the average being roughly 4.44%. Not a bad starting dividend yield for a passive dividend portfolio, that in hindsight, has performed well when measured against SPY and SCHD.

The average 5-year dividend growth rates for each top 20 list also appear to be quite attractive for a portfolio yielding in excess of 4%. While we can see that the dividend growth, return on capital and free cash flow to total debt ratio have all trended lower since June, they are still within a very respectable range.

Final Thoughts

Investing is inherently risky and this rules based approach to investing carries risk of loss as well. While I don't recommend for anyone to adopt this strategy, I hope it can inspire you to create your own investing strategy that is tailored to your own goals and objectives. Thus far I have deployed two actual portfolios leveraging the 4 factor strategy, both have adopted the original high growth focused strategy. I may initiate another portfolio in the near future that will leverage the high yield strategy I wrote about today.

Ideally, I would wait to have more data accumulated, to have proof that this strategy has merit. But in hindsight, once the data is accumulated, the opportunity to benefit from this strategy will be missed. Sometimes if you believe in a strategy you just have to roll the dice and take the risk, which is what I should probably do. I am currently tracking a total of four unique 4 factor strategies, each with a different dividend-oriented focus: high growth, high yield, dividend aristocrats and dividend kings. I intend on sharing the results of all four strategies here in the future.