Bulls make money, bears make money, and pigs get slaughtered…
That’s the No. 1 rule of investing, according to former hedge-fund manager and CNBC commentator Jim Cramer. And countless others have recited the old saying over the years. (See, for example, here and here.)
But today, I’m going to show you why that’s not always the case…
In short, you can avoid getting slaughtered if you’re a pig. However, you have to be a special kind of pig… In order to survive – and thrive – you must be a “prudent yield hog.”
We covered the first step in this process yesterday… If you’re a thoughtful yield seeker, you’ll use history-based analysis during your hunt instead of just buying any high-yielding stocks. That’s critical if you want to find stocks with attractive yields without being reckless.
However, it’s just the beginning. Today, I’ll share how we can take this idea a step further…
Sorting a list of income stocks by yield and picking from the top is easy… But such a naïve approach is dangerous.
The more we reach for yield, the greater the risk that we’ll step on financial land mines… By that, I’m talking about struggling companies that fail to make their expected dividend payments and stocks that underperform.
Yesterday, I showed you how to reduce such risks by using the market’s own judgment… You can avoid the riskiest situations by eliminating the extremely high yields from the start.
We can still do better…
In other words, we can pick from among the best opportunities within a “sweet spot” range. And through our own analysis, we can build on what we learn from looking at yield (like the higher the yield, the greater the risk).
For starters, I use yield itself as an indicator of market sentiment…
The market is often right about dividend risk. So when I want to be a prudent yield hog, I modify my search to take out stocks with yields ranked among the top 5%. That’s how we find the “sweet spot” yield – one that’s high, but not too high.
Once you’ve done that, it’s OK to then pick from the top of the list.
Simulating this way would’ve cut the yield on our test portfolio of the 20 highest-yielding stocks in the Russell 3000 Index from 11.8% to 5.6%. But here’s the important part… The 10-year average annual return would’ve jumped from 4.3% to 9.6%.
That’s great. But we could do even better using our proprietary “Power Gauge” system…
The Power Gauge is a 20-factor, forward-looking model. Chaikin Analytics founder Marc Chaikin created it using the knowledge and insights he gained through more than 50 years on Wall Street. It’s based on his experience with what works for stocks – and what doesn’t.
The Power Gauge uses both fundamental and technical analysis… In the end, it aims to identify the stocks likely to perform best.
For my prudent hog research, I used the Power Gauge system to cut out potential losers – the stocks ranked to underperform. These are the “bearish” rated stocks within the system.
This new “Power Zone” approach produced a 20-stock portfolio… In our simulation, it would’ve yielded 5.4% and had a 10-year average annual return of 12.5%.
That yield would’ve been much better than the iShares Select Dividend Fund (DVY). And you can see in the table below that the 10-year average annual return also would’ve been better…
This table paints a clear picture…
Chasing the highest-yielding stocks is a recipe for disaster. It led to low 10-year average annual returns in our simulated portfolio.
Next, finding the “sweet spot” by filtering out the top 5% of the highest-yielding stocks cuts out substantial risk. And it would’ve been enough to nearly double the 10-year average annual returns in our simulated portfolio.
But we can take it a step further with the Power Gauge… Using the system to filter out stocks with a “bearish” rating would lead to the highest potential returns through the “Power Zone” portfolio.
Simply put, with just a little bit of work, you can be a prudent yield hog. And with the help of the Power Gauge, you’ll make sure that you’re picking only the best of the bunch.