Dynamic Income & Dividends

A Simple Strategy for Excess Returns DIAD

Philip A. VenanziDuquesne MBAClass of 2015

Factors Driving Returns

Fama-French 5 Factor Model

1. Risk Stocks with a higher beta typically yield higher returns than lower beta stocks

2. Market Cap Small stocks typically outperform large stocks

3. Value & Growth Value stocks usually outperform growth stocks.

4. Profitability (higher future earnings) Stocks with higher future earnings will outperform stocks that will lower future earnings

5. Investment (momentum) Stocks with high momentum outperform stocks with low momentum Highly correlated with the value and profitability factors

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http://www.forbes.com/sites/phildemuth/2014/01/20/whats-up-with-fama-frenchs-new-5-factor-model-the-mysterious-new-factor-v/

Factors Driving Returns

“Warren Buffett on the Stock Market”

1. GDP Growth Does it correlate to growth in stock markets?

2. Interest Rates PV of future earnings:

Higher when interest rates are lower Lower when interest rates are higher

3. Valuation Finding stocks that are undervalued based on valuation of future cash flows

These are the “value stocks” that outperform growth stocks in the Fama-French model Market Cap to GDP – Long-term valuation indicator of the market as a whole

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Manager’s Philosophy

Dynamic Income and Dividend (DIAD) model The philosophy is centered around two main themes:

1) Income Generation2) Consistency

Follow a simple strategy to achieve consistent excess returns over the long-term (20+ years)

Focus on stocks generating consistent:1) Net positive income2) Dividend payouts

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Strategy Objectives

Follow a simple strategy to: Achieve consistent excess returns over the long-term (20+ years) Take advantage of the inefficiencies in the following factors:

1. Small-cap vs. Large Cap performance2. Value vs. Growth performance3. Momentum

Also looks to find stable sources of returns through income

Focus on stocks generating consistent:1) Excess net positive income

2) Dividend payouts

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Screening Criteria

The criteria below was used to achieve these objectives:1. A market capitalization minimum of $125 million

2. A return on investment (ROI) minimum of 12%

3. A previous year dividend yield minimum of 3%

4. A stock price minimum of $1

5. A rank of the 9 highest dividend yielding stocks from the previous year remaining Various screens of 25 and 15 stocks shows less diversification improves returns Additionally, a screen of 5 stocks shows even higher returns, but more down periods

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Screen Input

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Base Set Size Formula Min Max Passed

$C+$R 29866       29866$1 29866 mkval 125   5159$2 5159 roi 12   750$3 750 dvydc[-1] 3   127$4 127 prccm 1   127$5 127 @RANK(dvydc[-1],$) 1 9 9

Criteria Rationale

Price Minimum ($1 per share)

Used to eliminate penny stocks

Market Capitalization Minimum ($125 million)

Used to eliminate micro-cap stocks

However, this screen is meant to capture both large and small caps depending on their income and dividend characteristics Although small-caps typically outperform large-caps, there are inefficiencies in regards to

total returns when accounting for dividends. This screen is meant to capture the inefficiencies between large and small stocks in the

pursuit of excess returns.

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Criteria Rationale (continued)

Return on Investment Hurdle (12%)

Used to screen stocks that have extraordinary income and extraordinary return compared to other investments It is a simple measure that gauges an investments ability to generate return Additionally, it shows the consistency of a stock’s ability to generate income

Previous Year Dividend Yield Hurdle (3%)

In concordance with the ROI criteria, this ensures that investors receive at least 9% capital appreciation return and an additional 3% for reinvestment This screen also ensure the stocks in the portfolio show a consistent ability to generate

income and provide shareholders with additional cash payouts

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Criteria Rationale (continued)

Rank 9 Stocks by Highest Previous Year Dividend Yield

Of the stocks that remain, ranking the stocks with the highest previous year dividend yield has proven to deliver higher returns

Screens of 25 and 15 highest ranked previous year dividend yields show that diversification hurts returns.

Although 5 stocks results in an even greater return, it begins to open up the portfolio for larger drops in down periods and less frequent beats of the major indices.

9 stocks was considered the optimal amount of diversification because beyond the range between 5 and 9 stocks, the marginal decrease in returns typically becomes more consistent, while the jump between 15-25 to 5-9 is substantial. The graph on the next page illustrates this point.

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Criteria Rationale (concluded)

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Results of the Model

Only one period where the portfolio does not beat the S&P 500

Worst period return was -26.4% and only experienced two down periods

An initial $10,000 investment at the end of 20 years:

$121,023,200DIAD

SummaryCumulative. Ret. Annualized Ret. Average Ret Best Period Worst Period

Portfolios 1210232.0% 60.0% 74.0% 372.6% -26.4%S&P 500 554.1% 9.8% 11.7% 37.5% -37.0%S&P MidCap 1021.8% 12.8% 14.4% 37.4% -36.2%S&P SmallCap 800.9% 11.6% 13.0% 41.3% -31.1%Beats S&P 500 19 out of 20 PeriodsBeats S&P MidCap 20 out of 20 Periods Number of Down Periods: 2Beats S&P SmallCap 20 out of 20 Periods

Results of the Model

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Index Returns Excess Returns vs. Individual Returns

Rebalance Date

Return thru12-month

Return90-Day T

BillS&P 500

S&P MidCap

S&P SmallCap

90-Day T Bill

Portf. Sharpe Ratio

Lowest Highest Avg. # Stocks%

TurnoverSTD

Dec13 Dec14 20.7% 13.7% 9.8% 5.7% 0.0% 7.0% 11.0% 15.0% 20.7% 0.85 -13.3% 37.5% 20.7% 9 66.7% 83.91%Dec12 Dec13 113.5% 32.4% 33.5% 41.3% 0.1% 81.1% 80.0% 72.2% 113.4% 0.87 -21.7% 373.2% 113.5% 9 66.7% 85.32%Dec11 Dec12 63.8% 16.0% 17.9% 16.3% 0.1% 47.8% 45.9% 47.5% 63.7% 0.83 13.8% 149.6% 63.8% 9 33.3% 87.25%Dec10 Dec11 4.0% 2.1% -1.7% 1.0% 0.0% 1.9% 5.8% 3.0% 4.0% 0.81 -54.7% 51.2% 4.0% 9 66.7% 89.91%Dec09 Dec10 107.2% 15.1% 26.6% 26.3% 0.1% 92.1% 80.5% 80.9% 107.1% 0.84 72.4% 207.6% 107.2% 9 44.4% 91.05%Dec08 Dec09 151.9% 26.5% 37.4% 25.6% 0.1% 125.4% 114.5% 126.3% 151.8% 0.80 60.6% 313.5% 151.9% 9 77.8% 93.88%Dec07 Dec08 -26.4% -37.0% -36.2% -31.1% 0.1% 10.6% 9.9% 4.7% -26.5% 0.73 -68.3% 17.0% -26.4% 9 55.6% 94.88%Dec06 Dec07 120.4% 5.5% 8.0% -0.3% 3.3% 114.9% 112.4% 120.7% 117.1% 0.81 -96.2% 377.6% 120.4% 9 33.3% 94.49%Dec05 Dec06 59.1% 15.8% 10.3% 15.1% 4.9% 43.3% 48.8% 44.0% 54.2% 0.75 18.0% 143.7% 59.1% 9 22.2% 97.88%Dec04 Dec05 49.8% 4.9% 12.5% 7.7% 4.0% 44.9% 37.3% 42.1% 45.8% 0.73 -5.0% 123.3% 49.8% 9 33.3% 102.46%Dec03 Dec04 76.4% 10.9% 16.5% 22.6% 2.2% 65.5% 59.9% 53.7% 74.2% 0.73 9.5% 201.4% 76.4% 9 44.4% 107.52%Dec02 Dec03 118.0% 28.7% 35.6% 38.8% 0.9% 89.4% 82.4% 79.3% 117.1% 0.69 23.6% 288.9% 118.0% 9 55.6% 114.03%Dec01 Dec02 -9.5% -22.1% -14.5% -14.6% 1.2% 12.6% 5.0% 5.1% -10.7% 0.61 -44.8% 38.3% -9.5% 9 33.3% 120.92%Dec00 Dec01 29.3% -11.9% -0.6% 6.5% 1.7% 41.1% 29.9% 22.7% 27.6% 0.68 -37.2% 157.2% 29.3% 9 44.4% 125.31%Dec99 Dec00 35.2% -9.1% 17.5% 11.8% 5.7% 44.3% 17.7% 23.4% 29.4% 0.71 -71.1% 209.2% 35.2% 9 55.6% 134.37%Dec98 Dec99 372.6% 21.0% 14.7% 12.4% 5.2% 351.5% 357.9% 360.2% 367.4% 0.74 -63.6% 2619.4% 372.6% 9 55.6% 145.82%Dec97 Dec98 24.6% 28.6% 19.1% -1.3% 4.4% -3.9% 5.5% 25.9% 20.3% 2.10 -55.3% 222.7% 24.6% 9 44.4% 20.92%Dec96 Dec97 76.4% 33.4% 32.2% 25.6% 5.2% 43.1% 44.2% 50.8% 71.2% 3.06 -28.5% 247.1% 76.4% 9 55.6% 16.89%Dec95 Dec96 48.2% 22.9% 19.2% 21.3% 5.1% 25.2% 29.0% 26.9% 43.1% 27.09 -34.5% 163.6% 48.2% 9 66.7% 1.55%Dec94 Dec95 45.9% 37.5% 30.9% 30.0% 5.0% 8.3% 14.9% 15.9% 40.9% -- -17.3% 106.9% 45.9% 9 --

Results of the Model

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Return ValuesFrequency: Annually

Return Bar Graph

-100.0%

400.0%

-80.0%-60.0%-40.0%-20.0%

0.0%20.0%40.0%60.0%80.0%

100.0%120.0%140.0%160.0%180.0%200.0%220.0%240.0%260.0%280.0%300.0%320.0%340.0%360.0%380.0%

Dec1994

Dec2014

Dec1995

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DIAD S&P 500 Russell 3000 TR USD

Results of the Model

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Compound ReturnFrequency: Annually

Compound Return Graph

0.0%

1300000.0%

100000.0%

200000.0%

300000.0%

400000.0%

500000.0%

600000.0%

700000.0%

800000.0%

900000.0%

1000000.0%

1100000.0%

1200000.0% 1210232.0%

568.9%

Dec1994

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Dec1995

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Results of the Model

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Index Values (USD)Frequency: Annually

Index Line Graph

9,000.0

200,000,000.0

10,000.0

20,000.030,000.0

50,000.0

100,000.0

200,000.0300,000.0

500,000.0

1,000,000.0

2,000,000.03,000,000.0

5,000,000.0

10,000,000.0

20,000,000.030,000,000.0

50,000,000.0

100,000,000.0 121,033,200.5

66,762.9

Dec1993

Dec2014

Dec1994

Dec1995

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DIAD S&P 500 Russell 3000 TR USD

Summary Statistics

• Over a 20 year period, the DIAD portfolio strategy achieves returns of more than 6x that of indices that measure aggregate market performance.

• On a risk adjusted basis, DIAD does offer above average risk-adjusted returns, but due to the high standard deviation, the Sharpe ratio remains under 1.

• Additionally, the risk of the portfolio is very high, but it has low correlation to the market. Thus, this portfolio has capitalized on the inefficiencies that exist in the market.

 N Periods Geometric

Mean (%)

Arithmetic

Mean (%)

Standard

Deviation

(%)

Sharpe

Ratio

P/E Ratio Beta R-Squared N Positive

Periods

N Negative

Periods

DIAD 20 60.01 74.05 84.31 0.8783 0.0000 1.8803 0.19 18 2

S&P 500 19 9.65 11.64 20.14 0.5781 0.0000 1.0004 1.00 15 4

Russell 3000 TR USD 20 9.96 11.82 19.42 0.6087 0.0000 0.9880 0.99 16 4

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Conclusions This trading model is a simple, yet effective screening criteria that seeks out stocks that

generate consistent above average income and dividend distributions.

Beating the S&P 500 for 19 out of 20 periods and only 2 down periods (during periods of crisis in 2001-2002 and 2007-2008), this model exhibits return characteristics that consistently outperform indices that capture returns of the market in the aggregate.

Additionally, this model is consistent with traditional portfolio theory. The more diversified, the lower returns will be. Thus, if you are looking for more diversification and one fewer down period, you can increase your

number of stocks to 15 or 25. If you want to even higher returns but increased downside risk, you can reduce your number of

stocks to 5.

Lastly, this model has above average risk, but offers above average returns in excess of the risk taken. Additionally, the lack of correlation with the market is a characteristic that mitigates the downside risk when the market as a whole declines.

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Areas for Future Refinement Continue to reevaluate the optimal hurdle levels for:

Previous year annual dividend yield Return on investment

See if there are opportunities for even higher returns by focusing on: A model that switches between the number of stocks based on previous year returns:

Essentially, can previous year results indicate the raising or lowering the number of stocks the model should invest in the following year?

Find ways to lower downside risk without sacrificing the upside potential: Can additional asset classes beyond equities help achieve this goal?

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