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Tilting for yield and the bath analogy

Stocks and Shares ISA , Choosing funds for ISA's, risk factors for funds etc
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Itsallaguess
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Tilting for yield and the bath analogy

#546316

Postby Itsallaguess » November 13th, 2022, 6:58 pm

In a recent post on another thread, dealtn composed a great 'bath' analogy to help describe the role dividends can play in different types of investments, and how underlying company valuations might be affected by varying levels of underlying yields delivered from different companies -

https://www.lemonfool.co.uk/viewtopic.php?f=55&t=36639&start=80#p545898

This bath analogy was in response to a post from Rob which claimed that -

Dividends, growth in dividends and reinvested dividends are the main source of equity returns over the long run.

https://www.lemonfool.co.uk/viewtopic.php?f=55&t=36639&start=60#p545804

In addition to the above, mc2fool helpfully posted a link to the Credit Suisse Global Investment Returns Yearbook 2011 by Dimson, Marsh & Staunton, to help provide some long-term data in this area -

https://www.lemonfool.co.uk/viewtopic.php?f=55&t=36639&start=60#p545889

https://www.credit-suisse.com/media/assets/corporate/docs/about-us/research/publications/credit-suisse-global-investment-yearbook-2011.pdf

From the outset, I will come clean and profess to have previously agreed with the above 'bath' analogy, or at least a few different less descriptive variations of it, as it always instinctively made sense that receiving dividends for re-investment must usually create various frictional costs, in terms of things like stamp duty and trading costs etc., but after reading the above Credit Suisse document a number of times, I am now having doubts about my earlier instinctive judgement.

The above Credit Suisse study seems to shine a light on the largest issue with the 'bath' analogy, in that such an analogy ignores the fact that for any two given baths, with different 'yields' of water, they will be priced differently by the markets, and go on to deliver different long-term returns due to those market-price differences, meaning that dividends and a given 'bath-volume valuation' isn't necessarily the only thing that drives long-term returns. It's the dividends and the market-pricing of those bath-volumes that will do that...

In the above Credit Suisse document there is a section studying the following -

..a number of US researchers have, since the 1970s, documented a marked historical return premium from US stocks with an above-average dividend yield. The most up-to-date analysis is by Kenneth French of Dartmouth University.

Figure 5 below shows his most recent data, covering the performance since 1927 of US stocks that rank each year in the highest- or lowest-yielding 30% of dividend-paying companies, the middle 40%, and stocks that pay no dividends.

Non-dividend paying stocks gave a total return of 8.4% per year, while low-yield stocks returned 9.1% and high-yielders gave 11.2%.



Image

(Note - all images in this post are sourced from the above Credit Suisse document)


In the Credit Suisse document, they go on to say -

The longest study of the yield effect by far is our 111 year research for the UK. Prior to the start of each year, the 100 largest UK stocks are ranked by their dividend yield, and divided 50:50 into higher- and lower-yield stocks.

The capitalization weighted returns on these two portfolios are calculated over the following year, and this procedure is repeated each year.

Figure 6 below shows that an investment of GBP 1 in the low-yield strategy at the start of 1900 would have grown to GBP 5,122 by the end of 2010, an annualized return of 8.0%.

But the same initial investment allocated to high-yield stocks would have generated GBP 100,160, which is almost 20 times greater, and equivalent to an annual return of 10.9% per year.



Image


The Credit Suisse document also goes on to show how this yield-effect is consistent across the vast majority of the countries covered in the study, with only three very small markets not showing consistency. They say -

Across all 21 countries, the average [high-yield] premium was a striking 4.4% per year.


In trying to explain this reliable and long-term yield-premium, they say -

The yield premium is now widely viewed as a manifestation of the value effect.

Value stocks are those that sell for relatively low multiples of earnings, book value, dividends or other fundamental variables. In the context of yield, value stocks or high-yielders may be mature businesses, or else dividend payers with a depressed share price that reflects recent or anticipated setbacks.

Growth stocks, in contrast, often pay low or no dividends, since the companies wish to reinvest in future growth. They sell on relatively high valuation ratios, because their stock prices anticipate cash flows (and dividends) that are expected to grow. While many studies document the yield effect, even more show that value stocks have, over the long run, outperformed growth stocks.

Why have high-yielders outperformed low- and zero-yielders?

There are four possibilities.

First, it may simply be by chance and hence unlikely to recur. But this is hard to sustain, as while there can be lengthy periods when the effect fails to hold, it has nevertheless proved remarkably resilient both over the long run and across countries.

A second possibility is that we are observing a tax effect, since many countries’ tax systems have favored capital gains, perhaps causing growth stocks to sell at a premium. The impact of tax is controversial, but tax alone cannot explain the large premium. Furthermore, in the UK, there was a yield premium pre-1914, when income tax was just 6%. Also, if tax were the major factor, alternative definitions of value and growth stocks would work far less well than dividend yield as an indicator of high or low subsequent performance.

A third possibility is that investors become enthused about companies with good prospects, and bid the prices up to unrealistic levels, so growth stocks sell at a premium to fundamental value.

Evidence for this was provided in 2009 by Rob Arnott, Feifei Li, and Katrina Sherrerd in a study entitled Clairvoyant Value and the Value Effect (The Journal of Portfolio Management). They analyzed the constituents of the S&P 500 in the mid 1950s, comparing the stock prices at the time with what they termed “clairvoyance value.” This was the price investors should have paid if they had then had perfect foresight about all future dividends and distributions. Arnott classified growth stocks as those selling at a premium, i.e. on a lower dividend yield or at a higher price-to-earnings, price-to-book or price-to-sales.

Arnott and his colleagues found that the market had correctly identified the growth stocks, in that they did indeed exhibit superior future growth. However, they also concluded that investors had overpaid for this growth, by up to twice as much as was subsequently justified by the actual dividends and distributions to shareholders.

The final possibility is that the out-performance of value stocks is simply a reward for their greater risk. Indeed, hard-line believers in market efficiency argue that, whenever we see persistent anomalies, risk is the prime suspect. Since value stocks are often distressed companies, the risk argument seems plausible. This could also explain Arnott’s findings if the discount rates used to compute “clairvoyance value” had failed to cater adequately for differences in risk.



Given the above Credit Suisse study, I would like to ask the following two questions and invite feedback on them -

1. Does the above study deliver creditable data in terms of allowing investors to believe that over the long term, wealth can be created using high-yield investments?

2. Does the study reduce the relevance of the 'bath' analogy, because the bath analogy is most relevant only where describing two identical companies, that happen to have two different shareholder-return mechanisms, which, whilst instinctively correct in terms of explaining any additional frictional costs of the dividend-paying plug-hole, does not take into account the fact that in almost all circumstances, the two companies (baths) will actually be completely different, with different share-prices and valuation-multiples, and where any comparable long-term returns will be influenced by those different share-prices and valuation-multiples, and not just the water in each bath?


It's worth noting at this point that -

  • The above study covers 111 years of data from 1900 to 2010, and so does not contain data from the past 12 years.
  • The above study, and this post, clearly recognises and notes that differing levels of 'risk' could help to explain this long-term yield-premium.

With this often being a contentious area of debate, I would like to please ask if we could perhaps try to keep any comments directly related to either any of the above specific points, or directly related to the Credit Suisse study linked earlier in this post.

I would hope that by doing so, we might avoid this discussion becoming too contentious.

Cheers,

Itsallaguess

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Re: Tilting for yield and the bath analogy

#546340

Postby mc2fool » November 13th, 2022, 8:42 pm

Well blimey, I'm gobsmacked! :o Somebody actually read it!! I did think it had been submerged in the mudslinging and ignored!

One small point of clarification from your text:
Itsallaguess wrote:The Credit Suisse document also goes on to show how this yield-effect is consistent across the vast majority of the countries covered in the study, with only three very small markets not showing consistency.

More precisely, they say "In 20 of the 21 countries [studied], high-yielding stocks outperformed low-yielders. The exception was XXX, which is a very small market, where the analysis was based on a sample of just 20 stocks. In most other countries, the yield premium was appreciable, except in YYY and ZZZ, two other small markets, where it was less than 1% per year." (Country names purposely redacted to encourage people to actually read the report. ;))

Itsallaguess wrote:Given the above Credit Suisse study, I would like to ask the following two questions and invite feedback on them -

1. Does the above study deliver creditable data in terms of allowing investors to believe that over the long term, wealth can be created using high-yield investments?

Given that Dimson, Marsh & Staunton are amongst the world's leading historical empirical stock market analysts, and they have long datasets for many markets going back up to 111 years (at time of their report), it would just be churlish to deny the credibility of the data and analysis. There are, however, a couple of things that should be highlighted.

a) For folks that haven't read the report and may have missed it in your summary, this is not HYP (and nor is it selection by payout). The analyses split markets 50:50 by yield and annually rebalance. They, as the report puts it, "require a rigorous rebalancing regime".

b) Their studies are indeed "over the long term" -- 111 years is long term for any of us! And as they say, "there can be extended periods when the yield premium goes into reverse and low-yielders outperform", with some of those extended periods extending well through some of our retirement lifetimes!

c) And, of course, past performance is no guarantee of future results. :D

2. Does the study reduce the relevance of the 'bath' analogy, because the bath analogy is most relevant only where describing two identical companies, that happen to have two different shareholder-return mechanisms, which, whilst instinctively correct in terms of explaining any additional frictional costs of the dividend-paying plug-hole, does not take into account the fact that in almost all circumstances, the two companies (baths) will actually be completely different, with different share-prices and valuation-multiples, and where any comparable long-term returns will be influenced by those different share-prices and valuation-multiples, and not just the water in each bath?

The bath analogy was fine as far as it went, but as was pointed out in the other thread and repeated by yourself above, it only took into account "internal" (to the company) factors, being earnings and dividends, and didn't consider the external, market, factors, being price and valuation, the latter being expressed by P/E and/or yield, and changes in those can be very significant factors in investor returns (and losses).

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Re: Tilting for yield and the bath analogy

#546348

Postby Hariseldon58 » November 13th, 2022, 9:38 pm


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Re: Tilting for yield and the bath analogy

#546359

Postby Dod101 » November 13th, 2022, 11:14 pm

All of which just proves what I have been saying to my friend. Firstly and above all, you need to know why you are investing. What do you want from the exercise? In my case it is simple; I would like (and indeed get) a decent yield from my portfolio such that I can generate an income that I can live off with no real effort. Others will say 'I want capital gains to boost my pot' and even others will say,' I will be happy to maintain my assets in real terms'.

So I go for mostly higher yielding shares, but others will go for so called 'growth' shares which usually have a modest dividend. The trouble with all these studies is that in isolation they may well be right but the same conditions seldom present themselves in exactly the same manner and anyway, as always, it depends on the timescale and indeed the period we are investigating.

I therefore tend to ignore all these academic studies, although if it keeps the investigators in a job, that is OK by me.

Dod

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Re: Tilting for yield and the bath analogy

#546362

Postby tjh290633 » November 13th, 2022, 11:36 pm

Thanks for that information. You may recall a discussion between @dealtn and myself, where he pointed out that, comparing the TR versions of the HIX and LIX indices (The FTSE100HYTR and FTSE100LYTR respectively), that there were only 5 periods from 1998-9 to 2021-2 where the HIX TR index outperformed the LIX TR, for an investment made at the end of that financial year and held to the end of 21-22.

dealtn wrote:As I said. Since 1999 (when my records began) at the beginning of each tax year an investor could consider how a single investment in either index would have performed if left untouched, measured against Total Return of that investment.

Such an experiment results in "wins" for a singular investment in High Yield in the 5 years, being 1999, 2000, 2019, 2020 and 2021.

Such an experiment results in "wins" for a singular investment in Low Yield in the 18 years, being 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, and 2018.


I, on the other hand, had pointed out that the HIX TR value had always (going by the figures that I had available) been ahead of the LIX TR index since inception in 1996. In dealtn's analysis, it was only starting in the years 1999-2001 and 2020-21 that the result for the HIX TR would have been superior. It would appear that this effect is down to the very low value of the LIX TR in the years immediately after the dot-com mania in 1999-2000, when the Main FTSE100 index reached a high of 6,930, not regained until 2016.

This effect may be pertinent to the data quoted above. The Study quoted appears to be based on a starting date of 1927, and working cumulatively since that date. Their definition of High Yield differs from that used in the UK indices, where the split is taken where capitalisation of each half is the same, leading to a 131/219 split, whereas they have just taken a 50/50 split.

Using the data provided by dealtn I looked at the values, rebasing to unity at the first year end:

Year End   Low Yield   High Yield   LIX    HIX    Diff 
01/04/22 5499.9 7950.48 2.38 3.24 0.86
01/04/21 5406.33 6829.18 2.34 2.78 0.44
01/04/20 4375.93 5400.72 1.90 2.20 0.30
01/04/19 4836.51 7068.39 2.10 2.88 0.78
01/04/18 4605.47 7015.5 2.00 2.86 0.86
01/04/17 4313.15 6420.31 1.87 2.62 0.75
01/04/16 3600.28 5337.4 1.56 2.18 0.61
01/04/15 3761.66 5777.13 1.63 2.35 0.72
01/04/14 3354.93 5589.03 1.45 2.28 0.82
01/04/13 3027.84 5080.08 1.31 2.07 0.76
01/04/12 2663.61 4200.46 1.15 1.71 0.56
01/04/11 2816.51 4149.76 1.22 1.69 0.47
01/04/10 2442.82 3729.18 1.06 1.52 0.46
01/04/09 1692.97 2912.13 0.73 1.19 0.45
01/04/08 2348.72 3963.29 1.02 1.62 0.60
01/04/07 2326.8 4309.11 1.01 1.76 0.75
01/04/06 2005.9 3937.26 0.87 1.60 0.74
01/04/05 1464.48 3058.32 0.63 1.25 0.61
01/04/04 1379.17 2659.71 0.60 1.08 0.49
01/04/03 1161.15 2138.24 0.50 0.87 0.37
01/04/02 1482.04 2774.23 0.64 1.13 0.49
01/04/01 1954.19 2721.95 0.85 1.11 0.26
01/04/00 2565.8 2191.36 1.11 0.89 -0.22
01/04/99 2307.26 2453.9 1.00 1.00 0.00

This shows that in was only at the end of the first year that HIX TR lagged LIX TR. However, using dealtn's data, and starting at each year and holding to the last date, the result is:

From       Value of      Value of
Year End LIX from Yr HIX from Yr Difference
01/04/22
01/04/21 1.02 1.16 0.15
01/04/20 1.26 1.47 0.22
01/04/19 1.14 1.12 -0.01
01/04/18 1.19 1.13 -0.06
01/04/17 1.28 1.24 -0.04
01/04/16 1.53 1.49 -0.04
01/04/15 1.46 1.38 -0.09
01/04/14 1.64 1.42 -0.22
01/04/13 1.82 1.57 -0.25
01/04/12 2.06 1.89 -0.17
01/04/11 1.95 1.92 -0.04
01/04/10 2.25 2.13 -0.12
01/04/09 3.25 2.73 -0.52
01/04/08 2.34 2.01 -0.34
01/04/07 2.36 1.85 -0.52
01/04/06 2.74 2.02 -0.72
01/04/05 3.76 2.60 -1.16
01/04/04 3.99 2.99 -1.00
01/04/03 4.74 3.72 -1.02
01/04/02 3.71 2.87 -0.85
01/04/01 2.81 2.92 0.11
01/04/00 2.14 3.63 1.48
01/04/99 2.38 3.24 0.86

Which clearly shows the effect he noticed. It would appear, therefore, that it is the period under consideration which should be studied, not that from when data was first collected. That maybe should be 10-year or 20-year periods, in the way that I recall the Barclays Gilt/Equity study works. In other words, 10 or 20 years from each start date. The result for 10-year holding periods is:

Year End   10 Yr LIX   10 yr HIX   Diff 
01/04/22 2.06 1.89 -0.17
01/04/21 1.92 1.65 -0.27
01/04/20 1.79 1.45 -0.34
01/04/19 2.86 2.43 -0.43
01/04/18 1.96 1.77 -0.19
01/04/17 1.85 1.49 -0.36
01/04/16 1.79 1.36 -0.44
01/04/15 2.57 1.89 -0.68
01/04/14 2.43 2.10 -0.33
01/04/13 2.61 2.38 -0.23
01/04/12 1.80 1.51 -0.28
01/04/11 1.44 1.52 0.08
01/04/10 0.95 1.70 0.75
01/04/09 0.73 1.19 0.45

And here we see only the earliest 3 10-year periods show an advantage for the HIX.

Perhaps a cautionary tale.

TJH

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Re: Tilting for yield and the bath analogy

#546363

Postby mc2fool » November 14th, 2022, 12:16 am

tjh290633 wrote:The Study quoted appears to be based on a starting date of 1927, and working cumulatively since that date.

That's the US chart, the UK chart, also in the OP, runs 1900-2100 and shows the "yield premium" on an annual and a 5-year rolling basis.

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Re: Tilting for yield and the bath analogy

#546372

Postby Itsallaguess » November 14th, 2022, 5:56 am

mc2fool wrote:
The analyses split markets 50:50 by yield and annually rebalance.

They, as the report puts it, "require a rigorous rebalancing regime


Thanks for clearly highlighting something that I did originally intend to raise in my opening post, in the final section where I specifically recognise their other statement related to 'risk'.

Can I ask if you've seen any further details on their rebalancing regime?

If there are none easily available, do you think there are any safe assumptions we might make regarding it?

Cheers,

Itsallaguess

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Re: Tilting for yield and the bath analogy

#546397

Postby monabri » November 14th, 2022, 9:05 am

Something Gengulphus looked into a while ago ( February 2021) and Moorfield & MDW1954 updated/reviewed.

viewtopic.php?p=467290#p467290

The question G addressed was "how would Pyad's HYP1 have grown with dividend reinvestment? ".

Obviously, assumptions had to be made...

The "thought experiment" was initially carried out during Covid so the predictions were affected by the drop in both share values and income. The link above is to Moorfield's update, made a little later on in December 2021 but the whole post is contained in one thread.

Subsequently, in viewtopic.php?p=467290#p467290 , an estimate CAGR of 10.5% on dividend income was calculated ( revised by MDW1954).

Moorfield made a comment

"Accumulation-HYP1's income was £25,272 in Year 21, which works out at a compound annual growth rate of 10.5% since Year 1. (As mentioned previously, I have fixed this at 7.2% for my own long term forecasting.) Overall value has multipled 5.08x."

MDW1954 calculated an annual growth rate of just over 8.5% on the increase in portfolio value.

viewtopic.php?p=467530#p467530

MDW1954 also calculated an annual growth rate in dividend of c.9.75% ( a few postings later on in the discussion from 2021).

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Re: Tilting for yield and the bath analogy

#546405

Postby dealtn » November 14th, 2022, 9:16 am

Firstly as the "author"? of the analogy can I say it is good that the more relevant parts of that thread, subsequently locked, have been replicated (and in an appropriate place).

Itsallaguess wrote:
1. Does the above study deliver creditable data in terms of allowing investors to believe that over the long term, wealth can be created using high-yield investments?


Yes - although I think that is too simple a question. Perhaps you have misphrased it. It is obvious that wealth can be created by these, and many other, investment strategies. The more subtle, and more difficult to answer, question is whether such high-yield investment strategies deliver additional wealth compared to others (and does the Dimson/Marsh/Staunton analysis deliver any proof of that)?

Itsallaguess wrote:
2. Does the study reduce the relevance of the 'bath' analogy, because the bath analogy is most relevant only where describing two identical companies, that happen to have two different shareholder-return mechanisms, which, whilst instinctively correct in terms of explaining any additional frictional costs of the dividend-paying plug-hole, does not take into account the fact that in almost all circumstances, the two companies (baths) will actually be completely different, with different share-prices and valuation-multiples, and where any comparable long-term returns will be influenced by those different share-prices and valuation-multiples, and not just the water in each bath?




No. Simply because the bath analaogy is a different thing. The "bath" merely illustrates that what drives any "worth" is the water flowing into, and not leaving the bath (regardless of the route it takes). It makes no judgement on how people, or the market, values that "worth" nor about how those valuations might (and do) change over time.

Buffett has stated, approximately, that in the short term markets are "voting machines" but over the long term "weighing machines". The analogy only works in an empirical sense if we were looking solely at the long term weighing. It has nothing to say about voting. In the long run not only are we weighing, but we see the aggregation of all the short term voting, and the changes in those votings over that time.

No doubt if you wanted to you could tortuously stretch the analogy further to try and make it more applicable to that long term changing in voting. I think that complication isn't worth pursuing. You would need to consider people that preferred (or valued more highly) baths such as those that had less water flow initially over those with fully turned on taps, because there was an expectation over time the taps on the former would be incrementally turned on fuller up to and beyond those of the latter (or more taps added), for instance. Some might like shinier taps, or leakier plugs.

The closest you could get to applying this truly to the world of investment would be if the only thing of value in the bath (company) was water (liquid and easily measurable assets such as cash). The world isn't and will never be that simple.

The analogy works as a simple debunking of the lazy myth that it is dividends that are prime importance, and the reinvesting of them. In the non-existent investment universe 100% retained earnings, no dividends, exceeds the identical investment, that pays and reinvests those dividends (due to "leakage" or frictional costs) which in turn exceed the same dividend paying alternative where dividends are not reinvested. That's all.

_______

Turning to Dimson et al, it is important to recognise this quoted article isn't the sole piece of work in this area. This is research of a long run nature, and gets replicated, usually annually, although it is much less publicly available than it used to be (and when I was one of their students). The main thrust of the long run analysis isn't comparing different equity based investment strategies.

A good summary of the articles investigation on potential causes of the apparent outperformance of "high yielding" equity strategies has been given already. In brief 4 possible reasons are explored.

1) It doesn't exist. Given the volume of data, over many (many) years, and its visibility in most countries staock markets, this is dismissed. It (probably) exists.

2) Tax. Doesn't explain it.

3) High Yield is correlated with higher risk. Higher risk demand higher return, so it isn't unexpected that riskier strategies outperform in the long run. This explanation provides some, but not all, of the return premium.

4) Something else.

The something else put forward, which appears to hold empirically, is ironically not actually caused by "dividends" relationship with High Yield (as claimed by many) but by valuation. It is the (often) low capital valuations attached to high dividend paying companies, relative to the (often) high valuations placed on low, or non-existent, dividend paying companies (or lazily labelled "growth" stocks).

Valuations are ultimately determined by marginal buyers and sellers, which are people with underlying human emotions. Psychology determines that human behaviours often dismiss the "past" of ex-growth as being poor value, with no place in the future. Conversely the future, and all the growth and wonder of the new technology that will revolutionise the world, is often overvalued.

The effect is that (often enough, and noticeable over the long term results) there are secular under and over valuations of certain types of stocks. These "emotive" swings are sufficient that if you invest in the undervalued sufficiently often and benefit in the reversion to mean, or true valuations of these types of holdings (and then disinvest), you outperform the market - and also in reverse, buying overvalued and suffering that valuation reversion leads to under-performance in the long term.

Small over or under performance on average, over a long enough period, make (very) meaningful differences in portfolio performance due to compounding.

CRUCIALLY (and touched upon) this isn't strict buy and hold of high dividend (and slightly higher risk) stocks. This is about a value strategy. Buy low and sell as that value outs, and reinvest in the new marginally lower valued alternative opportunities.

You don't need to just buy certain stocks but have an unemotive, or mechanical, means to sell appropriately too (as some here have demonstrated). Value strategies work, but can (massively) underperform too, even over what seem to be very long periods of time.

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Re: Tilting for yield and the bath analogy

#546418

Postby mc2fool » November 14th, 2022, 10:24 am

Itsallaguess wrote:
mc2fool wrote:The analyses split markets 50:50 by yield and annually rebalance.

They, as the report puts it, "require a rigorous rebalancing regime

Thanks for clearly highlighting something that I did originally intend to raise in my opening post, in the final section where I specifically recognise their other statement related to 'risk'.

Can I ask if you've seen any further details on their rebalancing regime?

If there are none easily available, do you think there are any safe assumptions we might make regarding it?

I have no further details although I'm unsure of what any further details could be, it seems straightforward enough to me as described: split the market(s) down the middle, 50:50, by yield and after a year sell up (on paper at least) and use the proceeds to rebuy repeating the split. Or, more practically, rebalance (i.e. sell and buy only the ones that have changed which side of the split they are).

However, if you want to try asking them I believe DM&S are contactable, at least they were. I recall a time on TMF when it had been picked up, either from this paper or some other, that DM&S had made a statement along the lines of the infamous "most stockmarket returns come from dividends" (not an exact quote! And I think there was a "real" in there, IIRC) and some Fool emailed them to challenge that and one of them (can't remember which) replied and the Fool posted their reply (which basically doubled down) on TMF.

(OT: I do wish the Wayback Machine would implement text search through their archive!)

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Re: Tilting for yield and the bath analogy

#546424

Postby Itsallaguess » November 14th, 2022, 10:52 am

dealtn wrote:
The "bath" [anaology] merely illustrates that what drives any "worth" is the water flowing into, and not leaving the bath (regardless of the route it takes).

It makes no judgement on how people, or the market, values that "worth" nor about how those valuations might (and do) change over time.

.....

The analogy works as a simple debunking of the lazy myth that it is dividends that are prime importance, and the reinvesting of them.

In the non-existent investment universe 100% retained earnings, no dividends, exceeds the identical investment, that pays and reinvests those dividends (due to "leakage" or frictional costs) which in turn exceed the same dividend paying alternative where dividends are not reinvested.

That's all.


Thanks for the detailed responses - I was hoping you'd pick up on this new thread.

I'd like, if we could, to concentrate on your two particular points above.

I hope I'm correct in saying that your bath analogy was in direct response to Rob saying the following -

Dividends, growth in dividends and reinvested dividends are the main source of equity returns over the long run.

I can still clearly appreciate how your bath analogy accurately describes how two absolutely identical companies with differing shareholder-return preferences will perform differently over the long-term, and where the higher-dividend paying bath will always look to introduce frictional costs into any re-investment tasks, removing 'bath-water' with each frictional process, and hence delivering lower water levels over time into that particular dividend-paying bath.

Where I'm struggling is when I try to apply what the Credit Suisse study says into that two-bath scenario, because what I think they are saying is that the dividend-paying bath is likely to be priced by the market as a 'value' share, whilst the bath that doesn't pay dividends, and retains it's earnings, will be priced by the market as a 'growth' share, with different valuation multiples and expectations to suit.

This feels important, because the study says that they have seen evidence that generally over long periods, investors are good at spotting growth shares where they try to look for them, but crucially, they tend to over-pay for those growth shares in a way that detrimentally affects long-term returns -

From the Credit Suisse study -

A third possibility is that investors become enthused about companies with good prospects, and bid the prices up to unrealistic levels, so growth stocks sell at a premium to fundamental value.

Evidence for this was provided in 2009 by Rob Arnott, Feifei Li, and Katrina Sherrerd in a study entitled Clairvoyant Value and the Value Effect (The Journal of Portfolio Management). They analyzed the constituents of the S&P 500 in the mid 1950s, comparing the stock prices at the time with what they termed “clairvoyance value.” This was the price investors should have paid if they had then had perfect foresight about all future dividends and distributions. Arnott classified growth stocks as those selling at a premium, i.e. on a lower dividend yield or at a higher price-to-earnings, price-to-book or price-to-sales.

Arnott and his colleagues found that the market had correctly identified the growth stocks, in that they did indeed exhibit superior future growth. However, they also concluded that investors had overpaid for this growth, by up to twice as much as was subsequently justified by the actual dividends and distributions to shareholders.


So whilst you say that your bath analogy 'makes no judgement on how people, or the market, values that "worth" nor about how those valuations might (and do) change over time', I cannot then see how it's a relevant analogy where it's being given in response to Rob's statement that clearly does make a judgement on valuing 'worth', because it's specifically talking about long-term equity-returns, which I hope I'm right in saying are inextricably linked to both initial prices paid for investments, and any subsequent growth (or lack of growth) in those share-prices from the point of purchase.

I'm struggling to see how the bath analogy can be stated by you to not consider 'value', when it's being specifically provided as an analogy to debunk a statement that clearly does.

Can you help bridge that gap in my understanding?

Cheers,

Itsallaguess

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Re: Tilting for yield and the bath analogy

#546438

Postby Itsallaguess » November 14th, 2022, 12:12 pm

mc2fool wrote:
I have no further details [of the rebalancing process] although I'm unsure of what any further details could be, it seems straightforward enough to me as described:

Split the market(s) down the middle, 50:50, by yield and after a year sell up (on paper at least) and use the proceeds to re-buy, repeating the split.

Or, more practically, rebalance (i.e. sell and buy only the ones that have changed which side of the split they are)


Thanks.

Would it be fair to consider, do you think, that an income-investor who follows their own ongoing re-balancing process which broadly caters for the following aspects might be able to expect to take advantage of a worthwhile proportion of the 'high yield benefit' being covered in the Credit Suisse study?

  • Sell down investments that have seen their share price rise to such an extent that they cross a boundary into 'low yield' territory
  • Sell down investments that, for reasons other than the above but often relating to dividend payment levels, cross a boundary into 'low yield' territory
  • Re-invest any proceeds from the above processes, and also any surplus incoming dividends, into higher-yielding investments, whilst looking to maintain a broadly diversified and balanced income-portfolio

Can you think of any major advantages of a complete 'sell-down and re-purchase' re-balancing process that might be lost where the above re-balancing aspects might be alternatively followed?

Cheers,

Itsallaguess

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Re: Tilting for yield and the bath analogy

#546452

Postby mc2fool » November 14th, 2022, 12:59 pm

Itsallaguess wrote:Would it be fair to consider, do you think, that an income-investor who follows their own ongoing re-balancing process which broadly caters for the following aspects might be able to expect to take advantage of a worthwhile proportion of the 'high yield benefit' being covered in the Credit Suisse study?

  • Sell down investments that have seen their share price rise to such an extent that they cross a boundary into 'low yield' territory
  • Sell down investments that, for reasons other than the above but often relating to dividend payment levels, cross a boundary into 'low yield' territory
  • Re-invest any proceeds from the above processes, and also any surplus incoming dividends, into higher-yielding investments, whilst looking to maintain a broadly diversified and balanced income-portfolio

Can you think of any major advantages of a complete 'sell-down and re-purchase' re-balancing process that might be lost where the above re-balancing aspects might be alternatively followed?

Well, I'd start off with the obvious observation that the DMS study isn't about income investing and go on to say that your bullet points, unless I am overlooking something, sounds pretty much like what TJH does (and HYPTUS too?).

I'm not sure how we can answer your last sentence without analysis of long-run data of the sort DMS use, but now I realise that whereas I said earlier that I was unsure of what any further details of their rebalancing process could be, I had made the assumption that at each annual rebalance they balanced up/down to equal weighting of each stock in each group (low/high yield). They don't specify that, one way or the other, and only thing they say (p18) is that "The capitalization weighted returns on these two portfolios are calculated over the following year". Does that indicate they cap weight at rebalance or is it just in the computation of the returns? Dunno.

But in any case, if I understand your question, you are asking about the advantages/disadvantages of reverting all stocks to the initial weights (whatever that may be) at rebalance time vs just letting the ones that don't fall out of the high yield group run, unchanged in weight?

Well, of course the two have different frictional costs, but ignoring those and beyond that, I'm afraid it's a dunno from me. :D

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Re: Tilting for yield and the bath analogy

#546453

Postby Itsallaguess » November 14th, 2022, 1:05 pm

dealtn wrote:
Itsallaguess wrote:
1. Does the above study deliver creditable data in terms of allowing investors to believe that over the long term, wealth can be created using high-yield investments?


Yes - although I think that is too simple a question. Perhaps you have misphrased it.

It is obvious that wealth can be created by these, and many other, investment strategies.

The more subtle, and more difficult to answer, question is whether such high-yield investment strategies deliver additional wealth compared to others (and does the Dimson/Marsh/Staunton analysis deliver any proof of that)?


Just on that final specific point then, do you think the Credit Suisse long-term study linked in my opening post provides any evidence to back up their claims of a 'high-yield premium' that can deliver improved long-term results?

Cheers,

Itsallaguess

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Re: Tilting for yield and the bath analogy

#546454

Postby mc2fool » November 14th, 2022, 1:07 pm

dealtn wrote:The more subtle, and more difficult to answer, question is whether such high-yield investment strategies deliver additional wealth compared to others (and does the Dimson/Marsh/Staunton analysis deliver any proof of that)?

Well, they delivered proof that the particular strategy under discussion delivered additional wealth over the looooong term compared to the mirror low yield strategy, and by extension to a market tracker, but with the caveats they and you note of long periods of underperformance.

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Re: Tilting for yield and the bath analogy

#546476

Postby Itsallaguess » November 14th, 2022, 2:28 pm

mc2fool wrote:
Itsallaguess wrote:
Would it be fair to consider, do you think, that an income-investor who follows their own ongoing re-balancing process which broadly caters for the following aspects might be able to expect to take advantage of a worthwhile proportion of the 'high yield benefit' being covered in the Credit Suisse study?

  • Sell down investments that have seen their share price rise to such an extent that they cross a boundary into 'low yield' territory
  • Sell down investments that, for reasons other than the above but often relating to dividend payment levels, cross a boundary into 'low yield' territory
  • Re-invest any proceeds from the above processes, and also any surplus incoming dividends, into higher-yielding investments, whilst looking to maintain a broadly diversified and balanced income-portfolio

Can you think of any major advantages of a complete 'sell-down and re-purchase' re-balancing process that might be lost where the above re-balancing aspects might be alternatively followed?


I'm not sure how we can answer your last sentence without analysis of long-run data of the sort DMS use, but now I realise that whereas I said earlier that I was unsure of what any further details of their rebalancing process could be, I had made the assumption that at each annual rebalance they balanced up/down to equal weighting of each stock in each group (low/high yield).

They don't specify that, one way or the other, and only thing they say (p18) is that "The capitalization weighted returns on these two portfolios are calculated over the following year". Does that indicate they cap weight at rebalance or is it just in the computation of the returns? Dunno.

But in any case, if I understand your question, you are asking about the advantages/disadvantages of reverting all stocks to the initial weights (whatever that may be) at rebalance time vs just letting the ones that don't fall out of the high yield group run, unchanged in weight?

Well, of course the two have different frictional costs, but ignoring those and beyond that, I'm afraid it's a dunno from me. :D


Thanks, and that's about as good a response as I could have hoped for given the lack of clearer information both on their specific Credit Suisse rebalancing scheme, and the fact that as far as I can tell, they've not specifically mentioned any cap-weighted advantages or disadvantages in the high-yield study-data that I've seen.

That's clearly not to say that I'd be happy to completely discount any cap-weight vs equal-weighting advantages or disadvantages, but I think it's worth highlighting that in such a detailed long-term report, I don't think they specifically mention it in terms of it being a major influence one way or another, and we perhaps then might be able to consider it's importance or influence by it's absence, even if we can't by it's specific inclusion...

Like I say though - I think a 'not too sure' answer might be the best I could have hoped for, as it at least doesn't highlight any major obvious flaws in a proposal that if there's no major cap-weight vs equal-weight advantage or disadvantage, then with a fair wind, an investor who perhaps uses different regular balancing techniques to make sure that they maintain a diverse and balanced investment portfolio that continues to make sure that their investment-capital is always invested in diverse higher-yielding options, might be able to consider that they'll at least be able to take some advantage of the type of long-term 'high-yield premium' benefit that the Credit Suisse study highlights.

Cheers,

Itsallaguess

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Re: Tilting for yield and the bath analogy

#546482

Postby mc2fool » November 14th, 2022, 2:52 pm

Itsallaguess wrote:Thanks, and that's about as good a response as I could have hoped for given the lack of clearer information both on their specific Credit Suisse rebalancing scheme, and the fact that as far as I can tell, they've not specifically mentioned any cap-weighted advantages or disadvantages in the high-yield study-data that I've seen.

Well, as I said, they have responded to at least one Fool's email query in the past and they might again. Here the contact details for Dimson and Marsh. Maybe as dealtn was one of Marsh's students that might give you an additional in? ;)

Methinks your specific problem is that, as far as I've seen, all "yield" strategy studies are for overall return gains and not income-focused ones.

Just for amusement, here's one that actually led me (indirectly, by iterative searches) to TMF and the HYP board there, both for the first time. Not that it's at all HYP-like; their research led to the best gains being from stocks with high (but not highest) yields but with low payouts (i.e. high cover). Oh, and it's quarterly rebalancing! :D https://papers.ssrn.com/sol3/papers.cfm?abstract_id=946448

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Re: Tilting for yield and the bath analogy

#546487

Postby Itsallaguess » November 14th, 2022, 3:36 pm

mc2fool wrote:
Methinks your specific problem is that, as far as I've seen, all "yield" strategy studies are for overall return gains and not income-focused ones


Just on that point - it's not a 'problem', as part of why I've started this thread is that I'm trying to gauge an answer to the oft-repeated view that high-yield investment strategies might well be suitable for people 'looking for income' at the back-end of their investment-lives, but where some people think such an approach is 'not suitable' for people trying to perhaps build and maintain their wealth when they are younger, and where more growth-facing strategies are often firmly recommended instead.

On the face of it, this Credit Suisse study seems to discredit that particular stance, because it shows that worthwhile overall returns can be built up when not in 'income-taking-mode' by a strategy that maintains a particular re-balancing approach whilst focussing on long-term exposure to high-yielding equities whilst that pot is allowed to grow over many years.

So for this particular discussion, I'm happy to completely discount any particular aspect related to the 'taking of income from the pot', and concentrate for now on how the long term building of that pot by investing in high-yield investments can indeed be possible in some circumstances, and indeed this Credit Suisse study actually seems to suggest that doing so might actually deliver long-term advantages in doing so...

I'm happy to leave the 'what do we actually now do with the pot' question for another day...

Cheers,

Itsallaguess

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Re: Tilting for yield and the bath analogy

#546488

Postby mc2fool » November 14th, 2022, 3:40 pm

Itsallaguess wrote:
mc2fool wrote:Methinks your specific problem is that, as far as I've seen, all "yield" strategy studies are for overall return gains and not income-focused ones

Just on that point - it's not a 'problem', as part of why I've started this thread is that I'm trying to gauge an answer to the oft-repeated view that high-yield investment strategies might well be suitable for people 'looking for income' at the back-end of their investment-lives, but where some people think such an approach is 'not suitable' for people trying to perhaps build and maintain their wealth when they are younger, and where more growth-facing strategies are often firmly recommended instead.

Aha, ok, fair enuff guv! :D

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Re: Tilting for yield and the bath analogy

#546490

Postby dealtn » November 14th, 2022, 3:43 pm

Itsallaguess wrote:I'm struggling to see how the bath analogy can be stated by you to not consider 'value', when it's being specifically provided as an analogy to debunk a statement that clearly does.

Can you help bridge that gap in my understanding?

Cheers,

Itsallaguess


Honestly the bath analogy, which is mine, not Dimson et al's, is really to focus the mind on what drives "volume" of water. Which is the taps (water in) and how much water escapes.

Its simple point is that many focus on the dividend streams, which are the incomes "in" to the shareholders, when actually the dividends are the "money" out from the company's perspective. Of course from a shareholder perspective it is Total Return that matters and obviously the dividends received are a key component of that Total Return, but they are just a transformation from Capital into Income - a net zero (or worse due to frictional costs) movement of shareholder worth from bath to bucket.

Arguments made, by Rob and others, revolve around 1) the Dividends being the driver of shareholder returns (they aren't its company earnings that are), or 2) reinvestment of those dividends is what drives outperformance (which isn't true as they would underperform at the shareholder level the exact same company with no dividends, complete retained earnings, and no recycling of dividends to reinvest.

What is usually behind the argument, once teased away is 1) A portfolio with reinvested dividends exceeds one where dividends aren't reinvested. So obviously true its barely worth discussing or 2) High Dividend strategies outperform other strategies on a long term Total Return basis (as a generalisation).

Dimson et al's main body of work isn't specifically about 2) but it is true in this specific paper of 2011 they explore it and agree with it. CRUCIALLY though this long term outperformance is driven by 2 factors 1) Higher Risk and 2) Buying Value (and avoiding premium priced alternatives, and holding until that value is outed then repeated.

The bath analogy as stated has nothing to say about this, and as I said i think it is tortuous to extend it beyond its original intention.

Some strategies labelled as High Yield do tend to long term outperformance, and Dimson et al have empiracally shown this, but it is NOT the dividends, or the Highness of them, or the reinvesting of them, that drive this resulting Total Return premium. Its result is due to the 2 factors 1) Risk and 2) (mispricing and therefore) Value. Naturally there is a large correlation between "High Yield" and "Value" as lower prices increase Dividend Yield for any constant dividend, but correlation and causation are not equivalent. Importantly too it relies on selling as well as buying (capturing that outed value). Long Term buy and hold of High Dividend Stocks isn't sufficient. That doesn't capture the value outed over a "value cycle".

Long Term Buy and Hold of High Yield stocks may, and does, provide a good Total Return, and might exceed other alternatives, but that's not the "premium" Dimson et al identify and explore in their 2011 paper.


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