Introduction
The
world is continuously changing, so is the market. Take stock market for
example, numerous specialists, analysts and fund managers try their best to
beat the market. The methods they used can be classified into two categories,
technical analysis and fundamental analysis. Based on the market situation, in
terms of the form of efficiency, different methods apply to different markets.
However there are some unexplainable phenomena happened in the markets, such as
January and October effects. No one has provided a logical reason behind these
effects, yet. For such ever-changing markets, a question pops out: how do
ordinary investors make profit from these markets? An analyst offered a thought
for general public on Wall Street Journal: Dow-Dog strategy. The idea of
Dow-Dog strategy is that the highest ten dividend yield companies would
outperform the index, the benchmark of market. A simple and easy-achieved
alternative fit for all investors. To know whether Dow-Dog strategy works in
real world markets, researchers applied performance-measuring techniques to
assess outcomes of the top ten portfolios and the index. By calculating
compound returns, Sharpe ratio and Treynor ratio, investors can have a clear
image on how well the two subjects perform. Unfortunately, this strategy is not
fit for all stock markets. According to the research, Dow-Dog sometimes worked,
sometimes didn’t. However, the time period of the research is a bit out of
date. So our group decides to create our own Dog strategies with three
different portfolios: equally weighted portfolio, minimum-variance portfolio
and efficient portfolio, instead of just using equally weighted portfolio as
former researchers did. For the time period of 3 January 2012 to 31 October
2012 (211 days), we have found that these three portfolios outperformed FTSE
100, with efficient portfolio even achieved 41% excess return. Overall, we
could tell that different stock markets and time period might have certain
influences on success of Dow-Dog strategy.
Market Efficiency
Before
go through market efficiency, there are two types of analysis to find out the
real price of a company, technical analysis and fundamental analysis, must be
introduced first. Technical analysis is by scrutinized trading volume and value
to predict the best buying or selling time entry. The tricky point is to
predict the momentums of stock prices and therefore claim highest profit
through timing forecast. This way of analysis is also known as chart-reading
technique because analysts study stock price pattern and respond accordingly.
Fundamental analysis is using company’s annual report figures as base judgment
and combining with macroeconomics observation, industrial study and current
events to determine the value of a company. By digging into the past earnings
of a company, analysts thus could better predict the future earnings
performance. Either way of analysis aims to figure out the accurate price of a
company and then compares with the market price to see whether the price is
over- or under-value. For over-value stock, traders short sell it; for
under-value stock, traders buy it. The profit opportunity comes from detecting
inaccurate pricing stock quicker than other investors. Otherwise the market
would respond to the inaccurate price and the price would eventually reach its
fair value.
Fama
(1970) introduced three forms of efficient markets: strong-form market
efficiency, semi-strong form market efficiency and weak form market efficiency.
According to Fama’s theory, investors should first figure out what kind of
market efficiency they are dealing with and react properly respectively. For
weak form market efficiency, the stock price has already responded to all the
past information. It is meaningless for investors to analyse the past stock price
and trading volume. In the weak form efficiency market fundamental analysis
works well. At this point, all future information is considered randomly
dispersed and since no one can tell the future so technical analysis has a hard
time predicting future ups and downs. For semi-strong form market efficiency,
the stock price has responded to all public information. Under this situation,
neither technical analysis nor fundamental analysis could be applied as an
effective tool predicting future stock price. To profit from this form of
market, investors must have access to inside information that others do not
have. The inside information is limited to only few investors, generally
speaking, people who run this company. For strong form market efficiency, all public
and non-public information is reflected in stock price, which means that even
insiders couldn’t benefit from internal information because all the
information, whether internal or external, is open and free to public.
Obviously, investors need some new ideas to profit in this form of market.
Is Market Efficient?
This
question is often asked by researchers and still remained not answered. A stock
market must have a certain degree of efficiency but sometimes it’s difficult to
tell which scenario fits. Clearly not all stock markets fit for strong form
efficiency because confidential information is not free to the public. Although
the market might react in time, there is still a tiny time gap for insiders to
cut in and benefit from it. If the markets react very slowly, in other word:
inefficient, the profit gap might exist longer, loss gap as well. Active
portfolio managers didn’t outperform the market. This is really a situation
depends.
Investment Strategies
There
are many investment strategies, for example, buy and hold, market timing, and
liability-driven strategy, etc., for different preferences. In the end, the
ultimate goal is to make highest profit. Through market efficiency hypothesis,
investors implement different analyses to better interpret price movement.
However, there are some unexplained effects in the stock market. The stock
price usually goes up in January, known as January effect. This phenomenon was
initially recognized in stock market of United States, and later confirmed with
evidence from other stock markets of different countries. Opposite to January
effect, there is October effect, which stock price tends to fall. The effect is
even more explicit when separate capital by the size. For small capital
businesses, the effects are very clear because the high and low of returns are
more fluctuating than big capital businesses.
To
profit from buying stocks is not just through capital appreciation. Dividend
paid by a company is also a factor to take into account because that is the
other way of compensation made by that company for their overall stable stock
price. From the investors’ view of investment retrieve, there are two kinds of
stocks, value stock and growth stock. Value stock usually pays high dividend
and has low price-equity and price-book ratios. Growth stock normally keeps
dividend as reinvestment from shareholders and has high price-equity and
price-book ratios. One characteristic of growth stock is that it possesses high
return on equity, for average 15%. Investors buy growth stock for its future
potential in price growing, not in dividend paid.
Dividend Yield Strategy
To
start with Dow-Dog strategy, dividend yield must be explained in advance.
Dividend yield is calculated by putting one company’s dividends of this year as
numerator and its market price as denominator. Dow-Dog strategy is to pick out
the ten highest dividend yield companies within the index, e.g. DJIA 30,
investing equally. After one year, investors recalculate dividend yield for
that year and rearrange the top ten dividend-yield portfolio. To investors,
there must be certain level of connection between stock price and dividend. By
applying this strategy, investors can easily spot winners of market and
therefore bet on the right side.
There
were research results from three different countries’ stock markets:
1. For
US stock market, Dow-Dog strategy statistically outperformed the index, DJIA
30, during 1946 to 1995 (McQueen, 1997). However, after putting taxes (dividend
paid), transaction costs (yearly rebalance) and risks (diversified or not
diversified) into consideration, Dow-Dog strategy underperformed DJIA 30.
2. For
British stock market, Dow-Dog strategy didn’t take down the index, FSTE 100,
statistically and economically during 1984 to 1994 (Filbeck & Visscher, 1997).
Statistically, in terms of compound returns, FSTE 100 outperformed Dow-Dog
strategy in near six years out of ten-year period in single year holding
situation, and five times out of seven in multiple year holding situations.
After considering risks, taxes and transaction costs, the results were pretty
much the same. Filbeck & Visscher (1997) gave two possible explanations:
(i) FTSE 100 contained more industries than DJIA 30 with utilities,
transportations and financial institutions during that period; (ii) FTSE 100 is
a value-weighted index while DJIA 30 is a price-weighted index.
3. For
Canadian stock market, Dow-Dog strategy totally swiped the index, Toronto 35,
statistically and economically during 1987 to 1997 (Visscher & Filbeck,
2003). The returns of Dow-Dog strategy were enough covering for taxes and
transaction costs.
Practical Example
To
better understand Dow-Dog strategy, our group decided to take this year, 2012,
as our test field. First, we calculated dividend yield of each stock in FTSE
100 based on 1 November, 2012 and pick top ten highest dividend yield stocks
for portfolio. Secondly, we evaluated portfolio performance from 3 January 2012
to 31 October 2012 (211 days) on daily basis. Along with equally weighted
portfolio former research used, we readjusted for minimum risks for risk-averse
investors as minimum variance portfolio and maximum returns with higher risks
for risk seeking investors as efficient portfolio. From the results of these
portfolios in 211 days, efficient portfolio achieved almost 42% return; minimum
variance portfolio got 7% return; equally weighted portfolio had merely 2%
return, but still outperformed FTSE 100. All three portfolios performed better
than FTSE 100 during 211 days. According to our results, the choice of time
period and different weighted portfolio might be related to returns. Former
research calculated compound returns monthly for ten-year period and used
equally weighted portfolio.
Dividend Puzzle
A
dividend puzzle is that a financial manager could have borrowed money to pay
dividend but would never do that, even doing so for tax shield. One saying is
that borrowing money to pay dividend would send wrong message to investors: the
company is unable to pay dividend. Paying dividend without borrowing means a
financial manager must secure cash assets at certain level by the end of the
year for annual report and make sure those cash could cover dividend paid per
share. Otherwise investors and shareholders would spot this inability to pay as
bad sign of company operation. So a company would actually save some cash on
its statement of financial position if it planned a big dividend dispersed next
year. In reality, no one knows what happened after the closed door except for
insiders. If company A just ran out of cash accidentally before dividend paying
date, the financial manager of company A would definitely borrow some money.
Investors still get their dividend and remain unaware until something goes
wrong. Maybe logically investors know everything and react responsively, in
practice they don’t.
References
Berry,
MA 1995, 'Overreaction, Underreaction, and the Low-P/E Effect', Financial
Analysts Journal, 4, p. 21
Fama,
Eugene (1965), ‘The Behavior of Stock Market Prices’, Journal of Business 38:
34-105, doi: 10.1086/294743
Fama,
Eugene (1970), ‘Efficient Capital Markets: A Review of Theory and Empirical
Work’, Journal of Finance 25 (2): 383-417
Filbeck,
G, & Visscher, S 1997, 'Dividend yield strategies in the British stock
market', European Journal of Finance, 3, 4, pp. 277-289
Grossman,
S 1976, 'ON THE EFFICIENCY OF COMPETITIVE STOCK MARKETS WHERE TRADES HAVE
DIVERSE INFORMATION', Journal of Finance, 31, 2, pp. 573-585
McQueen,
G 1997, 'Does the 'Dow-10 Investment Strategy' Beat the Dow Statistically and
Economically?', Financial Analysts Journal, 4, p. 66
Visscher,
S, & Filbeck, G 2003, 'Dividend-Yield Strategies in the Canadian Stock
Market', Financial Analysts Journal, 59, 1, pp. 99-106
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