Dividend Investment Strategy: Relative Dividend Yield

The relative dividend yield strategy uses valuations to find undervalued dividend paying shares trading with a discount on the stock market. If a company’s shares dividend yield is significantly higher than that of the comparing index the stock is an potential buy. The comparing index can be anything from the S&P500 up to industry average or competitors average.

The idea behind the relative dividend yield strategy is the following; an above average high dividend yield means the stock is trading below it’s average historical valuation on the stock market and it’s comparing index. This is based on the stocks dividend yield versus it’s comparing dividend yield. This makes the relative dividend yield a measure of valuation to see if a company is trading at a discount.

Besides giving an overview of the shares current valuation, the relative dividend yield strategy also gives an indication of investors sentiment. A high relative dividend yield based on historical valuations shows fear on the market. A low relative dividend yield shows enthusiasm on the market. This makes the relative dividend yield strategy supports the ‘buy low sell high’ principle.

One of the advantages of the relative dividend yield strategy is that the strategy works, even if the market condition is strong or weak. Another advantage is that the selected stocks have a higher than average dividend yields. A potential buy signal is triggered when a stock has a dividend yield which is higher than 50% of the comparing indexes average dividend yield. That also means the stock is undervalued, this will reflect on stock price which will come to the average dividend yield overtime and therefore will reflect a significant return on investment.

Because the relative dividend yield strategy stocks are undervalued on the market, they are also out of favor on the market. This results in to a relative low share price, therefore it is not very likely the share price will fall much further. This lowers the investment risk for the company’s shares.

Another benefit of the relative dividend yield strategy is the sell signal it generates. When the yield drops below the comparing index or markets yield it’s time to sell the stock. This gives the investor a clear sell signal.

The relative dividend yield strategy is well suited for investors with a long term investing mindset. The average holding period of a stock is three to five years. This also means a low cost on brokerage and transaction fees, since you’ll buy and sell only when the signals tell you too. This leaves more money to be invested and therefore better returns.

Last but not least the relative dividend yield strategy has a lower than average market volatility.  This is because the investments are in dividend paying companies with a reputation for paying dividends. The shares of the selected companies will not move as much or as fast as the market does.

The relative dividend yield strategy is applied by performing the following steps:

The first step is come to a selection of stocks for the relative dividend yield strategy by applying the following filters:

         • Paying dividends for at least 5 consecutive years.

         • Price/Earnings ratio is below 20.

         • The company has a above industry average earnings growth.

         • Dividend pay-out ratio below 70%.

         • Debt is equal to or lower than industry average.

After applying the filters it’s time for step 2:

Once the criteria have been applied the dividend yield of the companies on the list and the dividend yield of the comparing indexes have to be researched. All companies which have a match with the following rule will stay on the list: “the company’s dividend yield has to be 50% higher than the comparing index dividend yield”. Continue doing this for the whole list until all companies have gone through the research and the dividend yields have been compared.

Step 3 is the last “buying” step:

Perform research on the remaining companies on the list, once you are sure about the company’s future performance you can buy their shares.

Step 4 is the selling step:

Sell the company’s shares once the dividend yield drops below the comparing index or markets dividend yield.

That’s how the relative dividend yield strategy is applied. The strategy suites well for long term investors focused on undervalued dividend paying stocks. The buy and sell signal makes the relative dividend yield strategy a perfect system based investing strategy working in any market condition. For more information see the book “Relative Dividend Yield” (John Wiley & Sons).