How to beat the market: low-risk dividends and how to find them

We all know that more risk means more reward, right? This is so abundantly obvious that the pre-eminent academic theory in equity investing, the so-called efficient market hypothesis (EMH) is founded on the idea.

There’s one problem, though. It turns out that in the real world, when it comes to investing in equities, this just isn’t true.

This helps explain why a by-the-numbers investment system for picking low-risk dividend paying shares, which I tracked for a decade while working for Investors Chronicle magazine, managed to outperform the market by 267%. This is one of four strategies covered in my new book Four Ways to Beat the Market.  

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Before exploring this system in more detail and finding out the UK stocks it is highlighting today, it’s worth touching on why the intuitively obvious relationship between risk and reward in investing crumbles under scrutiny. We’ll also look at how low-risk dividend investing works, when it works, and the traps investors can fall into.

Why it works

Back in the 1970s, researchers discovered that baskets of stocks that were less risky based on share price volatility tended to perform better than more volatile shares. This was the exact opposite of what finance theory assumed.

The many investigations into this phenomenon since suggest that the relationship between lower risk and better performance is not totally linear. It reverses slightly for the very lowest risk shares. Nevertheless, on average, even ultra-low-risk shares tend to do way better than high-risk ones.

Studies by psychologists into the way gamblers perceive risk helps explain this counterintuitive finding. The psychology of gambling is relevant to equity investors because investing outcomes are determined to a significant degree by luck as well as skill (proponents of EMH even argue the idea of stock-picking skill is an illusion), so there is always an element of gambling when buying shares.

It has been found that when there is the low probability of a very high payout from a bet, gamblers misperceive the odds. In such circumstances we believe we’re far more likely to win than is actually the case.

The best day-to-day example of this is the thrill of playing the lottery. While the maths says buying a ticket is for suckers, the thought of winning a few million quid says otherwise.

There’s even a pithy name for this phenomenon: long-shot bias.

What it tells us is that people overvalue risky investments, which leads to them performing worse on average. The flip side is that the shares of dull but reliable companies are often undervalued.

Finding dull companies

When it comes to finding dull and reliable companies, one way to identify them is to look for less-volatile shares, as the academics do. Another way is to look at how a company spends its money.

‘Exciting’ companies tend to plough all the cash they can into growth projects. If the company can make high returns on such investments that is great. However, all too often growth projects don’t live up the hype and end up destroying value for shareholders.

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Conservatively run, dull businesses will err on the side of caution. Rather than spend money on growth, they prefer to avoid risk and hand cash back to shareholders. That means they are likely to have strong records for paying dividends.

Also, if such a company is truly dull and consequently overlooked, it stands to reason a relatively low valuation will be put on its shares. For dividend payers, this is likely to show up as an attractive dividend yield. Very high dividend yields, though, are often a warning signs, as we’ll see in a second.

When it works

There’s good evidence that buying conservative, dividend-paying companies beats the market over the long term. Pim van Vliet and David Blitz, two proponents of dividend investing at Dutch investment firm Robeco, found a strategy targeting low-risk, higher-yielding US large-cap shares produced annual returns of 15.1% from 1929 to 2016 compared with 9.3% from the market. 

An added benefit of the strategy for nervous investors is that it takes the edge off the stock market’s ups and downs. Historically, the strategy has tended to hold up better to big sell-offs. The flip side, though, is that it gets left behind when the market gets hot.

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My stock screen based on this approach, which I tracked for Investors Chronicle between 2011 and 2021, also produced great results. Stock screens work by highlighting shares in companies that display financial characteristics associated with a desired type of investment opportunity.

We’ll find out about what the screen looks for in a minute, but first we need to know what traps investors adopting this approach need to know to avoid.

Dividend traps

Paying dividends is not always the sign of a conservative company.

The weird thing about dividends is that most of us can’t help but have a special affection for them. It is hard not to regard dividends in a money-for-nothing way. However, when we take a step back, it quickly becomes apparent that the reality is very different.

When a company hands cash back to its shareholders, it closes off the opportunity to use it in another way, be that to pay down debt for a money-making investment opportunity, or something else. That is why share prices fall by the amount of any dividend to be paid once it is no longer due.

Dividends are not free money. They are a zero-sum game. The very same result could be got from selling shares of an equivalent value. Dividends are just money that a company cannot find a good enough use for inside its business. A lack of opportunity is hardly something to celebrate.

However, because of the way our brains are wired, we do celebrate dividends: from triumphalist (albeit non-sensical) tweets about the month’s dividend “income”, to the launch of funds labelled “equity income”.

Investors’ odd affection for dividends is a real danger when a company tries to win plaudits by paying out cash when it really should be using money for other things. The “other thing” it is most dangerous for a company to prioritise dividends over, is paying down excessive debt. Very high dividend yields are often associated with such situations but can also simply reflect a business in a state of demise.

These kinds of situations should be avoided, no matter how temptingly high the yield looks.

High-yield, troubled companies will often experience erratic share price movements. This helps explain why pairing low volatility with dividends makes for such a good strategy.

Putting it all together

As we’ve seen, key to this strategy is hunting for shares that have a good dividend record, offer a decent dividend yield and have historically had less-volatile shares. The measure of share price volatility my screen uses is something called beta. This measures how sensitive a company’s share price is relative to moves by the wider market.

There are a few other tests we can throw in to try to home in on companies that are the real deal. The screen tests to check dividend payments are currently, and historically, well supported by earnings.

There is also a test to gauge whether the business is likely to be of decent quality based on its return on equity.

And while there is not a major test for debt, because conservatively run dull businesses can often take on a fair chunk of borrowing without it being a big issue, there is a test to check companies can cover upcoming bills. This is done using something called the current ratio. This ratio compares the amount of money a company has access to within 12 months with the amount it estimates it will need to pay out.

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Based on annual portfolio reshuffles, this screen produced a total return over 10 years of 346% compared with 79% from the FTSE All-Share, which is the index it picked stocks from. Factoring notional fees of 1.5% a year, the return drops to 284%.

Despite the impressive numbers, screens like this should be used as a way of generating ideas for further research rather than to create off-the-shelf portfolios.

The FTSE All-Share stocks currently highlighted by the screen can be found below.

My book Four Ways to Beat the Market, published by Harriman House, provides more detail on how this screen works, how to research the ideas it highlights, and how to adapt criteria to cope with changing market conditions. It also covers three other market-beating strategies.

Here’s what the screen looks for along with the FTSE All-Share stocks it is highlighting right now. I’ve also highlighted the test I feel are core to the screen while the others can be relaxed to try to achieve more results.

• A forecast dividend yield for the next 12 months greater than 3.5%. CORE TEST
• A one-year beta of 0.75 or less. CORE TEST
• Dividend payments covered 1.5 times or more by earnings.
• Ten years of unbroken dividend payments.
• Ten years of positive underlying earnings.
• Underlying earnings per share (EPS) higher than five years ago.
• Dividend per share (DPS) higher than five years ago.
• A return on equity of 12.5 per cent % or more.
• A current ratio (current assets to current liabilities) of one or more.

Only two stocks passed all the screens tests, which were recruitment firm Robert Walters (LSE:RWA) and packaging specialist Macfarlane Group (LSE:MACF). The economically sensitive nature of Robert Walters' business makes it something of a rogue choice for a screen that looks for low volatility. A further four stocks pass the screen's two core tests but fail one of its other non-core tests.

Algy Hall is an award-winning journalist and author of Four Ways to Beat the Market which can be bought by ii readers from all good book shops including Amazon.