Dynamic Income & Dividends A Simple Strategy for Excess Returns DIAD Philip A. Venanzi Duquesne MBA Class of 2015

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 DIAD

“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 DIAD

Dynamic Income and Dividend (DIAD) model  The philosophy is centered around two main themes: 1) Income Generation 2) Consistency  Follow a simple strategy to achieve consistent excess returns over the long-term (20+ years)  Focus on stocks generating consistent: 1) Net positive income 2) Dividend payouts DIAD

 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 performance 2. Value vs. Growth performance 3. Momentum  Also looks to find stable sources of returns through income  Focus on stocks generating consistent: 1) Excess net positive income 2) Dividend payouts DIAD

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 DIAD

Base SetSizeFormulaMinMaxPassed $C+$R29866 $129866mkval $25159roi $3750dvydc[-1]3 127 $4127prccm1 127

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. DIAD

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 DIAD

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 to 5-9 is substantial.  The graph on the next page illustrates this point. DIAD

 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: $121,023,200 DIAD

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 RatioBetaR-Squared N Positive Periods N Negative Periods DIAD S&P Russell 3000 TR USD DIAD

 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 and ), 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. DIAD

 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? DIAD