Dividend Income Investing: A Free Cash Flow Perspective

TrimTabs Free Cash Flow Investment Research

Dividend Income Investing: A Free Cash Flow Perspective

A Note From Our Research Desk | July 2019

Free Cash Flow Investing

Vince (Qijun) Chen

Jingtao Chen

vince.chen@ Jingtao.chen@

212-217-2514

212-217-2597

TrimTabs Asset Management

1345 Avenue Of the Americas, Floor 2 New York, NY 10105

Executive Summary

YIELD CURVE

? We believe dividend income investors should consider both the potential future dividend payout as well as the potential total return (dividend plus net appreciation) when evaluating a strategy.

? Stocks with high past dividend yields have generally maintained high payouts, but with drawdowns.

? For the total US market (S&P 1500 companies), high dividend yielding stocks may outperform overall stocks on a market cap weighted basis, but may not on an equally weighted basis. In addition, portfolios with high yielding stocks generally have higher volatility and more severe maximum drawdowns.

? The outperformance of high dividend yield stocks has been relatively stronger for large-cap stocks than for mid-, and small-cap stocks. All high dividend yield portfolios with different company sizes have outperformed on a market cap weighted basis, but mid- and small-cap high dividend yielding stocks have underperformed when they are equally weighted.

? Using a Free Cash Flow evaluation may help improve the total return of high dividend yield strategies and generally lead to reduced volatility and less severe maximum drawdowns.

? Free Cash Flow generation as a selection factor may enhance both total return and the risk-adjusted performance of the high dividend investing strategy, without giving up the ability to generate high future dividend income. More importantly, the Free Cash Flow generation factor has delivered a more consistent dividend yield compared to pure high historical dividend yielding stocks.

? For investors looking for more detail information, we have also performed analysis on using Free Cash Flow Trends, and how a focus on Free Cash Flow may be applied to a sector approach.

Dividend Income Investing:

A Free Cash Flow Perspective

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July 2019

YIELD Dividend income investing offers a chance for investors to geCnUeRraVtEe a stream of cash income. It has been widely applied by equity strategists, especially in the retirement investment space. However, we believe there should be two components to consider when it comes to dividend investing: dividend income generation and capital appreciation potential. In other words, for every dollar invested today, investors using a dividend investing strategy expect cash income in the future, which can be interpreted as the forward dividend yield (future dividends per share divided by the current price). And, over time, if the investment appreciates, the capital gain together with the dividend income, is the total return of the portfolio.

One of the most popular dividend strategies is to select companies with high historical dividend yields. But for dividend investing, we believe investors should also be looking at potential future dividends. So, the question is, do companies paying high dividends in the past continue to maintain high dividend payouts? Additionally, what is the performance of high dividend yield companies compared to non-dividend-paying stocks, as well as to the overall market?

To answer these questions, we conducted an empirical analysis among S&P 1500 companies and analyzed large, mid, and small companies in the S&P 500, S&P MidCap 400 and S&P SmallCap 600, respectively. We constructed model portfolios to determine if high dividend paying companies can maintain their payout in the future and, generally, what the performance is of high dividend yield as a stock selection strategy.

From May 1998 to May 2018, we ranked companies in each universe by trailing-twelve-month dividend yield and grouped dividend paying companies into quintile portfolios based on yield. We also created a basket of companies which have not been paying dividends. We then constructed both equally weighted and market cap weighted portfolios for each of these baskets, rebalanced on a monthly basis.

Future Dividend Yield of High Dividend Yield Stocks. We found that high dividend yield portfolios did provide a higher weighted average dividend yield in the proceeding twelve months, compared to the average S&P 1500 stock. The highest dividend yield quintile group in S&P 1500 delivered a weighted average of 4.90% past dividend yield and 4.03% in the next twelve months, compared to 1.83% past dividend yield and 1.77% next-twelve-month dividend yield for the average S&P 1500 company.

Dividend Income Investing:

A Free Cash Flow Perspective

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July 2019

YIELD Performance of High Dividend Yield Stocks. We then dCuUgRdVeEeper into total returns to answer the second question: does the dividend strategy outperform stocks that pay no dividend and does the dividend strategy outperform the general market? With an equally weighted approach, the highest dividend yielding stocks (Top 20%) in the S&P 1500 did not outperform the S&P 1500 in an equally weighted approach. Looking into different size groups, the highest dividend yielding stocks outperformed the average S&P 500 company, but that was not the case for the mid-cap and small-cap universes. On the other hand, with a market cap weighted portfolio construction approach, the highest yielding stocks outperformed the market cap weighted benchmark in the S&P 1500, as well as large (S&P 500), mid (S&P MidCap 400), small-cap (S&P SmallCap 600) universe, respectively. But compared to non-dividend-paying stocks, high dividend yield stocks or dividend-paying stocks, in general, did not produce a superior return. From a risk perspective, for all universes we modeled with either market cap weighted or equally weighted portfolio construction, high dividend yield stocks displayed higher volatility and maximum drawdown compared to the benchmark, but reduced risk compared to non-dividend-paying stocks.

The perspective of Free Cash Flow. At TrimTabs, we focus on a company's Free Cash Flow conditions to examine its fundamental strength. In this case, we are interested in whether a company's Free Cash Flow condition can help improve dividend investing strategies, not only in generating strong future dividend income, but also improving the capital appreciation potential.

We extended the dividend strategy by looking at a company's Free Cash Flow generation, which is whether a company has generated Free Cash Flow in the trailing twelve months. For each dividend yield quintile portfolio, we differentiate between dividend-paying companies based on Free Cash Flow generation. We found that inclusion of consideration of Free Cash Flow improves high dividend yield stocks' total return performance while delivering less severe drawdown and reduced volatility. Stocks in the highest dividend yield quintile portfolio with positive Free Cash Flow generation, for example, outperformed the S&P 1500 by 1.05% (11.63% - 10.58%) on a market cap weighted basis. And on a risk perspective, looking at Free Cash Flow reduced the volatility, and delivered less severe maximum drawdown of high dividend yield stocks. Similarly, we looked at the performance of the highest dividend yield stocks with Free Cash Flow generation in large-, mid-, and small-cap universes respectively, and we found that the outperformance and risk reduction was also found in each category.

Dividend Income Investing:

A Free Cash Flow Perspective

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July 2019

YIELD Regarding dividend income generation, high dividend yield CstUoRckVsEwith positive Free Cash Flow deliver slightly lower yield both in the past and future, but the "reversing effects" are less severe compared to pure high dividend yield stocks for different universes and weighting schemes. For example, while the weighted average next-twelvemonth dividend yield for the highest dividend yielding stocks with Free Cash Flow generation is 3.97%, or slightly lower than 4.03% produced by pure highest dividend yield quintile companies, the magnitude of reduction from the past dividend yield is lower, which was -15.90% (3.97%/4.72% -1) compared to the overall universe's -17.76% (4.03%/1.90%-1).

Based on our empirical research results, we believe investors should conduct more rigorous analysis when selecting a dividend investing strategy beyond just selecting companies with high dividend yield. Free Cash Flow can be one of the important factors to look at because it may not only help improve the performance without giving up the ability to generate high future dividend income but may also identify more consistent dividend payers compared to pure high dividend yielding stocks.

For readers who want more details on this topic, we have also performed an analysis using Free Cash Flow Trends and demonstrated how this focus could potentially improve dividend income strategies. We have also analyzed how a focus on Free Cash Flow may be applied to a sector approach to dividend income strategies. Please contact us for more information.

Our mission is to provide investors with Free Cash Flow based investment products and services to contribute to their long-term investment success.

Dividend Income Investing:

A Free Cash Flow Perspective

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July 2019

TrimTabsFreeCashFlowInvestmentResearch

DividendIncomeInvesting:AFreeCashFlowPerspective Stockswithahighdividendyieldhavemaintainedrelativelyhighpayouts,butwithadrawdown

Past/ForwardDividendYieldbyDividendYieldQuintilePortfolios

S&P1500Universe,11/30/1998to05/31/2019

Measures

Past Dividend

Yield (Weighted Average)

Overall NoDividendPayment 0.00% LowestDividendYield

0.50%

1.83%

Low Dividend Yield

1.27%

MidDividendYield

1.96%

High Dividend Yield

2.85%

HighestDividendYield

4.90%

Forward Dividend

Yield (Weighted Average)

Overall NoDividendPayment LowestDividendYield

0.09%

0.73%

1.77%

Low Dividend Yield

1.32%

MidDividendYield

1.98%

High Dividend Yield

2.76%

HighestDividendYield

4.03%

0.00% 0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

Dividend Yield

3.50%

4.00%

4.50%

5.00%

Source:TrimTabsAssetManagement,FactSet,S&PGlobal Thepast(forward)dividendyieldisthetrailing-twelve-month(next-twelve-month)dividendspaidbyacompanydividedbyitsmarketcapitalizationatthetimeofcalculation.Thequintile portfoliosareconstructedbysortingthetotaluniversebypastdividendyieldsandassigningstockstofiveportfolioswithanapproximatelyequalnumberofstocksbasedontheranking,ona monthlyrebalancebasis.Pastperformanceisnotanindicationoffutureperformance.

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TrimTabsFreeCashFlowInvestmentResearch

DividendIncomeInvesting:AFreeCashFlowPerspective Comparingthereturnsandrisksofdividendyieldstocksbyquintileportfolioswithoverallandnon-dividend-payingstocks

AnnualizedTotalReturnofDividendYieldStocksbyQuintiles

S&P1500Universe,11/30/1998to05/31/2019

Weighting Cap Weighted

Equally Weighted

Portfolios Overall NoDividendPayment LowestDividendYield Low Dividend Yield MidDividendYield High Dividend Yield HighestDividendYield Overall NoDividendPayment LowestDividendYield Low Dividend Yield MidDividendYield High Dividend Yield HighestDividendYield

AnnualizedTotalReturn 7.06%

3.93%

5.32%

7.75% 7.38%

8.54%

10.40% 10.58%

7.65%

9.01% 8.83%

9.57% 10.14%

12.23%

0% 1%

2%

3%

4%

5%

6%

7%

8%

9% 10% 11% 12% 13%

Portfolio Overall NoDividendPayment LowestDividendYield Low Dividend Yield MidDividendYield High Dividend Yield HighestDividendYield

DetailedPerformanceAnalysis

Weighting Measures

Cap Weighted

Equally Weighted

AnnualizedTotalReturn Annualized Standard Deviation Sharpe Ratio InformationRatio Maximum Drawdown AnnualizedTotalReturn Annualized Standard Deviation Sharpe Ratio InformationRatio Maximum Drawdown

Overall

7.06% 15.03% 46.98%

0.00% 50.25% 10.58% 18.78% 56.36%

0.00% 55.24%

No Dividend Payment 10.40% 22.14% 46.96% 30.03% 63.88% 12.23% 22.62% 54.08% 25.29% 53.31%

LowestDividend Yield

Low Dividend Yield

MidDividendYield

3.93%

5.32%

7.75%

18.07%

15.28%

14.50%

21.73%

34.80%

53.49%

-50.88%

-28.62%

9.57%

64.16%

46.92%

43.40%

7.65%

9.01%

8.83%

18.11%

17.20%

16.93%

42.26%

52.37%

52.17%

-57.05%

-31.46%

-29.64%

52.99%

53.19%

53.71%

HighDividend HighestDividend

Yield

Yield

7.38%

8.54%

14.20%

17.49%

51.96%

48.85%

3.89%

12.32%

49.31%

67.46%

9.57%

10.14%

16.70%

19.91%

57.27%

50.93%

-14.40%

-4.51%

55.66%

65.52%

Source:TrimTabsAssetManagement,FactSet,S&PGlobal Thepast(forward)dividendyieldisthetrailing-twelve-month(next-twelve-month)dividendspaidbyacompanydividedbyitsmarketcapitalizationatthetimeofcalculation.Thequintile portfoliosareconstructedbysortingthetotaluniversebypastdividendyieldsandassigningstockstofiveportfolioswithanapproximatelyequalnumberofstocksbasedontheranking,ona monthlyrebalancebasis.Pastperformanceisnotanindicationoffutureperformance.

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TrimTabsFreeCashFlowInvestmentResearch

DividendIncomeInvesting:AFreeCashFlowPerspective Theoutperformanceofhighdividendyieldstockshasbeenstrongeronlarge-capstocks,andwithamarketcapweightedapproach

PerformanceofHighest/LowestDividendYieldQuintilePortfoliosbyDifferentCompanySizeGroups

S&P500,S&PMidCap400,andS&PSmallCap600Universes,11/30/1998to05/31/2019

CapWeighted

S&P 500

10%

6.85%

10.69%

8.75%

9.77%

EquallyWeighted 11.35%

6.72%

10.94%

5% 3.23%

0% 15% 10%

5%

8.78%

9.62%

7.04%

S&PMidCap400

9.57%

10.76%

12.83%

7.81%

9.80%

AnnualizedTotalReturn

0%

10% 5%

7.34%

8.63%

4.32%

S&PSmallCap600

7.88%

10.89%

12.12%

7.70%

7.75%

0%

Overall

NoDividendPayment LowestDividend Yield

HighestDividend Yield

Overall

NoDividendPayment LowestDividend Yield

HighestDividend Yield

Source:TrimTabsAssetManagement,FactSet,S&PGlobal Thepast(forward)dividendyieldisthetrailing-twelve-month(next-twelve-month)dividendspaidbyacompanydividedbyitsmarketcapitalizationatthetimeofcalculation.Thequintile portfoliosareconstructedbysortingthetotaluniversebypastdividendyieldsandassigningstockstofiveportfolioswithanapproximatelyequalnumberofstocksbasedontheranking,ona monthlyrebalancebasis.Pastperformanceisnotanindicationoffutureperformance.

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