High-dividend-yield stocks are appealing because of their low volatility, income, and low price-to-book ratios, but dividend-paying stocks may be cheap for a good reason. Thus, investors need to be cautious to avoid a value trap. By choosing stocks with both high profitability and high dividend yield, investors can mitigate the uncertainty of whether dividends can be sustained.

The authors construct a profitable dividend yield (PDY) strategy and provide a risk-adjusted return analysis, concluding that the strategy’s high return and high Sharpe ratio make it a good long-term investment.

Wealth managers endeavor to construct portfolios with techniques that dampen volatility and provide for higher returns. The authors demonstrate that a PDY strategy can achieve both higher performance and lower volatility. Over the sample period, a dollar invested in the PDY strategy produces a high average excess return of 1.04% per month. Although there is a margin of underperformance in good times, over five-year holding periods, this strategy outperforms the market.

The authors use 40 years of US stock data and exclude REITs, financials, American depositary receipts, and closed-end funds. They remove the most illiquid stocks and stocks priced under $5 per share. For each year, the authors sort stock data into quintiles based on their profitability or gross profit-to-assets ratio (G) and dividend yield (D). The quintiles are value weighted.

The authors focus on the portfolio consisting of the stocks in the fifth quintile with the highest profitability (G5) and highest dividend yield (D5). The performance of this combined portfolio (G5D5) is outstanding. Compared separately with D5 and G5 portfolios, G5D5 has twice the alpha.

The authors believe that the beta anomaly plays a role in explaining G5D5’s returns. However, the quality minus junk (QMJ) factor can capture overall speculative propensities. When the authors add QMJ to the traditional three-factor model, alpha is completely explained. The authors suggest that investors’ preference for highly volatile “lottery-type” stocks and tendency to underpay for “boring” stocks imply that behavioral biases will continue and that this apparent anomaly will not be arbitraged away.

Although it may be going too far to declare that the recent success of this investing strategy is a newly discovered anomaly, the lower volatility of the G5D5 portfolio is noteworthy with monthly negative returns only 21% of the time. This type of investment appears to be ideal for retirees who can take a small amount of risk. It would be interesting to look closer at the portfolio characteristics to know how many stocks were in the portfolio and whether it was skewed to any particular industries or exposed to regulatory or political risk. The authors’ conclusions warrant future research.