A Security Market Plane Approach to Stock Selection

Because dividends are taxed at a higher rate than capital gains, as stock with a higher yields should have a higher expected return than a stock whose return is expected to result mostly from price appreciation. Adding yield to the traditional Security Market Line results in a "market plane" that relates security returns to both systematic risk and yield.A stock on the market plane will offer, in addition to the return justified by its beta, excess return related to its yield. Stocks with a high "yield alpha" may be especially rewarding portfolio candidates for institutions with low tax rates. Furthermore, just as a stock may lie above or below the Security Market Line to the extent it is perceived as "mispriced," so a stock my hover above or below the market plane, offering excess return in addition to the return justified by beta and yield together.Tests indicate that the market plane technique can identify stocks that are likely to outperform the market. However, the approach must be used with care. Too aggressive pursuit of the optimal portfolio may lead to excessive trading costs. On the other hand, the excess returns (even those associated with yield) do not persist for long periods, hence portfolios require fairly frequent updating. Careful trading, combined with some aggressive pursuit of the more likely candidates, should yield the best results