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    Dividends Count: Screening for Undervalued Stocks With Lower Risk

    by John Bajkowski

    Dividends Count: Screening For Undervalued Stocks With Lower Risk Splash image

    The tumultuous market has many investors reconsidering the desired risk level of their portfolio and their overall investment approach. More conservative and traditional approaches to stock selection that fell out of favor in the bull market of the 1990s are back in fashion. Once again, dividends matter. Dividends contribute to returns in any market situation, while the income appeal of dividend-paying stocks helps to limit steep losses if the market declines. A dividend-yield strategy can help you find potentially undervalued stocks with reduced downside risk, provided the dividend is secure. Because mostly mature firms pay significant dividends, dividend analysis is geared toward established firms that are past their explosive growth and cash-consuming stage.

    A stock’s dividend yield is computed by taking the indicated dividend—the expected dividend over the next year—and dividing it by the share price. For most stocks, the indicated dividend is the most recent quarterly dividend multiplied by four, although some firms have switched to a single annual dividend payment. If a stock is paying an indicated dividend of $1 per share and is trading with a price of $40, its dividend yield is 2.5% ($1 ÷ $40 = 0.025, or 2.5%). If a stock’s price rises faster than its dividend, the dividend yield will fall, indicating that the price may have been bid up too far and may be ready for a decline. Conversely, if the dividend yield rises to a high level, the stock may be poised for an increase in price, if the dividend can be sustained.

    The Dividend-Yield Strategy

    Like all basic value-oriented techniques, the dividend-yield strategy attempts to identify investments that are out-of-favor. Contrarian techniques such as this are based on the premise that markets tend to overreact to good and bad news and push the price of a security away from its intrinsic value. Value investors hope to identify these mispriced securities through the use of a consistent set of rules called a valuation model.

    Screening is the first stage in this process and it involves scanning a group of securities to find those that merit further in-depth analysis. Absolute or relative levels may be used in screening for high-yield stocks. A screen requiring an absolute level might look, for example, for a minimum dividend yield of 3% before an investment is considered. Absolute screens can lead to passive market timing—cash levels tend to build up when investors cannot find suitable investments that meet the minimum requirement during times of market extremes. Also, screens that only look at absolute levels can be weak because they may turn up securities from a single industry that traditionally has higher dividend yields, such as utilities and REITs.

    Screens based on relative levels compare the yield against a benchmark that may fluctuate, such as the current dividend yield for the S&P 500. In this case, the investor does not require that the yield meet some minimum level, but instead that it maintain its historical relationship with the benchmark figure. Common screens examining relative yields include comparisons against some overall market level, industry level, historical average or even some interest rate benchmark. The screens for this article were performed using a historical average as the benchmark.

    Applying the Screen

    AAII’s Stock Investor Pro program was used to perform the screening for this article.

    The first filter required that a stock trade on the New York Stock Exchange, American Stock Exchange or Nasdaq National or SmallCap market. This filter helps to establish minimum levels of liquidity. Stock Investor Pro currently tracks 8,712 companies and this filter reduced the universe of companies to 6,467 stocks.

    Next, the filter excluded closed-end mutual funds which have unique financial characteristics requiring that they be analyzed separately. This filter reduced the number of passing companies to 6,333.

    The screen then required that a company have seven years of both price and dividend records. When screening against a historical average, remember to include a time period that covers both the up and down periods of a market and economic cycle.

    Selecting a time period is a balance between using one that is too short and only captures a segment of the market cycle and one that is too long and includes a time period that is no longer representative of the current company, industry, or market. Periods of between five and 10 years are most common for these types of comparisons.

    The price history requirement reduced the number of passing companies from 6,333 to 3,515. The screen then looked for companies that have paid a dividend for each of the last seven years and have never reduced their dividend. This filter reduced the number of passing companies to 885.

    Dividend levels are set by the board of directors based on consideration of the current company, industry, and economic conditions. Because dividend cuts are tantamount to an announcement that the firm is financially distressed, dividends are set at levels that the company should be able to afford throughout the economic cycle.

    A lack of dividend growth or a decline in the dividend growth rate can also be troubling, especially after a period of regular annual dividend increases. Nearly 10% of the 885 companies paying a dividend over the last seven years had not increased their dividend payout over that time period. Investors such as Benjamin Graham required that stock dividends at least keep pace with inflation. Our screen was even more aggressive and demanded an annual increase in the per share dividend payout for each of the last six fiscal years, which reduced the number of passing companies from 885 to 425.

    The next filter required that the company’s current dividend yield be higher than its seven-year average dividend yield. This filter seeks out companies whose dividends have increased faster than increases in share price, or whose current share price has declined recently. This filter reduced the number of passing companies to 235.

    Payout Ratio

    While it might seem that the screening process should be over with this last filter, before a company can be considered for purchase the security of the dividend must be examined. A high dividend yield may be a signal that the market expects the dividend to be cut shortly and has pushed down the price accordingly. A high relative dividend yield is a buy signal only if the dividend level is expected to be sustained and increased over time.

    Measures exist that help to identify the safety of the dividend. The payout ratio is perhaps the most common of these and is calculated by dividing the dividend per share by earnings per share. Generally the lower the number, the more secure the dividend. Any ratio above 50% is considered a warning flag. However, for some industries, such as utilities, ratios around 80% are common. The current payout ratio for the Dow Jones utility group is 52%, versus 40% for the Dow Jones industrial group. A 100% payout ratio indicates that a company is paying out all of its earnings in the form of dividends. A negative payout ratio indicates that a firm is paying a dividend even though earnings are negative. Firms cannot afford to pay out more than they earn in the long term. The screen required a payout ratio of between 0% and 85% for utilities and between 0% and 50% for firms in other sectors. This filter eliminated about half of the companies, leaving 116 stocks. Dividends are paid in cash, so it is also important to examine the liquidity of a company.

    Financial Strength

    Financial strength helps to indicate liquidity and to provide a measure of safety for the dividend payout. One must consider both the short-term obligations of the company along with long-term liabilities when testing for financial strength. Common measures of the longer-term obligations of the company include the debt-to-equity ratio (which compares the level of long-term debt to owner’s equity), debt as a percent of capital structure (long-term debt divided by capital, which includes long-term sources of financing such as bonds, capitalized leases, and equity), and total liabilities to total assets. The screen used the ratio of total liabilities to assets because it considers both short-term and long-term liabilities. Acceptable levels of debt vary from industry to industry, so the screen looked for companies with total liabilities to assets below the norm for their industry. The financials and utilities passing have much higher values than the stocks in the consumer sectors. This filter cut the number of passing companies down to 68.

    Earnings Growth

    It is also important to examine the historical record of earnings. Dividend growth cannot deviate for very long from the level of earnings growth, so the pattern of earnings growth will help to confirm the stability and strength of the dividend. Ideally, earnings should move up consistently. The final screen required growth in earnings over the last three years greater than the norm for the industry, reducing the number of passing companies to the 35 displayed in Table 1.

    The stocks in Table 1 are ranked by their current dividend yield. The yield ranges from 0.6% for Home Depot, to 8.8% for Florida-based utility holding company TECO Energy.

    TECO Energy’s current yield of 8.8% is well above its seven-year average 4.8%, and the current median of 4.9% for the electric utility industry. TECO Energy shares suffered recently when an analyst at Credit Suisse First Boston downgraded the company’s stock rating to sell from buy, calling the shares overvalued and saying the company may need to issue more equity. TECO Energy has just completed a public offering of 15.525 million new common shares at a price of $23.00 per share. Credit Suisse First Boston and UBS Warburg were the joint lead managers. TECO Energy also successfully completed its $550-million offering of five- and 10-year notes.

    Historically, TECO’s dividends have grown at a 4.6% annual rate. Dividends have increased four cents per year since 1999, a decline from the six-cent-per-year increase observed in prior years.

    The historical earnings per share growth rate is 8.0%, but going forward the consensus earnings per share growth rate is 6.4%. Over the last month, three analysts have decreased their earnings growth estimate, while one analyst has increased the estimate.

    The payout ratio for TECO is 61%, below the industry median of 64%. Its ratio of total liabilities to total assets is 69.7%. It is common for capital-intensive industries with reasonably steady cash flows to carry higher levels of debt. The median ratio for the electric utility is 75.0%.

    The 52-week relative strength figure measures the relative stock price performance versus the S&P 500. Figures above 0% indicate that a stock has outperformed the market, while negative figures indicate underperformance. TECO Energy and Linear Technology share the honors of having the weakest relative performance—underperforming the S&P 500 by 30% over the last 52-weeks. Albemarle Corporation, a producer of high-performance chemicals and polymers, outperformed the S&P 500 by 83% over the same time period. The majority of the companies that passed the screens have outperformed the market over the last year.

    Conclusion

    Screening for relative high dividend yield is based upon the time-honored rule of buying low and selling high. Examining a stock’s dividend yield provides a useful framework to identify potential candidates.

    To succeed at this strategy, you need to develop a set of tools to not only identify which stocks have relatively high dividend yields, but also which of those stocks have the strength to bounce back.

    As is true for any screen, the list of passing companies represents only a starting point for further in-depth analysis.

       Definitions of Screens and Terms
    Dividend Yield—Co: Indicated dividend divided by current price. Provides a relative valuation measure when compared against historical average dividend yield or industry average.

    Dividend Yield—Ind: Median (mid-point) dividend yield for the primary industry in which the company operates. Provides a benchmark comparison to gauge the valuation levels of other firms in the same industry.

    7-Yr Avg Ann’l Yield: The average company dividend yield during the last seven years. Provides a benchmark against which to judge the current yield.

    7-Yr Ann’l Growth—Div: Annual growth rate in dividends per share over the last seven years. An indication of the past company strength and dividend payment policy.

    7-Yr Ann’l Growth—EPS: Annual growth rate in earnings per share over the last seven years. A measure of how successful the firm has been in generating the bottom line, net profit.

    Payout Ratio (Co): Dividends per share for the last 12 months divided by earnings per share for the last 12 months. Provides an indication of the safety of the dividend. Lower figures are considered safer. Figures ranging between 50% (85% for utilities) and 100% are considered early-warning flags. Negative values and values above 100% are considered red flags for a dividend cut if the levels persist. Beyond examining a single year, look for trends.

    Total Liab to Assets: Total liabilities divided by total assets as reported at the end of the most recent fiscal quarter. Provides an indication of the financial leverage of the stock. The higher the ratio, the greater the financial leverage and the higher the risk.

    52-Week Relative Strength: The price performance of a stock during the last year relative to the performance of the S&P 500. A figure of 0% indicates the stock had the same percentage price performance as the market over the last 52 weeks. A figure of 5% indicates that the stock outperformed the market by 5% over the last 52 weeks.


    John Bajkowski is AAII’s financial analysis vice president and editor of Computerized Investing.


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