DRP Stock Characteristics and How to Implement a High-Yield Screen
by Wayne A. Thorp
Every June, the AAII Journal publishes a listing of companies offering dividend reinvestment plans (DRPs). For individual investors, DRPs provide a low-cost approach to purchasing shares of the firms offering these plans.
This article discusses the investment characteristics of companies that offer DRPs. One feature that is common to almost all firms offering DRPs is that they pay dividends; this article, therefore, also shows how to implement a basic screen for firms with high dividend yields.
A Sector Breakdown
This years DRP survey covers 743 firms, 736 of which are currently tracked by and included in AAIIs fundamental database and stock screening program Stock Investor Pro.
Table 1 presents a sector breakdown of the firms that offer DRPs, as well as those firms that do not.
|TABLE 1. A SECTOR BREAKDOWN: DRPs vs. Non-DRPs|
|No. of Firms||Percent of Total||No. of Firms||Percent of Total|
|Source: AAII's Stock Investor Pro.
Data as of April 19, 2002
Dividend reinvestment plans have traditionally been offered to the shareholders of utilities and financial institutions, because these firms have a steady need for equity capital, they pay an above-average dividend yield, and they benefit from the goodwill of turning their customers into owners. It is not surprising, therefore, to see that financials and utilities make up 23.6% and 12.8%, respectively, of the universe of companies offering DRPs.
In contrast, financials make up 15.3% and utilities a scant 0.8% of the non-DRP universe. Other sectors in which DRP stocks tend to concentrate include conglomerates, consumer cyclicals, and consumer non-cyclicals.
In the non-DRP universe, the healthcare and technology sectors have proportions significantly higher than the DRP universe. These are higher-growth sectors that contain smaller firms that pay little no or dividends. Individuals who limit their investments to companies with dividend reinvestment plans would tend to exclude these sectors from their portfolio, or they would at least be limited to those companies within these sectors that tend to be larger, more mature, and pay dividends. For example, only 44 of the 2,128 companies in the technology sector, or 2.1%, offer DRPs.
Table 2 compares the investment characteristics of the DRP universe to the universe of non-DRP firms. Medians—the midpoint of the complete range of numbers—are used instead of averages to reduce the impact of outliers.
The companies offering DRPs are significantly larger and, due to their dividend policies, can be assumed to be more mature firms than those without dividend reinvestment plans.
Companies do not typically start paying cash dividends until they are past their rapid growth stage, when they are generating excess cash from operations and cannot find profitable capital projects for the firm.
|TABLE 2. INVESTMENT CHARACTERISTICS: DRPs vs. NON-DRPs*|
|Market Capitalization ($ mil)||1827.2||60.8|
|Sales—Latest 12 Months ($ mil)||1755.9||78.9|
|Growth (Five-Year Annual)|
|Earnings per Share (%)||3.2||0.0|
|Estimated Earnings per Share (%)||11.0||18.6|
|Dividend Yield (%)||2.1||0.0|
|Price-Earnings to Growth (PEG Ratio) (X)||1.7||1.1|
|Price-Earnings to Growth—Dividend Adjusted (X)||1.5||1.1|
|Gross Margin (%)||31.5||36.8|
|Net Profit Margin (%)||5.3||0.0|
|Return on Equity (%)||10.6||2.3|
|Long-Term Debt to Total Capital (%)||40.3||8.1|
|Total Liability to Total Assets (%)||70.6||57.4|
|Institutional Ownership (%)||56.5||13.8|
|Number of Institutional Owners||369||29|
|Insider Ownership (%)||10.9||35.0|
|Shares Outstanding (mil)||65.9||17.2|
|Price as a % of 52-Week High (%)||94.0||68.0|
|52-Week Relative Strength (%)||29.0||9.0|
|One-Year Price Change (%)||15.4||0.0|
|*All values are medians—the midpoints of the range|
This factor clearly shows up in the historical sales growth rate, as well as in the estimated growth rate in earnings. However, the historical earnings growth rate for the DRP stocks is higher than that of the non-DRP stocks. This can be attributed to several factors, including a significantly higher number of negative five-year earnings growth rates that contributed a negative bias to the non-DRP median, as well as the differing industry compositions within each group. As you would expect, though, those firms that offer DRPs have a higher growth rate in dividends.
During bear markets, dividend-paying value stocks tend to outperform growth-oriented issues. This is echoed to some extent by the price-earnings ratios of the DRP and non-DRP universes. The median price-earnings ratio of 19.6 for the larger-cap DRP stocks exceeds the non-DRP multiple of 18.9. Again, however, industry concentrations within the two groups may have also played a role.
The median dividend yield for the roster of DRP stocks is greater than that of the non-DRP group—2.1% versus 0.0%. In fact, only 18% of the firms in the non-DRP universe pay any dividend at all.
The ratio of price-earnings to earnings growth (PEG ratio) is often used to measure the balance between value and growth. A firm with a low price-earnings ratio may not be a bargain if the company has poor earnings growth prospects. Firms with higher growth prospects are attractive, as long as you do not have to pay too much for the earnings. Companies with a PEG ratio near 1.0 are considered fairly valued; a ratio of 0.5 or lower is considered undervalued; a ratio above 1.5 is considered overvalued.
The stocks of the non-DRP group have a lower median PEG ratio, yet they appear to be fairly valued at 1.1, while the DRPs have a median PEG ratio of 1.7. The higher price-earnings ratio of stocks that offer DRPs coupled with a lower expected earnings growth rate accounts for the higher PEG ratio for these stocks.
Many investors adjust the PEG ratio to acknowledge the contribution dividends make to overall return. This adjusted ratio is calculated by dividing the price-earnings ratio by the sum of the earnings growth rate and the dividend yield. For the DRP universe, this brings the median PEG ratio down to 1.5.
Management & Ownership
DRP companies currently have better bottom-line profitability ratios than those of non-DRP firms, but profit ratios are very industry-specific. Given the differences in industry weightings for the two groups, the ratio differential may or may not be significant.
When it comes to measures of financial structure, some observations can be made. Large, established firms with proven track records have greater access to the debt markets than smaller firms. The difference in the ratio of long-term debt to total capital is a prime example of this. Smaller firms must rely more on equity financing, short-term bank loans, and growth in supplier-provided accounts payable as sources of external funding. The ratio of total liabilities to total assets considers the complete debt structure of the firm.
DRP companies have attracted much more institutional coverage than the non-DRP universe. Over half of the shares for this group are held by institutions, whereas only 13.8% of non-DRP stock is held by institutions. The median number of institutions with a position in a DRP company is 369, while the median number is only 29 for a non-DRP firm.
Managers and founders are more likely to own a higher percentage of the outstanding stock of smaller firms. Therefore, it is not surprising that the insider ownership statistics are much higher for the smaller, non-DRP companies than for the larger DRP firms.
Lower prices are typically associated with smaller-cap stocks, and the price statistics of the group of non-DRPs reflect this—the median price of the non-DRP universe is significantly lower, $5.39 versus $29.17, for the DRP firms.
Both groups have outperformed the S&P 500, as measured by 52-week relative strength. However, the DRP group is outperforming the S&P 500 by 29.0%. On a relative basis, the larger-capitalization DRP companies have been the stronger performers, although the smaller-cap non-DRP firms have also outperformed the S&P 500, in this case by 9.0% over the last year.
A High-Yield Screen
An investor looking for an aggressive, high-growth portfolio must look beyond the DRP universe. However, as recent market activity has shown, it is useful to have a well-diversified portfolio, and in such a case DRPs can provide beneficial diversification. By applying a screen searching for out-of-favor, high-relative-yield stocks, you may uncover some companies that warrant further research and analysis.
For comparison purposes, the same screening criteria were applied separately to the DRP and non-DRP universes. The screen searches for companies with high relative dividend yields and above-average earnings growth.
Traditionally, financials and utilities have paid higher dividend yields and required a separate relative dividend yield screen. Since these companies tend to have the highest dividend yields, they are prime candidates for investors looking to create a high-dividend-yield portfolio.
The first screen looked for companies that have paid a dividend for each of the last six years and have not cut their dividend over the same period. Companies that are forced to cut their dividends, no matter what the reason, are typically greeted with negative reaction from the market. This screen reduced the number of DRP firms from 736 to 453 and the universe of non-DRP stocks from 8,140 to 736.
It is important for a company to demonstrate the ability to increase dividend payments over time. Therefore, the next screen looked for companies with a five-year annualized dividend growth rate greater than the median growth rate for the companys industry over the same period. This screen dropped the totals to 346 DRP stocks and 533 non-DRP stocks.
The next filter required that the current yield of a company be higher than its five-year average. This isolates companies whose dividends have increased faster than increases in share price, or whose current share price has recently fallen, in an attempt to identify stocks that are out-of-favor—hopefully due to a short-term market overreaction to bad news. This criterion cut the list of DRP stocks to 117, while the non-DRP universe was winnowed down to 185.
The safety of the dividend is also important. A high dividend yield may be a signal that the market expects the dividend to be cut shortly and has pushed down the stock price accordingly. A high relative dividend yield is attractive only if the dividend level is expected to be sustained or even increased.
The payout ratio is the most common measure of dividend safety. It is computed by dividing the dividends per share by the earnings per share. Typically, the lower the ratio, the more secure the dividend. Any ratio above 50% is generally considered a warning flag, but some stable industries, such as utilities, have higher payout ratios. Here, the screen looked for firms with payout ratios below 50%, which left 60 DRP stocks and 98 non-DRP firms.
The final screen required a minimum level of earnings growth. This criterion looked for firms with earnings growth rates in the upper half of their respective industries, which recognizes the growth differences between industries and tends to lead to more meaningful screening results.
Forty-five stocks with DRPs passed all of these filters and 55 stocks without DRPs passed the complete screen. The 10 stocks from each group with the highest dividend yields are presented in the Passing Companies Table.
Two data points included in Table 3, but not used as a screen are worth mentioning: the 52-week relative strength figure and the one-year price change.
Relative strength reflects the price performance of a stock over the last year relative to the performance of the S&P 500 index. The base figure, which represents performance equal to that of the index, is 0%. Numbers greater than 0% reflect performance that was above that of the S&P 500 for the period, while negative numbers reflect underperformance. For example, in the DRP group at the top of Table 3, the telecommunications company SBC Communications, Inc., has a 52-week relative strength of 10%. This indicates that SBC has underperformed the S&P 500 by 10% over the last 52 weeks. Based on the data in the Passing Companies Table, only a few companies in the passing DRP universe have actually underperformed the S&P 500 index. However, two of the three DRP firms that did underperform did so rather significantly. On the other hand, Commercial Bancshares was the best performer of the 20 stocks listed in the Passing Companies Table with a 52-week relative strength value of 69, meaning that is has outperformed the S&P 500 by 69% over the last year.
It is also important to consider the performance of a company relative to its peer group. This can be done using the median values provided in the Passing Companies Table for the complete 736-stock DRP segment as well as the 8,140 stocks that make up the non-DRP universe.
Relative strength numbers for each industry can be found on the Internet at popular investment-related Web sites such as Multex.com (www.multex investor.com). Industry data can also be found within databases included with fundamental stock screening packages, like the one included in AAIIs Stock Investor Pro software.
Roughly a third of each group—four DRPs and three non-DRPs have seen their stock price fall over the last year, as illustrated by the one-year price changes. One-year price change is simply the percentage change in a companys stock price over the last 52 weeks. Because of falling stock prices, for the most part, these stocks are near the top of each list as far as dividend yield goes, with Hawkins, Inc., being the sole exception. Keep in mind, however, that price drops tend to be due to the cyclical nature of the industries.
The list of DRP stocks passing the high-yield screen is not a diversified portfolio, nor does it serve as a recommended stock list. There is a heavy concentration of cyclical firms, which carry more risk late in the economic cycle.
Furthermore, as with all contrarian screens, your analysis should focus on whether or not the market is too pessimistic in its assessment of the future of these stocks.
This initial screen for high-yielding DRP and non-DRP firms is meant only to be starting point in the analysis process. Throughout the year, the AAII Journal and AAII.com present articles that illustrate how individual investors can analyze the prospects of specific stocks by applying a variety of secondary screens and demonstrating how these techniques may be useful.
Before making any investment decision, you should gather all pertinent information and understand the investment thoroughly. Also, keep in mind that no one investment technique will be best in all market environments.
Firms with dividend reinvestment plans offer investors advantages, but remember to buy them because you are optimistic about performance, not simply because the company offers a DRP plan.
The following is a short description of the screens and terms used in Table 3.
Dividend Yield—Current: Indicated dividend divided by current price. Provides a relative valuation measure when compared against historical average dividend yield.
Dividend Yield—Five-Year Average: Average company dividend yield during the last five years.
Growth Rate—Dividends per Share: Annual growth rate in dividends per share over the last five years. An indication of the past company strength and dividend payment policy.
Growth Rate—EPS: Annual growth rate in earnings per share over the last five years. A measure of how successful the firm has been in generating the bottom line, net profit.
Growth Rate—Estimated EPS: Consensus estimate of the long-term (five years) growth rate in earnings as tracked by I/B/E/S.
Payout Ratio: 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. Figures between 0% and 50% are considered safer. Figures ranging between 50% 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.
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.
Price Change (1 Yr.): The percentage change in stock price over the last 52 weeks.
Wayne A. Thorp is associate financial analyst of AAII.