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Using DRPs: An Approach Focused on Value With Downside Protection

by Wayne A. Thorp, CFA

Using DRPs: An Approach Focused On Value With Downside Protection Splash image

In this period of market instability, many investors are looking for shelter from the tempest.

One way to stabilize your portfolio returns is with dividends. Why? Remember that total return consists of price appreciation and dividend income, and while prices go up and down, dividend income tends to be steadier.

A conservative, low-cost approach to investing in dividend-paying stocks is with dividend reinvestment plans (DRPs or DRIPs); particularly those that sell initial shares directly to the public (direct purchase plans or DPPs/DIPPs). Direct purchase plans allow you to bypass a broker, and often the commissions they charge. With these plans, dividend payments immediately go to work for you with little or no transaction costs. [Our annual guide to direct purchase plans begins on page 13 of this issue.]

While DRP investing offers distinct benefits, these plans do offer unique challenges as well. By investing exclusively in companies with DRPs, you may end up with a portfolio overweighted in certain market segments, such as banks and insurance companies. Focusing your investments on a limited number of sectors or industries can lead to a non-diversified portfolio with a rate of return that does not compensate you for your higher risk.

When used as part of a fully diversified investment portfolio, however, stocks with dividend reinvestment plans provide balance to more aggressive, high-growth holdings.

High-Yield Screens

AAII tracks two high-yield screens that seek companies from both the DRP and non-DRP universes with traits that include:

  • An established history of stable or rising dividends;
  • High dividend yields relative to their historical norms; and
  • Earnings and dividend growth that outpaces industry norms.

Stock Investor Pro, AAII’s fundamental stock screening and research database, includes the high-yield screen for stocks offering DRPs. The program currently tracks over 1,200 companies offering DRPs and DPPs, with plan data provided by DRIP Wizard (www.dripwizard.com).

Screen Performance

Each month, AAII.com lists the 30 companies with the highest dividend yields in the DRP and non-DRP universes and tracks the performance of these stocks held in hypothetical portfolios.

Both high-yield screens have outperformed the S&P 500 index on a cumulative basis since the beginning of 1998. The high-yield DRP screen has generated a cumulative return of 154.2% over the period from January 1998 through April 2008, while the high-yield non-DRP screen returned 347.5% over the same period. Keep in mind that this performance does not include dividend payments or dividend reinvestment.

Sector Breakdown

Table 1 presents a sector breakdown of the 1,207 firms with dividend reinvestment plans currently tracked by Stock Investor Pro compared to the firms without DRP plans.

Historically, financial institutions and utilities offered dividend reinvestment plans to their shareholders because of their need for a steady source of equity capital. Therefore, it is not surprising that the financial sector makes up 32% of the DRP universe while utilities account for 8.1%. The technology sector even accounts for 7.6% of the DRP universe, the fourth-highest concentration. This may signal the “maturing” of many high-tech firms.

However, the technology sector still makes up the largest percentage of the non-DRP universe, at 22.1%, whereas financial firms and utilities account for 17.9% and 1%, respectively. Technology and healthcare firms have significantly higher proportions within the non-DRP universe as compared with the DRP universe. These higher-growth sectors tend to have smaller firms that pay little or no dividends. Individuals who limit their investments to companies with dividend reinvestment plans would exclude these sectors from their portfolio, or they would be limiting themselves to dividend-paying companies within these sectors that tend to be larger and more mature.

Profiles of Passing Companies

Table 2 presents the characteristics of the companies passing the high-yield screen from both the DRP and non-DRP universes, as well as for all of the companies in both the DRP and non-DRP universes.

One method of identifying “value” stocks is to look for those with high dividend yields. In the case of this high-yield screen, a company’s current yield must exceed its average yield over the last five years. When comparing the stocks passing the high-yield screen from the DRP and non-DRP universes to the typical exchange-listed stock, we find valuations for the high-yield stocks that point to a definite value slant. Only for the price-earnings-to-EPS-growth, or PEG ratio, do we find the high-yield firms on the same footing with exchange-listed stocks—all three groups have a PEG ratio of 0.9.

An additional requirement of the high-yield screen calls for companies to have an average annual earnings per share growth rate for the last five years that is at least as high as their industry’s median growth rate. Interestingly, the passing companies from both the DRP and non-DRP universes have median five-year earnings growth rates—12.3% and 10.2%, respectively—that are lower than that of all exchange-listed stocks (14.9%).

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Despite the long-term success of the high-yield screen relative to the S&P 500, the relative performance for the current passing companies over the last year has been noticeably weaker. Looking at the relative price strength versus the S&P 500 over the last 52 weeks, the high-yield stocks from both the DRP and non-DRP universes have underperformed the index by 19% and 22%, respectively. Contributing to their underperformance, most likely, is the high concentration of financial companies among the high-yield stocks. Financial sector stocks currently make up two-thirds of the high-yield DRP companies and over three-quarters of the non-DRP high-yield companies.

In contrast, the typical exchange-listed stock has “only” underperformed the S&P 500 by 11% over the last year.

Sector DRPs Non-DRPs
No. of
Firms
Percent
of Total
No. of
Firms
Percent
of Total
Basic Materials 91 7.5 492 6.3
Capital Goods 56 4.6 373 4.8
Conglomerates 14 1.2 16 0.2
Consumer Cyclical 53 4.4 337 4.3
Consumer Non-Cyclical 64 5.3 228 2.9
Energy 39 3.2 437 5.6
Financial 386 32 1,389 17.9
Healthcare 39 3.2 985 12.7
Services 252 20.9 1,562 20.1
Technology 92 7.6 1,717 22.1
Transporation 23 1.9 154 2.0
Utilities 98 8.1 78 1.0

Passing Companies

Table 3 lists the top 10 stocks that passed the high-yield screen as of May 9, 2008, from both the DRP and non-DRP universes, ranked in descending order by current dividend yield.

Historically, we limit the number of passing companies to the 30 highest dividend yielders from each universe.

Conclusion

While firms with dividend reinvestment plans offer investors attractive benefits, such as low transaction costs, it is important that you focus on the merits of the investment itself, and then take advantage of the dividend reinvestment plan. You need to consider companies with DRPs within the context of your entire investment portfolio. Do not invest in a company strictly based on whether it offers a dividend reinvestment plan.

Remember, too, stock screens such as this high-yield approach only represent a starting point in the investing process. They allow you to isolate companies with similar quantifiable characteristics. However, it is important to perform additional due diligence on any company that passes a stock screen such as this. The end goal is to find stocks that match your investing tolerances and constraints.

What It Takes: High-Yield Screen Criteria

The following criteria are applied separately to those groups of companies offering dividend reinvestment plans and to those that do not offer dividend reinvestment plans:

  • The dividend for the last four quarters is greater than or equal to the dividend for the last fiscal year;
  • The annual dividend has increased over each of the last five years;
  • The company has been paying a dividend for at least six years;
  • The annualized growth rate in dividends over the last five years is greater than the median annualized growth rate in dividends for the industry over the same time period;
  • The current dividend yield is greater than the average yield over the last five years;
  • The payout ratio (dividends per share divided by earnings per share) for the last four quarters is less than or equal to 50%;
  • The annualized growth rate in earnings over the last five years is greater than or equal to the median annualized growth rate in earnings for the industry over the same time period; and
  • The 30 companies with the highest dividend yields from both the DRP and non-DRP universes are included in the final results.

 

Wayne A. Thorp, CFA is a vice president and senior financial analyst at AAII and editor of Computerized Investing. Follow him on Twitter at @WayneTAAII.


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