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    A Conservative Approach to Screening for High Dividend Yields

    by Wayne A. Thorp

    Dividends have regained some of the luster they lost during the raucous tech boom of the late 1990s. Two major reasons for this are:

    • A “flight to quality” by investors stung by the market collapse following the bursting of the Internet bubble, and
    • A change in the tax law that now taxes many dividends at a more favorable rate.
    Conservative investors are attracted to dividend-paying stocks because the dividends—and the yields on dividend-paying stocks—provide a bit of a safe harbor during market tempests.

    A conservative, low-cost way to invest in dividend-paying stocks is through dividend reinvestment plans. With these plans, dividend payments are put to work immediately with little or no transaction costs involved. [For more on the basics of dividend reinvestment plans, see our annual guide.]

    One potential pitfall to investing only in companies with dividend reinvestment plans is that you may overweight your portfolio in a particular area of the market. That’s because companies that offer dividend reinvestment plans tend to be concentrated in certain industries, such as financial firms. Concentrating your portfolio in a limited number of industries will lead to a portfolio that is undiversified—a big risk for which you are not compensated by higher returns.

    Stocks with dividend reinvestment plans can, however, provide balance and diversification to investors who also hold aggressive, high-growth stocks in their portfolios.

    A High-Yield Screen

    If you are looking to diversify your stock holdings to include more conservative dividend-paying stocks, AAII tracks two screens that seek companies with high dividend yields relative to their historical norms, coupled with earnings and dividend growth exceeding industry norms:

    • Companies offering dividend reinvestment plans;
    • Companies that do not offer dividend reinvestment plans.
    Stock Investor Pro, AAII’s fundamental stock screening and research database, includes the high-yield screen for stocks offering dividend reinvestment plans.

    Screen Performance

    AAII tracks over 50 stock screening methodologies and reports the companies passing each of these screens on AAII.com each month. In addition, users can view the performance of simple hypothetical portfolios invested in each screening methodology that have been backtested over the last seven years. The high-yield screens for both the dividend-reinvestment-plan and non-dividend-reinvestment-plan universes are part of this analysis.

    Figure 1.
    High-Yield
    Screen Performance
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Figure 1 shows that the stocks passing the high-yield dividend screen—both in the dividend-reinvestment-plan and non-dividend-reinvestment-plan universes—have outperformed the S&P 500 index since January of 1998, as well as the S&P MidCap 400 and S&P SmallCap 600 indexes.

    Overall, the high-yield dividend-reinvestment-plan screen has generated a cumulative return of 130.3% over the period from January 1998 through April 2005, while the high-yield non-dividend-reinvestment-plan screen returned 271.2% over the same period. Note that this performance does not include dividend payments or dividend reinvestment. Utilities make up a large portion of dividend-reinvestment-plan stocks (currently, over 23%), which may help to explain why the high-yielding non-dividend-reinvestment-plan stocks outperformed the dividend-reinvestment-plan stocks over this time period.

    High-yield screens tend to be value-oriented in their approach, and while studies have shown that value investing outperforms growth-oriented investing over the long term, there will be periods when value lags growth.

    This is illustrated in the performance chart in Figure 1. From the beginning of 1998 until the end of 2000, the high-yield screens vastly underperformed the S&P 500. Both the dividend-reinvestment-plan and non-dividend-reinvestment-plan high-yield screens saw their cumulative performances bottom-out in February 2000.

    The next month, the S&P 500 peaked at levels it has yet to regain, and the high-yield screens began a steady ascent as high-tech issues collapsed.

    Profile of Passing Companies

    The characteristics of the stocks from the dividend-reinvestment-plan and non-dividend-reinvestment-plan universes passing the high-yield screen are presented in Table 1.

    TABLE 1. High-Yield Screen Portfolio Characteristics
    Portfolio Characteristics (Medians) High-Yielders Exchange-Listed
    Stocks
    Firms With
    Div Reinv Plans
    Firms W/O
    Div Reinv Plans
    Price-earnings ratio (X) 14.8 12.6 19.0
    Price-to-book-value ratio (X) 2.6 1.7 2.0
    Dividend yield (%) 2.7 3.0 0.0
    Dividend growth rate—hist 5yr (%) 10.6 17.4 0.0
    EPS growth rate—hist 5yr (%) 12.3 16.4 10.2
    EPS growth rate—est 3-5yr (%) 10.4 10.7 14.1
    Market cap ($ million) 10,000.0 637.4 362.7
    Relative strength vs. S&P 500 (%) -4.0 -7.5 -1.0
    Monthly Observations
    Average no. of passing companies 30 30  
    Highest no. of passing companies 31 31
    Lowest no. of passing comapanies 19 27
    Monthly turnover (%) 26 29

    Table 2 lists the 10 companies for both the dividend-reinvestment-plan and non-dividend-reinvestment-plan universes with the highest dividend yields that passed the screen as of May 6, 2005.

    Historically, we limit the number of passing companies to the 30 highest dividend yielders from each of the two universes, and we post these companies at the AAII Web site. The specific screening criteria for the high-yield screen are listed at the end of this article.

    Yield Requirement The cornerstone of the high-yield screen is the requirement that the current dividend yield (indicated dividend—the dividend the company expects to pay over the next 12 months—divided by stock price) be greater than the average yield over the last five years. For the companies passing the high-yield screen as a whole, the median yield of the dividend-reinvestment-plan companies (2.7%) and that of the non-dividend-reinvestment-plan companies (3.0%) is greater than that of all exchange-listed stocks, which is 0.0% (see Table 1). Among those companies offering dividend reinvestment plans, First Horizon National Corp. (FHN) and U.S. Bancorp (USB) have the highest dividend yield, at 4.2%. Among the non-dividend-reinvestment-plan firms, Southern Peru Copper Corp. (PCU) has an astounding 18.0% dividend yield, based on an indicated dividend of $9.51 over the next 12 months and a current share price of $52.70.

    Dividend Growth Rates When searching for high-yield stocks, it is important to attempt to gauge the “safety” of the dividend payment—any cutting or discontinuation of the dividend payment will usually have a devastating impact on the share price.

    Companies passing the high-yield screen must have increased their dividend over each of the last five years, and they must have an annualized dividend growth rate over the last five years that exceeds the median growth rate for the industry.

    The dividend-reinvestment-plan companies passing the high-yield screen have a median dividend growth rate of 10.6%; while the non-dividend-reinvestment-plan companies have seen their dividends grow at an annualized median rate of 17.4%. Both of these groups outpace the median growth in dividends for all exchange-listed stocks, which is 0.0%.

    For the top-yielding stocks in Table 2, the median dividend growth rate for those companies offering dividend reinvestment plans climbs to 16.6% and for non-dividend-reinvestment-plan companies, the median dividend growth rate jumps to 31.3%.

    Southern Peru Copper has the highest dividend growth rate—74.0%—among the companies listed in Table 2. However, it is important to keep in mind the base-year numbers when examining growth rates. In the case of Southern Peru Copper, it has increased its dividend from $0.15 per share to $2.39 in the latest fiscal year.

    Payout Ratio One other indication of the “safety” of a dividend is the payout ratio (dividends per share divided by earnings per share). The higher the payout ratio, the higher the percentage of earnings being paid out as dividends—and, the higher the risk that the company may have to cut its dividend should it run into trouble.

    Some industries, such as utilities, have payout ratios that can be as high as 70% or 80% of earnings, and higher.

    In the short run, companies can have payout ratios over 100%, where dividends exceed earnings. However, this cannot last for very long. The high-yield screen calls for a payout ratio for the last four quarters of less than or equal to 50%.

    For the top-yielding companies listed in Table 2, U.S. Bancorp has the highest payout ratio, 47.6%, among dividend-reinvestment-plan firms, while River Valley Bancorp leads the non-dividend-reinvestment-plan companies with a payout ratio of 50.0%, right at the cut-off.

    Price-Earnings Ratio Any screen looking for high-yield stocks tends to be value-oriented, since high-yield stocks are often those of more mature companies whose stock price has declined. Whether this decline is deserved is a different story.

    The value orientation of our own high-yield screen is indicated by the median price-earnings ratios (share price divided by earnings per share) for those companies passing the screen from both the dividend-reinvestment-plan and non-dividend-reinvestment-plan universes. The median price-earnings ratio for the companies passing the high-yield screen in the dividend-reinvestment-plan universe is 14.8, and 12.6 for the companies passing the screen from the non-dividend-reinvestment-plan universe (Table 1). These compare to a median price-earnings ratio for all exchange-listed stocks of 19.0.

    EPS Growth When implementing a value-oriented screen, it is always a good idea to use qualifying screens for financial strength. If you don’t, you run the risk of including companies that are selling at “value” prices but whose financial condition will make a rebound in share price difficult, if not impossible.

    One financial strength filter in the high-yield screen requires that the annualized growth rate in earnings per share over the last five years be greater than or equal to the median annualized growth rate in earnings for the industry over the same time period.

    The results: The median growth rates in historical earnings for companies passing the high-yield screen in the dividend-reinvestment-plan universe (12.3%) and non-dividend-reinvestment-plan universe (16.4%) exceed the median of all exchange-listed stocks at 10.2% (Table 1).

    Market Capitalization Companies that pay a dividend tend to be more mature—their growth opportunities have diminished to the point where there is no longer the need to plow excess cash back into the firm. Instead, the company passes this money on to shareholders. Mature companies tend to be larger, as illustrated by market capitalization.

    The median market capitalizations of companies passing the high-yield screen in both the dividend-reinvestment-plan universe ($10 billion median market cap) and the non-dividend-reinvestment-plan universe ($637.4 million median market cap) surpass that of all exchange-listed companies ($362.7 million median market cap).

    Relative Strength While the companies passing the high-yield screen have been able to generate returns above the market over the long term, Table 1 shows a different story more recently. Looking at the relative strength versus the S&P 500 over the last 52 weeks, the dividend-reinvestment-plan companies passing the high-yield screen have underperformed the S&P 500 by 4.0%, and the high-yield stocks in the non-dividend-reinvestment-plan universe have lagged the S&P by 7.5%. Exchange-listed stocks have also underperformed the S&P over the last 52 weeks by 1.0%. In fact, only seven of the 20 high-yield firms listed in Table 2 have managed to outperform the S&P 500 over the last 52 weeks—four dividend-reinvestment-plan firms and three non-dividend-reinvestment-plan firms.

    ONEOK is the best-performing high-yielder in the dividend-reinvestment-plan universe, having outpaced the S&P 500 by 37% over the last 52 weeks, along with posting a 38% increase in share price over the same period.

    Among the high-yielders in the non-dividend-reinvestment-plan universe, Southern Peru Copper outperformed the S&P by 78% over the last 52 weeks, with a price increase of 76%.

    Conclusion

    This high-yield screen seeks companies with high dividend yields whose dividend payments have experienced consistent dividend growth that exceeds industry norms as well as by growing earnings and reasonable payout ratios.

    However, the companies passing this—or any other stock screen—do not present a “recommended” or “buy” list of stocks. Any stocks that turn up from any quantitative stock filter require further analysis by the investor.

    In addition, while firms with dividend reinvestment plans offer investors the advantage of low transaction costs, you should keep your focus on the merits of the investment, and then take advantage of any plan. Don’t pick a company merely because it offers a dividend reinvestment plan.

    Overall, it is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing constraints and requirements before committing your investment dollars.

       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 (trailing 12 months) 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 (trailing 12 months) is less than or equal to 50%;
    • The annualized growth rate in earnings (total, non-diluted) over the last five years is greater than or equal to the median annualized growth rate in earnings (total, non-diluted) for the industry over the same time period; and
    • The 30 companies with the highest dividend yields from both the dividend-reinvestment-plan and non-dividend-reinvestment-plan universes are included in the final results.


    Wayne A. Thorp, CFA, is associate editor of Computerized Investing and AAII’s financial analyst.


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