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    A High-Yield Approach to Value Investing

    by Wayne A. Thorp

    Conservative investors are attracted to dividend-paying stocks because the dividends—and the yields on dividend-paying stocks—provide a measure of safety from market declines.

    A conservative, low-cost way to invest in dividend-paying stocks is through dividend reinvestment plans (DRPs), particularly those that will sell their initial shares directly to the public (direct purchase plans). With these plans, dividend payments are put to work immediately with little or no transaction costs involved. [See our annual guide to direct purchase plans.]

    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 rates of return.

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

    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; and
    • 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.

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

    Screen Performance

    The companies passing the high-yield screens for both the dividend-reinvestment-plan and non-dividend-reinvestment-plan universes, along with simple hypothetical portfolios, have been reported and tracked on AAII.com for the last eight-plus years. Both high-yield screens have outperformed the S&P 500 index cumulatively since January of 1998.

    Overall, the high-yield dividend-reinvestment-plan screen has generated a cumulative return of 161.6% over the period from January 1998 through April 2006, while the high-yield non-dividend-reinvestment-plan screen returned 338.7% over the same period (Figure 1). Keep in mind that this performance does not include dividend payments or dividend reinvestment. Historically, utilities have made up a large portion of dividend-reinvestment-plan stocks, although the percentage of the universe has dropped from roughly 23% last year to almost 14% this year. This high concentration of utilities may explain why the high-yield non-dividend-reinvestment-plan stocks outperformed the dividend-reinvestment-plan stocks over the testing period.

    Profile of Passing Companies

    The characteristics of the stocks passing the high-yield screen from both the dividend-reinvestment-plan and non-dividend-investment-plan universes are presented in Table 1. [Note that some of the dividend-reinvestment-plan firms listed do not offer direct purchase of initial shares and therefore do not appear in our annual guide of direct purchase plans.]

    Table 1. High-Yield Portfolio Characteristics
    Portfolio Characteristics (Median) Firms With
    Div Reinv Plans
    Firms W/O
    Div Reinv Plans
    Exchange-
    Listed
    Stocks
    Price-earnings ratio (X) 16.6 13.2 21.1
    Price-to-book-value ratio (X) 2.62 2.09 2.34
    PE to EPS estimated growth (X) 1.5 1.6 1.4
    Dividend yield (%) 2.7 3.6 0.0
    Dividend 5-yr. historical growth rate (%) 12.5 15.5 0.0
    EPS 5-yr. historical growth rate (%) 14.3 17.8 11.1
    EPS 3-5 yr. estimated growth rate (%) 10.2 9.5 14.5
    Market cap. ($ million) 9,873.1 855.2 477.2
    Relative strength vs. S&P (%) -10 -6 4
    Monthly Observations
    Average no. of passing stocks 30 30  
    Highest no. of passing stocks 31 31  
    Lowest no. of passing stocks 19 27  
    Monthly turnover (%) 25.3 29.1  

    Screens seeking high-dividend-yield stocks tend to be value oriented. As a result, the median price-earnings ratio (share price divided by earnings per share) is 16.6 for the passing companies in the dividend-reinvestment-plan universe and 13.2 for those companies in the non-dividend-reinvestment-plan universe. In both cases, the median price-earnings ratio is lower than the median price-earnings ratio for all exchange-listed stocks (21.1).

    Interestingly, however, the median price-to-book ratio for the passing companies offering dividend reinvestment plans (2.62) is above the median value for all exchange-listed stocks (2.34). This is most likely due to the high number of financial firms offering dividend reinvestment plans. However, those companies passing the high-yield screen that do not offer a dividend reinvestment plan have a lower median price-to-book ratio of 2.09.

    Given that the high-yield screen also requires companies to have an annualized growth rate in earnings per share over the last five years that matches or exceeds their industry median growth rate, it is probably not surprising that the passing companies from both the dividend-reinvestment-plan and non-dividend-reinvestment-plan universes have median five-year growth rates in earnings—14.3% and 17.8%, respectively—that exceed that of all exchange-listed stocks (11.1%).

    Despite the fact that both screens have outperformed the broad market indexes over the last eight years,Table 1 shows that relative performance over the last year has not been quite so good. Looking at the relative strength versus the S&P 500 over the last 52 weeks, both groups of companies currently passing the high-yield screen have underperformed the S&P 500 by 10% and 6%, respectively. Exchange-listed stocks, in comparison, have outperformed the S&P 500 by 4% over the same period.

    Passing Companies

    Table 2 lists the top 10 companies that passed the high-yield screen as of April 28, 2006, from both the dividend-reinvestment-plan and non-dividend-reinvestment-plan universes with each group ranked in descending order by dividend yield. Historically, we limit the number of passing companies to the 30 highest dividend yielders from each of the two universes. Specific screening criteria for both approaches are presented at the end of this article.

     

    Dividend yield forms one of the cornerstones of the high-yield screen, with passing companies required to have a current dividend yield that is greater than its average dividend yield over the last five years.

    Among those companies offering dividend reinvestment plans that passed the high-yield screen, First Horizon National Corp. (FHN) has the highest dividend yield at 4.2%. Interestingly enough, First Horizon held the same spot last year. For companies passing the high-yield screen that do not offer dividend reinvestment plans, SK Telecom Co. (SKM) leads all firms with a robust 8.2% dividend yield, based on an indicated dividend of $2.20 per share over the next 12 months and a current share price of $26.70.

    In addition to requiring an increased dividend over each of the last five years, the high-yield screen also calls for companies to have an annualized growth rate in dividends over the last five years that is greater than the median dividend growth rate for its industry over the same time period.

    Among companies that offer a dividend reinvestment plan and passed the high-yield screen, First Niagra Financial Group (FNFG) has the highest dividend growth rate at 28.1%. For those passing companies that do not offer a dividend reinvestment plan, SK Telecom Co. (SKM) again leads the way with a dividend growth rate of 126.0%. Whenever you see such high growth rates, it is a good idea to look at the raw numbers. In this case, SK Telecom’s dividend climbed from $0.02 per share to $1.18 per share in five years.

    When analyzing dividend-paying stocks, it is important that the company will be able to sustain and increase its dividend payments over time. One way to gauge this is by looking at the company’s 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 greater the risk that the company may have to cut its dividend should it run into trouble. Some industries with stable earnings, however, such as utilities, have payout ratios that can be as high as 70% or 80% of earnings, or higher.

    The high-yield screen calls for a payout ratio for the last four quarters (trailing 12 months) that is less than or equal to 50%.

    For the top-yielding companies listed in Table 2, BB&T Corporation (BBT) just comes in under the 50% payout ratio barrier at 48.9% among the dividend-reinvestment-plan companies, while Unilever N.V. (UN) has the highest payout ratio among non-dividend-reinvestment-plan companies with a payout ratio of 41.7%.

    Conclusion

    While the companies passing this high-yield screen have appealing characteristics—high dividend yields, dividend payments that have experienced consistent growth and exceed industry norms, as well as growing earnings and reasonable payout ratios—it is important to realize that stock screening is only the first step in the stock selection process. The stocks passing this or any other screen do not represent a “recommended” or “buy” list of stocks. They merely represent a starting point for further analysis.

    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 tolerances and constraints 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 (see the AAII Stock Screens area of AAII.com).
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