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    Dividend Reinvestment Plans: Value Investing With a Dividend Boost

    by Wayne A. Thorp

    Many investors today focus on the price performance of their holdings, forgetting one of the basic principles of investing: Total return consists of price appreciation and dividends received. Conversely, many value investors often rely on dividends to stabilize their returns, especially during periods of market instability.

    A conservative, low-cost approach to investing in dividend-paying stocks is with dividend reinvestment plans (DRPs), particularly those that sell initial shares directly to the public (direct purchase plans) instead of having to go through a broker. With these plans, dividend payments immediately go to work for you with little or no transaction costs. [Our annual guide to direct purchase plans starts on page 15 of this issue.]

    While there are distinct benefits to DRP investing, one potential pitfall to investing exclusively in companies with dividend reinvestment plans is that you may end up with a portfolio that is overweighted in particular sectors of the market. This is because companies that offer DRPs tend to be concentrated in specific industries, such as banking and insurance. Concentrating your portfolio in a limited number of sectors or industries can lead to a non-diversified portfolio without a rate of return that compensates you for the higher risk.

    Stocks with dividend reinvestment plans, however, can provide balance and diversification to those already invested in aggressive, high-growth stocks.

    High-Yield Screens

    If you are looking to diversify your stock holdings to include more conservative, dividend-paying companies, AAII tracks two stock screens that seek companies in both the DRP and non-DRP universes with:

    • High dividend yields relative to their historical norms; and
    • Earnings and dividend growth that outpace industry norms.

    Stock Investor Pro, AAII’s fundamental stock screening and research database, includes the high-yield screen for stocks offering DRPs.

    Screen Performance

    Each month, AAII.com lists the companies in the DRP and non-DRP universes passing the high-yield screen and tracks the performance of these stocks 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 200.9% over the period from January 1998 through the end of April 2007, while the high-yield non-DRP screen returned 378.2% over the same period. Keep in mind that this performance does not include dividend payments or dividend reinvestment. Historically, utilities have made up a larger proportion of the DRP stocks relative to stocks in other sectors. This high historical concentration of utilities in the DRP screen may explain why the high-yield non-DRP stocks outperformed the DRP stocks over the testing period.

    Profile of Passing Companies

    The characteristics of the companies passing the high-yield screen from both the DRP and non-DRP universes are presented in Table 1.

    A common method of isolating potential value stocks is by looking for those with high dividend yields. The value orientation of the stocks passing this high-yield screen is also apparent when looking at their price-earnings ratios. The median price-earnings ratio (share price divided by earnings per share) is 15.1 for the passing companies that offer DRPs and 13.4 for those that do not. In both instances, the median price-earnings ratio is lower than the median price-earnings ratio for exchange-listed stocks (20.0).

    The median price-to-book ratio for the passing DRP companies (2.15) is only slightly lower than the median value for all exchange-listed stocks (2.25). The companies passing the high-yield screen that do not offer DRPs have a much lower median price-to-book ratio of 1.62.

    An additional requirement of the high-yield screen calls for companies to have an annualized growth rate in earnings per share over the last five years that matches or exceeds their industry’s median growth rate. The passing companies from both the DRP and non-DRP universes have median five-year earnings growth rates—20.7% and 17.3%, respectively—that exceed that of all exchange-listed stocks (15.5%).

    Despite the long-term success of these two screens relative to various broad market indexes, Table 1 shows that the relative performance for the current passing companies has not been nearly as strong. Looking at the relative strength versus the S&P 500 over the last 52 weeks, the two groups of companies have underperformed the index by 12% and 14%, respectively.

    In contrast, the typical exchange-listed stock has underperformed the S&P 500 by 6% over the last year.

    Table 1. Tracking Error vs. Market Capitalization and Style Difference
    Portfolio Characters (Median) High-Yielders Exchange-
    Listed
    Stocks
    Firms With
    Div Reinv Plans
    Firms W/O
    Div Reinv Plans
    Price-earnings ratio (X) 15.1 13.4 20.0
    Price-to-book-value ratio (X) 2.15 1.62 2.25
    PE to EPS estimated growth (X) 1.5 1.8 1.5
    Dividend yield (%) 2.3 3.1 0.0
    Dividend 5-yr. historical growth rate (%) 16.0 14.9 0.0
    EPS 5-yr. historical growth rate (%) 20.7 17.3 15.5
    EPS 3-5 yr. estimated growth rate (%) 10.3 9.0 14.2
    Market cap. ($ million) 7890.4 352.6 518.7
    Relative strength vs. S&P (%) -12 -14 -6
    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 (%) 25.6 29.0  

    Passing Companies

    Table 2 lists the top 10 common stocks that passed the high-yield screen as of May 4, 2007, from both the DRP and non-DRP universes, with each group ranked in descending order by current dividend yield. [For the sake of discussion, we excluded exchange-traded funds (ETFs) and closed-end funds from this listing, but such securities do figure into performance calculations.]

    Historically, we limit the number of passing companies to the 30 highest dividend yielders from each universe. Specific screening criteria for both approaches are presented at the end of this article. [Note that some of the DRP firms listed do not offer direct purchase of initial shares and, therefore, do not appear in our annual guide to direct purchase plans.]

    Dividend yield is the cornerstone of the high-yield screen, with passing companies needing a current dividend yield greater than their five-year average. Dividend yield is calculated by dividing the firm’s indicated dividend (most recent quarterly dividend per share multiplied by four) by the current stock price.

    Among those common stocks with DRPs that also passed the high-yield screen, Pfizer Inc. (PFE) has the highest dividend yield at 4.3%. The company pays a healthy indicated dividend of $1.16 per share. For companies not offering a DRP, 21st Century Holding Co. (TCHC) leads all firms with an impressive 6.5% dividend yield. However, on May 4, the insurance holding company’s stock plunged almost 45% after it released disappointing first-quarter results. Its current dividend yield is based on a current stock price of $11.05 and an indicated dividend of $0.72 per share.

    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 period. Among companies with a DRP that passed the high-yield screen, cruise line Carnival Corp. (CCL) has the highest dividend growth rate of 19.7%.

    For those passing companies in the non-DRP universe, 21st Century Holding Co. again leads the group with a dividend growth rate of 57.2%. The company has steadily raised its dividend from $0.05 per share in 2001 to $0.48 per share in 2006. Based on 21st Century’s indicated dividend of $0.72, the company plans to increase its annual divided by 50% in 2007.

    When analyzing dividend-paying stocks, it is important to determine whether the company will be able to maintain—and, we hope, increase—its dividend payments over time. One useful measure in determining this is a company’s payout ratio (dividends per share divided by earnings per share). The higher the payout ratio, the higher the percentage of company earnings paid out as dividends—and, of course, 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 higher than 60% of earnings.

    The high-yield screen calls for a payout ratio for the last four fiscal quarters (trailing 12 months) that is no more than 50%.

    For the top-yielding companies listed in Table 2, Associated Banc-Corp (ASBC) is flirting with the 50% payout barrier at 49.2% among companies offering DRPs.

    Meanwhile, First National Lincoln Corp. (FNLC) shares the same payout ratio of 49.2% among companies that do not have a DRP.

     

    Conclusion

    The high-yield screen identifies companies with strong dividend credentials—high dividend yields, a record of consistent and rising dividend payments that exceed industry norms, as well as growing earnings and reasonable payout ratios. While this may be the case, it is important to realize that the stocks passing this or any other quantitative screen do not represent a “buy” or “recommended” list. Stock screening is actually the starting point, not the finish line.

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

    In addition, while firms with dividend reinvestment plans offer investors the benefits of low transaction costs, you should keep your focus on the merits of the investment, and then take advantage of the DRP plan if the company fits within your investing framework. In the end, do not pick a company merely because it offers a dividend reinvestment plan.

       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 financial analyst at AAII and editor of Computerized Investing.


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