Implementing a High-Yield Screen to Invest in Stocks With DRPs
by John Bajkowski
Many individuals are attracted to companies with DRPs because these firms offer a low-cost approach to purchasing shares over an extended period of time. However, an investor should purchase and hold a company with a dividend reinvestment plan only if it is an attractive investment when considered against other investment opportunities. This article explores the overall characteristics of stocks with DRPs and shows how to implement a basic screen for firms with high dividend yields.
In this issue, the AAII Journal publishes a guide to companies offering dividend reinvestment plans (DRPs). The companies that offer DRPs can be accessed on AAII.com in the Investor Resources area.
A Sector Breakdown
This years DRP survey covers 789 firms, 765 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 within Stock Investor as defined by three groups: stocks that offer DRPs, stocks paying a dividend without a DRP and stocks not paying any dividend at all.
|TABLE 1. A Sector Breakdown: DRPs vs. Non-DRPs|
|Dividend Paying Stocks||Stocks Without
Dividend reinvestment plans have traditionally been offered to the shareholders of utilities 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 utilities make up 12.3% of the universe of companies offering DRPs. Ninety-four utility stocks offer DRPs while only 22 utility stocks do not pay any dividend and 32 pay a dividend but do not offer DRPs.
Financials are another sector associated with above-average yields; however, DRPs are not as prevalent in this sector. A total of 954 out of 1,373 financials pay a dividend, but only 184 offer DRPs. Even so, financials make up 24.1% of the DRP universe.
In the non-dividend-paying universe, the healthcare and technology sectors have proportions significantly higher than in the dividend-paying 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 141 of the 1,916 companies in the technology sector pay a dividend and only 46 of these offer DRPs.
Table 2 compares the investment characteristics of the DRP universe to the universe of non-DRP dividend paying stocks as well as stocks that do not pay any dividends. Medians—the midpoint of the complete range of numbers—are used instead of averages to reduce the impact of outliers.
|TABLE 2. Investment Characteristics: DRPs vs. Non-DRPs|
|Market Capitalization ($ mil)||1,438.60||382.4||34.0|
|Sales—Latest 12 Months ($ mil)||1,473.00||269.9||61.9|
|Total Assets—Latest Quarter ($ mil)||2,899.40||824.0||61.3|
|Growth (Five-Year Annual)|
|Earnings per Share (%)||1.8||5.5||-2.5|
|Estimated Earnings per Share (%)||10.0||12.0||18.4|
|Dividend Yield (%)||2.5||2.3||0|
|Price-Earnings to Growth (PEG Ratio) (X)||1.5||1.1||0.8|
|Price-Earnings to Growth—Dividend Adjusted (X)||1.3||1.0||0.8|
|Gross Margin (%)||34.3||37.3||38.2|
|Operating Margin (%)||11.6||19.6||-0.9|
|Net Profit Margin (%)||5.9||9.4||-3.8|
|Return on Equity (%)||10.9||10.2||-0.2|
|Long-Term Debt to Total Capital (%)||39.8||12.9||8.3|
|Total Liability to Total Assets (%)||70.4||68.2||52.8|
|Institutional Ownership (%)||58.5||16.2||12.9|
|Number of Institutional Owners||381.0||71.0||22.0|
|Insider Ownership (%)||7.0||20.6||27.7|
|Shares Outstanding (mil)||64.8||19.9||18.1|
|Volume-Average Monthly (1,000s)||6,287.50||425.0||555.0|
|Price as a % of 52-Week High (%)||82.00||89.00||59.00|
|52-Week Relative Strength (%)||1.00||11.50||-16.00|
|52-Week Price Change (%)||-12.00||-3.60||-30.90|
|*All values are medians—the midpoints of the range.|
The companies offering DRPs are significantly larger than dividend-paying stocks without DRPs as well as non-dividend-paying stocks. Most stocks with DRPs are mid-cap and larger, while the majority of non-dividend-paying stocks would be classified as micro-cap stocks, too small for even many small-cap mutual funds to consider for investment.
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.
This factor clearly shows up in the historical sales growth rate, as well as in the forecasted growth rate in earnings. However, the historical earnings growth rate for the dividend-paying DRP and non-DRP stocks is higher than that of the non-dividend-paying stocks. This can be attributed to several factors, including a significantly higher number of extremely negative five-year earnings growth rates that contributed a negative bias to the non-DRP median and average, as well as the differing industry compositions within each group. Interestingly, the smaller, dividend-paying non-DRP stocks offer a slightly higher dividend growth rate. The higher growth in sales and historical and expected earnings seems to have provided the necessary cushion for these stocks to expand dividends at a higher rate.
The three-year bear market has reduced valuation levels for non-dividend-paying stocks more dramatically than the dividend-paying groups. During bear markets, dividend-paying value stocks tend to outperform growth-oriented issues. Since March 2000, the price-earnings ratio for dividend-paying stocks has increased (13.1 to 16.0 for DRP stocks; 12.1 to 15.5 for non-DRPs), while the price-earnings ratio has contracted for non-dividend-paying stocks (17.7 to 16.6). However, industry concentration within each group has played a role and economic slowdown has impacted sectors and industries differently.
The median dividend yield for the roster of larger, more mature DRP stocks is greater than that of the dividend-paying non-DRP group—2.5% versus 2.3%.
The ratio of price-earnings to expected 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 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; while a ratio above 1.5 is considered overvalued.
Both the dividend-paying and non-dividend-paying stocks of the non-DRP groups have lower median PEG ratios, although the dividend-paying stocks are more richly valued at 1.1, versus 0.8 for the non-dividend stocks. The median for the DRPs universe is 1.5, which would tend to indicate that this group is overvalued. The higher expected growth of the non-dividend-paying stocks accounts for the lower PEG ratio for those 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 ratio down to 1.3.
Management & Ownership
Currently dividend-paying companies tend to have better bottom-line profitability ratios than those of non-dividend 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.
The companies with DRPs have attracted much more institutional coverage than the other groups. Over half of the shares for DRP stocks are held by institutions, versus only 16.2% of non-DRP dividend-paying stock, and 12.9% of the non-dividend-paying stocks. The median number of institutions with a position in a DRP company is 381, while the median number is only 22 for a non-dividend paying 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 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-dividend-paying universe is significantly lower, $2.63 versus $24.58 for the DRP firms, and $19.03 for non-DRP, dividend-paying firms.
Both dividend-paying groups have outperformed the S&P 500, as measured by the 52-week relative strength. However, the dividend-paying DRP group has outperforming the S&P 500 by 11.5%. On a relative basis, the mid-capitalization dividend-paying companies have been the strongest performers 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 dividend-paying universes. The screen searches for companies with high relative dividend yields and above-average earnings growth.
The first screen looked for companies that have paid a dividend for each of the last six years and have not cut their divided 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 765 to 464 and the universe of dividend-paying non-DRP stocks from 1,757 to 729.
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 350 DRP stocks and 527 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 overreaction by the markets to bad news. This criterion cut the list of DRP stocks to 204, while the non-DRP universe was winnowed down to 224.
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. The lower the ratio, typically, 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 106 DRP stocks and 144 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.
Eighty-one stocks with DRPs passed all of these filters and 111 dividend-paying stocks without DRPs passed the complete screen. The 10 stocks from each group with the highest current dividend yield are presented in Table 3.
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 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, telecommunications company Altria Group (formerly Philip Morris) has a 52-week relative strength of 35%. This indicates that Altrias 42% price decline has underperformed the S&P 500 by 35% over the last 52 weeks. Based on the data in Table 3, only a few companies in the passing DRP universe have actually outperformed the S&P 500 index.
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 Table 3 for the complete 765-stock DRP segment as well as the 1,757 stocks that make up the dividend-paying non-DRP universe. Relative strength numbers can be found on the Web at popular investment-related Web sites such as Multex.com (www.multexinvestor.com). Industry data can also be found in databases included with fundamental stock screening packages, like the one included in AAIIs Stock Investor Pro software.
The price-change and relative strength figures highlight that strong dividend growth and generally weak price performance have pushed these stocks to the top of each list as far as dividend yield goes.
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 a starting point in the analysis process. 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.
Diversifying your investments, minimizing taxes and transaction costs, maintaining a portfolio of investments at a level of risk you are comfortable with, and taking a longer-term perspective are investment approaches that will prove most valuable over time.
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 dividend reinvestment plan.