Many respondents to a July AAII survey said they were favoring dividend-paying stocks over pure growth or value stocks. The reasons are not surprising. The stream of income offered by dividends provides some comfort in volatile market conditions. Furthermore, Treasury yields have fallen to low levels. During July and August, yields on the 10-year note were below 3%. Dividend-paying stocks can offer comparable yields with the possibility of dividend growth and capital appreciation.

Not all dividends are created equal, however. Many companies have either cut or eliminated their dividends since 2007. Therefore, it is important that investors pay attention to how committed management has been to ensuring dividends are paid and whether the size of the dividend has increased, stayed the same or been cut.

High Relative Dividend Yields

AAII tracks a high-yield screen that seeks companies with characteristics that include:

• An established history of rising dividends;
• A high dividend yield relative to its historical norm;
• Earnings growth that outpaces industry norm; and
• Liabilities below the industry norm.

A history of rising dividends implies that management has historically maintained a focus on providing an increasing level of income to shareholders.

The relative dividend yield is a measure of valuation. It is used to signal whether a company is trading at a discount compared to its historical range. Higher yields signal a lower valuation, though other measures, such as the price-earnings ratio, should also be considered. A higher yield can also signal concerns about the company’s business or financial status; therefore, thorough research is required.

Above-industry-average earnings growth suggests the company’s profitability should have the ability to support higher dividends in the future. Both characteristics increase the possibility, but do not guarantee, that dividends may be raised in the future. Lower levels of debt allow for more cash to be available for dividend payments. (Less cash needs to be used to service debt.) Comparing debt levels to the industry median allows the strategy to adjust to differing capital requirements.

Each month at AAII.com, we post an updated list of the companies that pass the high-relative-yield screen. We also show the performance of the strategy based on a hypothetical portfolio. Investors wanting a more frequent update of the passing company list can use Stock Investor Pro, AAII’s fundamental stock screening and research database program.

Screen Performance

The High Relative Dividend Yield screen has outperformed the S&P 500 index on a cumulative basis since the beginning of 1998. This screen has achieved a cumulative return of 138.4% over the period of January 1998 through July 2010 (Figure 1). The performance does not include dividend payments; returns would have been higher if dividend payments were added in to the calculations.

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The stream of income provided by dividends is perceived as providing a cushion against turbulent market conditions. Though the periodic payments do add to overall portfolio performance, dividend-yielding stocks are not immune from the volatility of the overall market. In 2007 and 2008, our High Relative Dividend Yield screen fell 9.6% and 21.4%, respectively.

Sector Breakdown

Financial companies comprise the largest group of passing companies (27% of the current results). Consumer non-cyclicals and services were the second- and third-most represented sectors. No single sector stood out as having companies with the highest relative yields.

Despite the sector’s reputation for paying dividends, only two utility companies passed the screen. This does not mean that utility companies no longer are a source of income, but rather that many did not meet the criteria for a high relative yield or rising dividends.

What It Takes: Screen Criteria

The High Relative Dividend Yield screen uses the following criteria:

• The company does not trade on the over-the-counter exchange and is not in the miscellaneous financial services industry (the latter requirement is to exclude closed-end funds);
• The company has seven years of price and dividend records;
• The annual dividend has increased over each of the last six years and the company has not reduced its annual dividend payment;
• The seven-year growth rate in dividends is greater than 3%;
• The current dividend yield is greater than the average yield over the last seven 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 85% for utilities and less than or equal to 50% for companies in other industries;
• Total liabilities relative to assets is below the industry median for the last reported fiscal quarter; and
• The annualized growth rate in diluted earnings per share from continuing operations over the last three years is greater than or equal to the median annualized growth rate for the industry over the same time period.

Passing Companies

Table 1 presents the characteristics of the companies passing the High Relative Dividend Yield screen. Table 2 lists the 20 highest-yielding exchange-listed stocks that passed the High Relative Dividend Yield screen using data as of August 6, 2010. The passing companies have increased fully diluted earnings per share from continuing operations over the last seven-year period by a median of 12.3%, compared to 5.2% for all exchange-listed stocks. Yields, based on the indicated dividend (the cumulative dividend a company expects to pay over the next four quarters), are a median 2.3% for passing companies compared to 0.0% for all exchange-listed stocks.

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The company with the highest yield was Vodafone Group VOD. VOD yielded 7% as of August 6, 2010. Vodafone is a global telecommunications company and is a co-owner of Verizon Wireless. The company has a seven-year dividend growth rate of 23.0% and a seven-year earnings growth rate of 17.5%. Its payout ratio of 37.8% compares to an industry median of 22.7%.

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Though dividends have been consistently raised, earnings have been volatile. The company lost money between fiscal 2004 and fiscal 2007. Profits also pulled back during fiscal 2009. (Vodafone operates on an April to March fiscal year.)

Dividend Reinvestment Plans (DRPs)

Some of the companies identified by the screen do provide dividend reinvestment plans (DRPs or DRIPs), but not all—as is noted in Table 2.

These plans allow shareholders to use their dividends to purchase additional shares of stock, instead of receiving dividends in cash. (The dividend is still taxable, even if it is reinvested, for shares held in a non-retirement account.)

There are typically little or no transaction costs, though you should check with the company to be sure.

Conclusion

This High Relative Dividend Yield screen identifies companies with strong dividend credentials that are trading at relatively high yields. Though dividends can add to total return, they do not protect a stock from the market’s volatility.

Keep in mind that 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. The end goal is to find stocks that match your investing timeframe, tolerances and constraints.

Finally, pay attention to any tax legislation this year. If Congress does not act, dividend tax rates will rise in 2011. This will adversely impact aftertax returns and could potentially influence sentiment toward high-yield stocks. If Congress does act, it is unclear what the tax rate on dividends will be and how it might affect investing decisions.