STOCK INVESTOR PRO > August 2008

Stock Investor Adds Updated DRP Data

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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.

Recently, the DRP data in Stock Investor was updated using data provided by Simplisoft, a firm specializing in tax and accounting software specifically designed for dividend reinvestment plan investors. For more information, go to www.dripwizard.com.

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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.

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

Sector Breakdown

Currently, approximately 1,200 companies in the Stock Investor database are designated as offering a dividend reinvestment plan. Table 1 presents a sector breakdown of the firms offering DRPs, as well as those firms that do not.

Table 1. Sector Breakdown
Sector DRPs Non-DRPs
No. of
Firms
Percent
of Total
No. of
Firms
Percent
of Total
Basic Materials 91 7.6 487 6.3
Capital Goods 55 4.6 375 4.9
Conglomerates 14 1.2 15 0.2
Consumer Cyclical 53 4.4 334 4.3
Consumer Non-Cyclical 63 5.3 221 2.9
Energy 39 3.3 439 5.7
Financial 376 31.4 1,394 18.1
Healthcare 39 3.3 977 12.7
Services 253 21.2 1,540 20
Technology 92 7.7 1,687 21.9
Transporation 23 1.9 156 2
Utilities 98 8.2 81 1.1
Total 1,196   7,706  

Traditionally, financial institutions and utilities offered dividend reinvestment plans to their shareholders because of their need for a steady source of equity capital. Therefore, it is not surprising that the financial sector accounts for almost a third of the DRP universe (31.4%), while utilities account for 8.2%. The technology sector even makes up 7.7% of the DRP universe, giving it the fourth-highest concentration. This may signal the “maturing” of many high-tech firms.

Among the non-DRP universe, however, technology companies still make up the largest percentage at 21.9%, whereas financial and utility sector firms account for 18.1% and 1.1%, respectively. Technology and healthcare firms have significantly higher proportions within the non-DRP universe as compared with the DRP universe. These sectors tend to have more high-growth companies paying little or no dividends. Individuals who decide to limit their investments to companies with dividend reinvestment plans would be limiting themselves to dividend-paying companies within those sectors that tend to be larger and more mature.

Comparing Characteristics

Table 2 compares the investment characteristics of the DRP universe to the non-DRP universe of firms. Medians—the midpoint of the complete range of values—are used in place of averages to reduce the impact of outliers.

The companies offering dividend reinvestment plans are significantly larger based on both market capitalization and annual sales. Furthermore, due to their dividend policies, we can assume that these firms are more mature than those without dividend reinvestment plans.

Companies do not typically start paying cash dividends until they are past their “rapid growth” stage, when they are still generating excess cash from operations but can no longer find profitable internal capital projects.

This factor also shows up in the historical sales and earnings growth rates and projected earnings growth rates. As you would expect, however, those firms offering DRPs have a higher dividend growth rate.

Table 2: Investment Characteristics: DRPs vs. Non-DRPs*
Size DRPs Non-
DRPs
Market Cap ($ Million) 1,805.50 64.3
Sales—Trailing 12 Months ($ Million) 1,555.80 69.9
Growth (Five-Year Annual)
Sales (%) 9.8 12
EPS Historical (%) 10.8 14.9
EPS Estimated (%) 10.8 15
Dividends (%) 6 0
Valuation
Price-Earnings Ratio (X) 14.5 15.8
Dividend Yield (%) 2.9 0
Price-to-Book-Value Ratio (X) 2 1.5
Price-Earnings-to-Est EPS Growth (PEG) (X) 1.4 1.1
Price-Earnings-to-EPS Est Grth—Div Adjusted (X) 1.1 1.1
Profitability
Gross Margin (%) 37.3 36.2
Net Profit Margin (%) 9 1.5
Return on Equity (%) 11.8 6.6
Financial Structure
Long-Term Debt to Total Capital (%) 30.4 9
Total Liabilities to Total Assets (%) 67.5 56.6
Shares/Ownership
Insitutional Ownership (%) 58.1 25.8
Number of Institutional Shareholders (X) 342 45
Insider Ownership (%) 4 17.3
Shares Outstanding (Million) 76 26.6
Price
Price per Share ($) 23.55 4.28
Price as a % of 52-Week High (%) 72 53
52-week Relative Strength (S&P=0) (%) –3.0 –16.0
One-Year Price Change (%) –20.4 –31.5
*All values are medians—the midpoint of the range.
Data as of July 18, 2008.

Valuation Comparisons

During bear markets, dividend-paying value stocks tend to outperform growth-oriented issues. However, during this current bear market, financial stocks have borne the brunt of the market’s wrath. As we touched on earlier, financial stocks make up a sizeable proportion of the DRP universe. Perhaps as a result, we see that the price-earnings ratio for the DRP universe is lower than that of the non-DRP universe (14.5 versus 15.8).

The median dividend yield for the roster of DRP firms is greater than that of the typical non-DRP stock—2.9% versus 0.0%. In fact, only 29% of the firms in the non-DRP universe pay any dividend at all.

The ratio of price-earnings to 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 it has poor earnings growth prospects. Firms with higher growth prospects are attractive, as long as you don’t pay too much for the earnings. Companies with a PEG ratio near 1.0 are usually considered fairly valued; a ratio of 0.5 or lower is considered undervalued; a ratio above 1.5 is considered overvalued.

The stocks of the non-DRP group have a lower median PEG ratio than the typical DRP stock. However, the typical stock in both groups appears to fairly valued. The higher price-earnings ratio of the non-DRP universe was offset by the higher expected earnings growth rate for these companies.

Some investors adjust the PEG ratio to acknowledge the contribution dividends make to overall investment return (total return = capital gains + interest and/or dividends). This dividend-adjusted ratio is estimated by dividing the price-earnings ratio by the sum of estimated earning growth and the dividend yield. For the DRP universe, its PEG ratio falls to 1.1 when adjusted for dividends.

Management & Ownership

DRP companies currently have better bottom-line profitability ratios than those of non-DRP 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.

DRP companies have attracted much more institutional coverage than the non-DRP universe. Over half of the shares for this group are held by institutions, whereas only 25.8% of non-DRP stock is held by institutions. The median number of institutions with a position in a DRP company is 342, while it is only 45 for a non-DRP 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 for 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 per share of the non-DRP universe is significantly lower, $4.28 versus $23.55 for the DRP firms.

Both groups have underperformed the S&P 500, as measured by 52-week relative strength. However, the DRP group is underperforming the S&P 500 by 3% while the non-DRP universe is underperforming the S&P 500 by 16%.

High Yield Screen in Stock Investor

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.

Figure 1:
The *DPS with High Yield
screen seeks out
dividend-paying firms that
have high relative dividend
yields and above-average
earnings growth.
CLICK ON IMAGE TO
SEE FULL SIZE.

The *DRPs with High Yield screen in Stock Investor (Figure 1) seeks out companies offering dividend reinvestment plans with high relative dividend yields and above-average earnings growth. Traditionally, financials and utilities have paid higher dividend yields and required a separate relative dividend yield screen. Since these companies tend to have the highest dividend yields, they are prime candidates for investors looking to create a high-dividend-yield portfolio.

The screen begins by excluding those firms that do not offer a dividend reinvestment plan and institutes a minimum dividend yield requirement of 2%.

From there, the screen looks for companies that have paid a dividend for each of the last six years and have not cut their dividend 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.

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 company’s industry over the same period.

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—we hope due to a short-term market overreaction to bad news.

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. Typically, the lower the ratio, 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%.

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.

Conclusion

While firms with dividend reinvestment plans offer investors attractive benefits, such as low transaction costs, it is important that you focus on the merits of the investment itself, and then take advantage of the dividend reinvestment plan. You need to consider companies with DRPs within the context of your entire investment portfolio. Do not invest in a company strictly based on whether it offers a dividend reinvestment plan.

Remember, too, 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 such as this. The end goal is to find stocks that match your investing tolerances and constraints.