S&P 500 10 Sectors
Most investors would agree that proper portfolio construction requires proper diversification. The legendary Ben Graham once said "to win you must not lose," wise words from one of the wisest investors that ever lived. A properly diversified portfolio is one of the best strategies to protect against loss.
However, diversification can also be carried too far. Peter Lynch in his best-selling book ‘One up on Wall Street’ coined the expression “diworseification” a trap investors should be careful not to fall into. In other words, a portfolio could become so over-diversified that it fails to get the job done. Mathematically speaking, every time you add a name to a portfolio, your portfolio becomes closer to average, and most of us want to do better than average.
The S&P 500 contains 500 companies spread out over 10 sectors and is often considered a proxy for the overall market. Consequently, many investors utilize the S&P 500 as the benchmark that their managers are measured against. Additionally, there has been a long-standing debate between whether passive portfolio management is superior to active portfolio management. We will let the pundits continue to fight that one out.
This article will review 10 dividend paying companies, one from each S&P 500 sector that in the aggregate pay a higher dividend yield than the larger index. For simplicity, this portfolio is equal weighted. Note, however, that the S&P 500 is not an equal weighted index. This more concentrated portfolio also has a history of performance which is greater than the S&P 500.
Figure 1 below lists the 10 companies that this series of articles will review, and provides a summary of the most important metrics based on fundamentals on each. Deeper into the articles EDMP, Inc. F.A.S.T. Graphs™ will provide a more comprehensive look at each of these companies.
Figure 1 Portfolio Review (Click to enlarge)
In order to compile this list of above-average achievers, in both capital appreciation and current dividend yield, each company had to meet certain criteria. First of all, each selection had to have historical earnings-per-share growth in excess of the S&P 500 index. Next, each selection had to have a current dividend yield that was higher than the 2.2% current yield for the S&P 500. Since valuation is very important, each company had to have a current PE ratio that was no more than 120% of the modern 17.5 historical normal S&P 500 PE ratio. Also, because controlling risk was a major consideration, only companies with a market cap greater than $5 billion were included.
Fundamentals at a Glance
Figures 2A and 2B below look at the S&P 500 through the lens of our EDMP, Inc. F.A.S.T. Graphs™ since calendar year 2000, and are offered as the benchmark to measure our selection criteria against. The blue line with asterisk represents the historical twenty-year normal S&P 500 PE ratio of 17.5. The black line represents monthly closing stock prices.
When the black price-line touches the blue line with asterisk the S&P 500 is theoretically trading at fair value. When the black price-line is above the normal PE ratio (blue line with asterisk), the index is overvalued; when the price touches the normal PE, the S&P 500 is fairly valued, and of course; when the black line is below the normal PE, under-valuation exists.
Note how overvalued the S&P 500 was at the beginning of this period in calendar year 2000, how it reverted to earnings justified levels, and then how closely the price-line has correlated to earnings ever since.
Figure 2A S&P 500 11yr EPS Growth Correlated to Price (Click to enlarge)
Figure 2B calculates the performance associated with Figure 2A.
Figure 2B S&P 500 11yr Dividend and Price Performance (Click to enlarge)
Figures 3A and B through 7A and B in Part 1 look at five of our ten selections through the lens of our EDMP, Inc. F.A.S.T. Graphs™ since calendar year 2000. We selected one company from each of the 10 major sectors of the S&P 500. Therefore, this concentrated portfolio will be as broadly diversified as the S&P 500 regarding a cross-section of sectors. However, remember that this portfolio will be equally weighted with a theoretical 10% of the portfolio invested in each sector.
Each company in this hypothetical portfolio will have a yield higher than the S&P 500 currently has, and in the aggregate offers a yield that is also currently higher than the yield on a 10-year T-bond . The key factor here is that we expect the yield to increase based on original cost each year, as the dividends are expected to increase consistent with earnings increasing.
Sector One: Consumer Staples
Figures 3A and 3B look at Sysco Corp. (SYY). As this graph illustrates, this extremely high-quality food distributor has historically commanded a premium PE ratio from Wall Street. Thanks to the “Great Recession,” Sysco's current PE ratio is half what the market has normally capitalized their earnings at, and therefore its current yield of 3.3% is abnormally high. Sysco’s historical earnings-per-share growth has been almost triple what the S&P 500 has accomplished, and is forecast to continue to grow in excess of 10% over the next five years.
Figure 3A SYY 11yr EPS Growth Correlated to Price (Click to enlarge)
Figure 3B calculates the performance for Sysco Corp. associated with Figure 3A. Even though Sysco Corp. started this time period slightly overvalued, it nevertheless was able to outperform the S&P 500 over this so-called “lost decade.”
Figure 3B SYY 11yr Dividend and Price Performance (Click to enlarge)
Sector Two: Consumer Discretionary
Figures 4A and 4B look at the McDonald's Corp. (MCD). This fast food behemoth generated a historical earnings-per-share growth rate of just under 11% per annum and offers a 3.2% current dividend. Future earnings are forecast to grow in excess of 9% a year for the next five years.
Figure 4A MCD 11yr EPS Growth Correlated to Price (Click to enlarge)
Figure 4B calculates the performance associated with Figure 4A. Once again, even though overvaluation was present in the beginning, McDonald's Corp. outperformed the S&P 500 because of above-average earnings growth. Also, note how the dividend grew each year as earnings grew.
Figure 4B MCD 11yr Dividend and Price Performance (Click to enlarge)
Sector Three: Industrials
Figures 5A and 5B look at Illinois Tool Works (ITW). Illinois Tool Works manufactures components and fasteners for the automotive and construction industries and general industrial applications. Although somewhat cyclical, this stalwart offers a 2.7% current yield and is forecast to grow earnings at 16.5% over the next five years, as earnings of this semi-cyclical rebound after the recent “Great Recession.”
Figure 5A ITW 11yr EPS Growth Correlated to Price (Click to enlarge)
Figure 5B calculates the performance associated with Figure 5A. Even when considering the cyclical nature of this high-quality business, ITW was still able to generate positive capital appreciation and a growing dividend income stream since calendar 2000.
Figure 5B ITW 11yr Dividend and Price Performance (Click to enlarge)
Sector Four: Materials
Figures 6A and 6B look at Air Products and Chemicals Inc. (APD). This leading supplier of industrial gases has generated a historical earnings growth rate of 8.3%, although with some inconsistency. The current dividend yield is slightly less than what a ten-year T-bond offers, and higher than the current yield on the S&P 500. However, estimated five-year earnings growth is forecast at greater than 11% which has the potential to compensate long-term shareholders with the opportunity to receive an above-average total return.
Figure 6A APD 11yr EPS Growth Correlated to Price (Click to enlarge)
Figure 6B calculates the performance associated with Figure 6A. In addition to producing a growing dividend income stream, Air Products and Chemicals Inc. has also produced a quite acceptable level of capital appreciation.
Figure 6B APD 11yr Dividend and Price Performance (Click to enlarge)
Sector Five: Financials
Figure 7A and 7B review Hudson City Bancorp Inc. (HCBK). This top 50 bank based on asset size has consistently grown earnings right through the last two recessions. Consequently, its operating performance is one of the best in this otherwise very troubled sector. Moreover, the current price earnings ratio is quite low indicating a very attractive valuation.
Figure 7A HCBK 11yr EPS Growth Correlated to Price (Click to enlarge)
Figure 7B calculates the performance associated with Figure 7A. As is clearly evident, this atypical financial institution has rewarded shareholders quite handsomely from both the perspective of capital appreciation and a rich and growing dividend.
Figure 7B HCBK 11yr Dividend and Price Performance (Click to enlarge)
Conclusion of Part 1 (of two parts)
In Part 1 of this two-part series on 10 stocks that match the S&P 500 sectors, we have covered the first five examples. In Part 2 of this two-part series, we will cover the second five examples and also provide both a summary, and concluding remarks. These first five selections are offered in no particular order and therefore represent five of the ten possible sectors picked at random.
One of the goals of these articles is to illustrate that quality above average dividend yielding selections can be found in virtually every sector. It is not our intention to suggest that these are the absolute best choices for each sector, rather to simply illustrate that a good selection in each sector that meets strict criteria can be found. For many of the sectors several choices were available and we, therefore, simply picked one of many.
We suggest that when reviewing the EDMP, Inc. F.A.S.T. Graphs™ and charts that special attention be given to the information listed on the right of each graph A. Here you will find information that provides a perspective of how fast each selection has grown earnings and the normal price earnings ratio that the market has capitalized those earnings at.
For each chart B. the dividend cash flow table illustrates the increasing dividend income stream that each selection provided shareholders. Dividends are not reinvested and therefore are assumed to be spent. Finally, focus on the total annualized rate of return and how it compares to the performance of the S&P 500 found in figure 2B. For a review of the next five selections, tune in to Part 2.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: Long: SYY, MCD, HCBK, CVX, JNJ, CTL, FPL, ADP at the time of writing.