Why The Highest-Yielding Dividend Stocks Deliver The Best Capital Gains

Includes: CVX, LO, MO, RAI, XOM
by: Tim McAleenan Jr.


The top quintile of dividend-paying stocks has outperformed the bottom quintile of dividend-paying stocks by 1.4% per year.

The "Dividend Aristocrats" have outperformed the S&P 500 by 6% annually since 1969.

Big Oil (Exxon and Chevron) and Big Tobacco (Altria, Reynolds American, and Lorillard) are big contributors to the outperformance of dividend-paying stocks.

One thing that can be seemingly counterintuitive is the notion that the companies that pay out the highest amount of dividends can also deliver the greatest amount of capital gains as well. According to Steve Johnson's individual research which also acknowledges the work of Professor Jeremy Siegel, we can see the following:

The top quintile [of dividend-paying stocks] returned 13.8 per cent a year since 1994, with a deviation of 15.4 per cent, against a return of 12.4 per cent and a deviation of 25.3 per cent for the bottom quintile.

The research echoes the findings of Jeremy Siegel, professor of finance at the University of Pennsylvania's Wharton School. In his book "The Future for Investors", Mr. Siegel demonstrated that an investor who purchased the 20 highest-yielding stocks in the S&P 500 every year from 1957 to 2004 would have outperformed the market by 3 per cent a year.

Indeed, the S&P Dividend Aristocrats Index, which features 57 companies that have increased their dividend annually for the past 25 years, has outperformed the S&P 500 by 6 per cent a year since 1969.

The question worth pursuing then is why certain companies can seemingly pay out a lot of current profits to shareholders and still be able to grow despite mailing profits to shareholders instead of using the money to fund growth. Usually, the answer is two-fold: the best-performing dividend stocks are those that manage to simultaneously retain a good chunk of profits while offering investors a high yield (the ability to do both is often, but not always, a signal that a stock is undervalued) or those that are able to grow profits organically without retaining much in the way of profits.

The examples of the first type of company are those in the oil sector. Since 1956, Exxon (NYSE:XOM) has returned 13.5% while Chevron (NYSE:CVX) has returned 14.2%. For most, but not all, of that time, Exxon and Chevron had yields in the 4-6% range, enough to quantify them for inclusion in the highest-yielding quintile of dividend stocks within the S&P 500.

In the case of Exxon, the company changed its business model in the 1990s to start spending as much money buying back stock as paying dividends, and that is why the typical starting dividend yield for Exxon's stock has shifted to the 2.5%-3.0% range. In the case of Chevron, investors became accustomed to recognizing the quality of the holding so that the typical valuation of 6x-9x earnings that existed in the 1960s, 1970s, and 1980s shifted to around 10-11x earnings over the past fifteen to twenty years. That's why its typical dividend yield is now in the 3-4% range rather than the 4.5%-5.5% range.

The other type of company that is generally responsible for explaining the outperformance of top quintile dividend stocks is that tobacco companies have been able to offer high yields and high growth rates despite retaining a low percentage of earnings.

Altria (NYSE:MO) is almost always in the top quintile of dividend payers, and the company has compounded at 20.59% annually since 1970, making it the best performing stock you could have purchased in the United States over the past 44 years. Reynolds American (NYSE:RAI), which has only existed in its current form since June 1999, has delivered 22.44% returns over that time frame. And Lorillard (NYSE:LO), which got spun off from Loews (NYSE:L) in 2008, has delivered returns of 19.21% since then. All three of these companies typically maintain dividend payout ratios in the 60-85% range, both now and on an historical basis.

The knowledge that the top quintile of stocks has tended to outperform the S&P 500 is only useful information to have if you can explain why that is the case, and then apply that knowledge to your future stock selection process.

Big oil and tobacco stocks tend to share a characteristic that make them ripe for sustained outperformance: they are almost perpetually undervalued because people think Exxon and Chevron are too big to grow, and they think that the increasing regulation and taxation of the tobacco industry will make it difficult for Altria, Reynolds, and Lorillard to continue to thrive. This is important because all five of those companies repurchase shares, and the cheaper prices enable them to stimulate earnings per share at a boosted rate.

When you have a perpetually undervalued stock that is paying out a high dividend, you suddenly create a situation where stock gets retired on the cheap, dividends get reinvested in a way that allows you to grab a bigger slice of income, and these factors are combined with a favorable third element: growth. Exxon and Chevron boost production through expensive capital projects, and the big tobacco players have shown an ability to raise prices and diversify profits in excess of expectations. Growth, high dividends, and perpetual undervaluation rarely walk hand-in-hand, but they do for the big oil and tobacco sectors.

When you study why the highest quintile of stocks have outperformed, you should identify which ones are largely responsible for that outperformance. It's almost entirely energy and tobacco companies, mixed in with a few others. A careful study of why this is the case will point out that growth, reinvested dividends, and perpetual undervaluation during buybacks are the keys to growth. After reviewing these studies of high-yielding dividend stocks, the next question is to ask yourself whether your portfolio has room for a high-yielding energy or tobacco company.

Disclosure: I am long XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.