Evaluating Stocks Like Bonds: An Example Using the Dow

by: Tom Au, CFA

Ben Graham believed in evaluating stocks as if they were bonds, which is done through dividend yields. One illustration of this is using the 30 stocks of the Dow. There is a naive strategy, of buying the ten highest yielding stocks. But that is only part of the equation. The trick is not really to buy stocks that are high-yielding, but are high-yielding relative to their qualities, growth prospects, etc. For instance, General Motors was not a buy at any yield. Perhaps the best proxy is a purchase of (Dow) stocks whose yields are high relative to their past, or whose spreads are historically high relative to the whole.

We'll use the yields of stocks as of the end of 2009. This allows for some "backtesting," since the stocks have, of course, shown some performance since then.

1) As of 12/31/09, three stocks, Chevron (NYSE:CVX), McDonald's (NYSE:MCD), and Pfizer (NYSE:PFE) had almost identical yields of 3.53%, 3.52%, and 3.52%, respectively. But this is a normal yield for Chevron, an unusually low yield for Pfizer, and an unusually high yield for McDonald's. The indicated trade (which we did not do) was to sell Pfizer, following its run-up on the Wyeth acquisition, and buy McDonald's.

Result to date: McDonald's' YTD performance is 11.7%, Chevron's is -1.0%, and Pfizer's is -17.3%, in exactly the rank order that would have been predicted by the above analysis.

2) DuPont (NYSE:DD), Kraft, (KFT) and Merck (NYSE:MRK) were all yielding over 4% on 12/31/09, which was high for them. The indicated trade was to buy all of them.

Result to date: With YTD performances of 20.8%, 7.5&, -5.7% respectively, two out of three have outperformed. Now yielding 4.4!%, Merck's yield is not far from a historical high (of about 5%).

3) With yields of around 3%, Boeing (NYSE:BA), Caterpillar (NYSE:CAT), Johnson & Johnson (NYSE:JNJ), and Procter and Gamble (NYSE:PG) were trading at uncharacteristically high yields on 12/31/09, suggesting the purchase of all of them. This was particularly true of Boeing, less so of the others.

Result to date: With YTD performances of 25.9%, 22.4%, -9.8%, and 0.9%, all but Johnson & Johnson are outperforming so far, the first two in a big way.

4) Telecoms: AT&T (NYSE:T) was trading "wide" of Verizon (NYSE:VZ) on 12/31/09; the reverse is usually true. The indicated pair trade was long T short VZ.

Result to date: AT&T's performance of -7.5% is decidedly better than Verizon's of -12.3%. But both high-yielding stocks have done badly in absolute terms.

5) Dividend cutters: Alcoa (NYSE:AA), JP Morgan Chase (NYSE:JPM), and Bank of America (NYSE:BAC) are all yielding less than 1% following dividend cuts. This is in contrast to stocks like Cisco Systems (NASDAQ:CSCO) or Hewlett Packard (NYSE:HPQ), for which sub-1% yields are normal.

Result to date: The YTD performance of the first three are -30.7%, -6,8%, and -3.3%, all below the index. But Hewlett and Cisco are also underperforming as well.

These examples illustrate that while an absolute yield strategy isn't very robust, a relative yield strategy might be.

Disclosure: Long PFE, T, VZ