Dow Components Ranked by Dividend Risk and Growth

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 |  Includes: CVX, DD, HD, INTC, JNJ, MCD, MDLZ, MMM, MRK, PFE, PG, T, TRV, UTX, VZ, WMT
by: Bennington Investment Ideas
The Dow Jones Industrial Average (DJIA) is one of the leading stock market indicators in the world. The DJIA is the subject of several investing strategies, including the Dogs of the Dow which basically states that a portfolio of the top 10 dividend yielding stocks will outperform the DJIA over the next year. However, the 2011 DOD is currently underperforming. I would offer a new metric to screen for potential Dow investments.
Table 1 shows the DOD components selected for 2011 with both the yield at year end 2010 and current dividend yield.
Table 1: 2011 Dogs of the Dow Stocks
Ticker
Name
12/31/2010 Dividend Yield
2/25/2011 Current Dividend Yield
Current Dividend Yield Rank
AT&T Inc.
5.9%
6.1%
1
Verizon Communications Inc.
5.5%
5.4%
2
Pfizer, Inc.
4.6%
4.2%
4
Merck & Company, Inc.
4.2%
4.7%
3
Kraft Foods Inc.
3.7%
3.7%
5
Johnson & Johnson
3.5%
3.6%
6
Intel Corporation
3.4%
3.3%
7
E.I. du Pont de Nemours and Company
3.3%
3.0%
10
McDonald's Corporation
3.2%
3.3%
8
Chevron Corporation
3.2%
2.8%
11
Click to enlarge
Data is sourced from www.dogsofthedow.com on February 27, 2011

The highest yielding stocks at the end of 2010 are still the highest yielding with the exception of Proctor & Gamble (NYSE:PG) which would replace Chevron (NYSE:CVX). However the difference in yield is very small.
Balancing Dividends with Growth and Risk
One of the flaws of the Dogs of the Dow investment strategy is that it fails to consider growth and risk with respect to the selection. Some of the Dow stocks are simply in higher growth sectors and industries in others, offering them greater growth potential. Historical 5 year average sales growth ranged from negative figures to barely positive to high teens. While the ability to convert sales into cash flow and dividends may vary, the large range of differences clearly impacts potential dividend yields going forward. One way to balance growth and risk with dividend yield is to look at the dividend formula:
Current Price = Forward Dividend / (Required Equity Return – LT Growth)

So looking at this equation to maximize the Price, one wants to maximize the Forward Dividend, minimize the Required Equity Return and maximize the LT Growth or some combination of these levers. Some rearranging shows that the goal is to maximize the following:
DRG Index = Forward Dividend Yield – Required Equity Return + LT Growth

The Required Equity Return can be calculated using the Capital Asset Pricing Model. The Risk Free Rate is most typically associated with the U.S. Treasury bond with the most appropriate time frame to match that of stocks. I would use the 10-year bond, which is currently yielding 3.42% and 6% for the equity risk premium. The Forward Dividend Yield which can be calculated based upon the Current Dividend Yield and some estimate of 1 year of Dividend growth.
Table 2 shows these three metrics as well as the current dividend yields for all 30 DJIA stocks.
Table 2: DJIA Components
Ticker
Current Dividend Yield
Forward Dividend Yield
Required Equity
Return
LT Growth
DRG Index
DRG Index
Ranking
6.1%
6.5%
7.4%
5.3%
4.4%
13
5.4%
5.7%
7.5%
14.9%
13.0%
1
4.7%
4.7%
7.7%
3.7%
0.7%
23
4.2%
4.2%
7.6%
9.8%
6.5%
5
3.7%
3.8%
6.8%
8.0%
5.0%
10
3.6%
4.0%
6.8%
5.8%
3.0%
16
3.3%
3.7%
10.1%
10.0%
3.6%
14
3.3%
3.6%
6.4%
9.3%
6.5%
4
3.1%
3.4%
6.5%
9.2%
6.0%
6
3.0%
3.1%
11.8%
7.7%
-1.0%
26
2.8%
3.1%
7.9%
5.6%
0.8%
22
2.7%
2.9%
7.0%
9.0%
4.9%
11
2.7%
2.9%
13.3%
9.8%
-0.6%
25
2.6%
2.8%
8.2%
12.9%
7.6%
3
2.4%
2.4%
7.0%
9.8%
5.2%
7
2.4%
2.7%
9.8%
11.5%
4.4%
12
2.3%
2.5%
5.3%
11.1%
8.4%
2
2.3%
2.4%
8.3%
11.0%
5.1%
9
2.3%
2.3%
11.0%
9.8%
1.1%
21
2.1%
2.2%
6.3%
6.4%
2.3%
17
2.0%
2.3%
9.4%
12.4%
5.2%
8
1.7%
1.8%
13.7%
14.0%
2.1%
18
1.7%
1.7%
15.0%
10.8%
-2.5%
28
1.6%
1.8%
7.8%
9.3%
3.3%
15
0.9%
1.0%
10.1%
11.1%
2.0%
19
0.8%
0.8%
9.6%
10.0%
1.1%
20
0.7%
0.7%
16.0%
9.8%
-5.4%
29
0.4%
0.4%
10.3%
9.8%
-0.1%
24
0.3%
0.3%
16.7%
9.8%
-6.6%
30
0.0%
0.0%
10.9%
9.8%
-1.1%
27
Click to enlarge
Data provided by Zacks.com services. Forward Dividend Yields were calculated based upon historical dividend growth balanced with projected earnings growth. Lt Growth was provided by Zacks.com services. For stocks where data was not available, AA, JPM, BAC, CSCO, BA, GE and TRV, the average growth from the others was applied - 9.8% This may create some distortions; however, with the exception of TRV these stocks were not ranked very high on the DRG Index.

The expectation would be that this ranking would have been similar to the same calculation at the end of the year.

Table 3: YTD Performance of DOD Stocks vs. DRG Index Stocks
Rank DOD Price Return DRG Index Price Return
1 T -4.3% VZ 0.5%
2 VZ 0.5% WMT -4.0%
3 PFE 7.7% HD 5.8%
4 MRK -10.7% MCD -3.0%
5 KFT 0.6% PFE 7.7%
6 JNJ -3.6% PG -2.3%
7 INTC 3.9% TRV 7.0%
8 DD 8.4% UTX 5.9%
9 MCD -3.0% MMM 4.6%
10 CVX 11.9% KFT 0.6%
Average 1.2% Average 2.3%
Click to enlarge
Data is sourced from www.dogsofthedow.com. YTD is through February 25.

Conclusion
The DRG Index offers a modification on the Dogs of the Dow investment strategy by balancing growth and risk with dividend yield. The key caution is that performance comparison over a larger time frame would be needed. The other challenge with the DRG Index is that it requires additional inputs that have a higher subjectivity than simply looking at Dividend Yields. For example, the measure of risk is based on beta which is highly sensitive to the time frame over which it is calculated. The other issue is that both strategies failed to identify some of the top performing companies and while the DRG Index has a higher average return, it still trails the average of all the DJIA components.

The DRG Index does offer a good screening mechanism to identify potential stocks to review for inclusion in a portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.