As a total return and dividend growth investor, I continually seek out research-based opportunities that may deliver above-market returns with higher levels of safety. Recently, I found a 2009 report by Credit Suisse that provides an analysis focused on U.S. and global stock performance based on dividend yield and payout ratio groupings. This article summarizes some of the results and provides discussion about the relationship between yield, payout, and P/E ratios and what it can tell investors.
The Credit Suisse researchers examined stock data from 12 countries over an 18-year period, from 1990-2008. They created nine groupings, based on dividend yield (low, medium, high) and payout ratio (low, medium, high), such that each combination was represented. They also tracked non-dividend stocks and used the S&P 500 to represent the overall market performance. Similar groups were created for the other countries' stock markets as well. The portfolios were equally weighted and rebalanced quarterly, with the study tracking the total return.
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The chart above shows the results for the U.S. stock market. The High-Yield, Low-Payout group showed the best performance over the 18-year period, followed by Low-Yield, Low-Payout. Both groups outperformed the S&P 500 (SPY) and non-dividend stocks. I found it interesting that in the 2000-2003 time period when the S&P declined, both of the Low Payout groups showed quite a bit of positive return.
The chart below provides the numerical results, and there are some definite patterns. For reference, the non-dividend stocks provided an annualized return of 10.6% and the S&P 500's annualized return was 8.4% over these years.
The Low Payout groupings, regardless of yield level, provided the highest levels of total return and handily beat the S&P 500 and the non-dividend stock groups. High-Yield, Low-Payout offered the best return, perhaps demonstrating value from the higher dividend level. Investors also benefitted from the firm having more room to raise its dividend, due to the low payout ratio, and less likelihood of a dividend cut, as earnings readily covered the dividend.
The Medium Payout groupings also performed well, with all beating the S&P 500, and two of the three beating non-dividend stocks. I was not surprised that the High-Yield, Medium-Payout group did well. U.K. stock research, as well as this comprehensive report from Tweedy, Browne Fund, indicates that high-yield stocks tend to outperform. I was more surprised that the Low-Yield, Low-Payout did the best of this series, though perhaps this reflects smaller growth firms that are able to reinvest their capital effectively.
Lastly, the High (or Negative) Payout series performed the worst, not only relative to the other payout groups, but relative to the S&P and non-dividend stocks as well. As dividend investors know, a high payout ratio can be problem if the firm encounters issues with its earnings. It also may limit growth, as most of the earnings are being distributed to shareholders. Based on this research, investors should limit their exposure to these companies, if not avoid them completely, as better opportunities exist in the other categories.
The study found considerable support for the High-Yield, Low-Payout strategy in other markets. Out of 11 foreign markets, High-Yield, Low-Payout delivered the best total returns in seven of them: Canada, China, France, Italy, Japan, South Korea, and the U.K. In four countries, the High-Yield, High-Payout grouping delivered the best results: Australia, Germany, Hong Kong, and Switzerland. In the latter two, the High-Yield, Low-Payout group underperformed the respective market index. However, in all countries, high dividend yield portfolios outperformed low dividend yield portfolios.
The Relationship Between Dividend Yield, Payout, and P/E Ratios
While analyzing the research results, I thought more about the relationship between dividend yield, payout, and P/E (Price/Earnings) ratios. It can be represented algebraically, with Yield equaling Payout multiplied by the inverse of the PE ratio, which is referred to as the Earnings Yield (E / P), or Yield = Payout * (1 / PE).
Implications of Low Payout Ratio
Because of this relationship, if the payout ratio (Div / Earnings) is low, then the yield provides us with some information about the stock's valuation. If the yield is also low, then the stock's earnings yield must be low, which implies a higher P/E ratio. For example, Sigma-Aldrich (SIAL) has a 1% yield, a 20% payout ratio, and its PE is around 20, which is high relative to the overall market and more mature dividend growth stocks. Whether that PE ratio is warranted depends on growth forecasts and other factors, and obviously the exact PE number depends on the specific yield and payout ratios. If the payout ratio is low enough, the PE could be relatively low too. In general, though, with payout held low, a lower yield means a higher PE stock.
Likewise, a higher yield with a lower payout suggests a stock with a lower PE ratio. Typically, low PE is one metric used to identify value stocks, which may explain why this group delivered the highest total return over the 18-year period. In addition, while the yields are already high, the low payout means there is room for dividend growth, which contributes to higher stock prices in the future, and less chance of a dividend cut, which avoids stock price declines. Seems like a win-win to me! The box below lists a few stocks that fit this category.
Implications of a High Payout Ratio
If the payout ratio is high (say 80%), then the formula again tells us some basic information about the stock based on the yield. In this situation, if the payout is high, but the yield is low (e.g. 2%), then the PE ratio must be relatively high, in this example, 40. Generally, a firm with a consistently high payout probably isn't growing fast enough to support a PE of 40, so this is a potential sign of overvaluation. The dividend could also be at risk if earnings decline, since the payout level is high. In the meantime, the low yield means the investor isn't getting much income return for his or her money. Perhaps not surprisingly, this group delivered the worst performance in the study.
If the yield is high (e.g. 8%), then the PE will be relatively low. In this case, it will be 10, as 8% = 80% payout * 1/10. While the low PE generally means the stock isn't overvalued, it can also mean that the firm isn't growing that quickly. The high payout ratio means that the firm isn't reinvesting much capital into growth opportunities and there isn't much room for dividend increases. While the stock may be a reasonable value, its dividend growth and earnings growth may be limited. In addition, should earnings head south, the dividend could be at risk. This group did perform better than the Low-Yield, High-Payout group, but still underperformed the S&P 500.
One caveat that came to mind is that the Earnings number can be subject to one-time adjustments that can throw off the ratios. For example, in the January 31 CCC list, CenterPoint Energy (CNP) had a yield of 4.39%, payout of 25%, and a PE of 5.8, which all sounds good from a numbers standpoint, though the extra low PE raised my suspicions. According to Yahoo Finance, its last year's earnings were over $3/share, but for next year, it is projected at closer to $1/share. This says to me that there were one-time gains that inflated earnings last year, and therefore this causes problems with the payout and PE ratios, as the earnings value is too high by a factor of 3! Adjusting the earnings to $1.18 per Yahoo's estimate results in an adjusted payout ratio of 69% and a PE of 16, which means this stock is not really in the Low Payout category.
As readers who have followed my articles know, I have been creating and tracking portfolios of consistent dividend growth stocks that implement the different dividend strategies that I have researched. These include models focused on high yield and small-cap dividend stocks. I plan to develop a portfolio based on this research, with a focus on the High-and-Medium-Yield, Low-Payout sectors, and the High-Yield, Medium Payout sector. While my personal focus is on total return, these sectors offer higher yields and the low payout ratios provide dividend security, which will be attractive for income investors. This portfolio will differ from my other ones in that REITs and MLPs will pretty much be excluded due to the low payout ratio requirement. I will be curious to see what names appear on the final list, the resulting yield and dividend growth rates, and how well it performs over time compared to the other models.