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In my previous article, I discussed recent research that shows that high-yield, low-payout stocks outperform the overall market in total return, as well as other yield-payout groups. This article focuses on the construction of a High-Yield, Low-Payout dividend growth stock portfolio by applying a screening process to the CCC stock list.

Because we are so close to the beginning of the year, I decided to use the December 31, 2011, CCC list and give this virtual portfolio a starting date of January 1, 2012. This will allow for a full year of data, and make it more comparable to my other dividend growth portfolio models. The portfolio will contain 30 stocks with $10,000 invested in each one.

Determining "High" and "Low"

In the research, stocks were sorted into high, medium, and low groups based on yield and payout. No specific cutoff numbers were given, though the appendix does say that stocks were first sorted by yield. I chose a slightly different approach. I sorted the combined CCC stock list (around 450 stocks) by payout, and then checked each third to get an idea of what the cutoffs looked like based on the data set. This check yielded the following cutoffs:

Low

Medium

High

Yield

<2.2%

2.2% < x < 3.6%

>=3.6%

Payout

<33%

33% < x < 60%

>=60% or negative

I didn't want to be too restrictive, as I planned to apply additional filters, and this universe also included MLPs and REITs, which were sure to be eliminated due to high payout ratios, so I relaxed the limits slightly, settling on the cutoffs in the table below. I reduced the high yield cutoff, as this group would not have many 4%+ stocks, compared to other models I have created; "high" is a relative term. The cutoff choices impact whether a stock such as Campbells Soup (NYSE:CPB) ends up being in the Medium Yield-Medium Payout or High Yield-Medium Payout group. Readers are free to choose different cutoffs.

Low

Medium

High

Yield

<2.1%

2.1% < x < 3.5%

>3.5%

Payout

<45%

45% < x < 65%

>65% or negative

Screening Process

Using these cutoffs, I sorted the CCC list into the nine combinations of low, medium, and high payout and yield. The table below shows how many stocks are in each classification. In general, I would classify the top left squares as signaling an overvalued stock, based on the high payout and low yield. There are few stocks in that region, though those that froze or cut their dividend are removed from the CCC list, so there is survivor bias. There are many in the Low-Low group, which includes smaller firms with good earnings and dividend growth. The High-High group contains most of the MLPs, utility, tobacco, and REIT stocks; higher yield, but potentially less growth.
Group Sizes

The lower right quadrant is the focus of this model. The Medium-Medium group contains the likes of Johnson & Johnson (NYSE:JNJ), Pepsi (NYSE:PEP), and Procter & Gamble (NYSE:PG). Nothing wrong with those stocks, but as we move to the right, we get similar yields with lower payout ratios, so there is more room to grow the dividend. Moving to the High Yield-Medium Payout group provides higher yields than JNJ, at comparable payout levels, which also seems like a good upgrade. The holy grail though is the High Yield-Low Payout, where just 18 stocks of the original 448 ended up. In an effort to achieve more value, this model will not utilize stocks from the Medium-Medium group; it draws from the other 3 groups in this quadrant (around 145 stocks).

Screened Group Characteristics

After combining the stocks from the Hi-Med, Hi-Low, and Med-Low yield-payout groups, I made two adjustments. First, I removed all stocks below a $250MM market cap, as I wanted firms that were more liquid in terms of trading volume and that had achieved a minimum size. Next, I removed all stocks with payouts above 60%, as I wanted to leave some room before crossing into the high payout category at 65%. This mainly eliminated a bunch of small banks and some higher yielding utilities and consumer staples stocks. Those interested in higher yields could skip this step. 108 stocks remained in the screened group.

Portfolio Stats

Next, I added sector tags and sorted the list by sector and yield. By count, the group is heavy on financials (20%), industrials (20%), and consumer discretionary (11%) stocks. However, several of the stocks were small caps, so I also calculated market cap weightings, which favored energy (25%), consumer staples (14%), and info tech (14%). To determine the portfolio weightings, I averaged the count and market cap weightings. Based on this, industrials received the highest allotment of stocks (5), followed by energy and financials (4 each). I am curious to see how this portfolio plays out, as my other models are more heavily weighted toward consumer staples. In a recovery, I would expect it to outperform, though with the low payout, it could outperform regardless as long as the dividends keep getting boosted.

For reference, this universe had an average yield of 3.1%, a payout ratio of 37.5%, and 1-, 3-, and 5-year dividend growth rates [DGRs] of 13.7%, 11.2%, and 14.1%. Already, we can see that while the yield is lower than other income-focused models, the payout is also much lower, and the DGRs are consistently in the double-digits.

Stock Selection ProcessScoring System

Because the focus of this model is on dividend yield and payout ratio, I created a scoring formula that utilized those two variables, in addition to the next year's earnings growth rate and the 1-yr and 5-yr DGRs. The formula ranked these metrics for each stock according to the table above then summed the values. Since I want the model to be relevant for income investors, I double-weighted the yield score to emphasize yield, knowing that the average payout is relatively low. I then searched for the highest scoring stocks in each sector, with preference given to those with higher yields or higher DGRs in the case of a tie score. The final portfolio is presented below.

There were three instances where I made executive decisions that did not strictly follow the scoring system.

  1. The Industrials sector had many high-scoring defense firms, so after choosing Raytheon (NYSE:RTN) and Lockheed Martin (NYSE:LMT), I ruled out more defense selections. This resulted in CSX (NYSE:CSX) being chosen over General Dynamics (NYSE:GD), despite a lower yield.
  2. In the Info Tech sector, Intel (NASDAQ:INTC) was one point below Accenture (NYSE:ACN) and Analog Devices (NASDAQ:ADI), but its yield was over 65 basis points higher and I like the firm, so I chose it.
  3. In Utilities, CMS Energy (NYSE:CMS) had a one-point advantage over the selected stocks, but it is overdue for a dividend increase and its payout ratio had the lowest score.

It is also worth mentioning that I used the CCC data, which comes from Yahoo Finance, as is. There are potential issues with the payout ratios, as one-time earnings gains or losses can throw off the value. I figured that if the firm had one-time charges causing a high payout ratio, then I probably would want to stay away from it anyway. One-time gains make the ratio lower than it should be, so I did investigate some ratios below 30% to verify that the earnings were consistent. One example where it was not is CenterPoint Energy (NYSE:CNP), so I adjusted the payout ratio based on the current year's earnings.

High-Yield, Low-Payout PortfolioHigh Yield Low Payout Portfolio

Portfolio Observations

Portfolio comparisons
As of December 31, 2011, the final portfolio had an average yield of 3.57%, a payout ratio of 37.28, and its 1-, 3-, and 5-year DGRs were 19.7%, 15.1%, and 18.1% respectively, which exceed the overall screened universe's traits. Compared to my Small-Cap, Dividend Aristocrat, and Income-Growth DG models, this portfolio had the lowest payout and highest DGRs, but not the lowest yield. It also had the highest beta, though still lower than the market. The High-Yield, Low-Payout portfolio also has 6 non-US holdings, only 5 of its holdings overlap with the Income-Growth model, and only 3 overlap with the DA+ portfolio, so these models hold mostly different stocks. It will be interesting to compare the performance results over time.

Note: As of this week, the current portfolio yield was around 3.4% due to price appreciation since January 1.

I was surprised that this group offered a yield so close to 4% considering it contained no MLPs or REITs, and no high yield-high payout stocks like Altria (NYSE:MO) or Verizon (NYSE:VZ). The yield is about 15% less than the Income-Growth DG model, but the dividend growth rates are doubled and the payout ratio is 42% lower. Seems like a great combination!

The majority of the portfolio resides in low-payout stocks. The table below sorts the portfolio holdings based on yield and payout for your reference.

Medium Payout
(45% to 60%)

Low Payout
(<45%)

Medium Yield
(2.1% to 3.5%)

Wal-Mart (NYSE:WMT)
Safeway (NYSE:SWY)
Walgreens (WAG)
Chevron (NYSE:CVX)
Travelers Comp (NYSE:TRV)
Eaton Vance (NYSE:EV)
Southside Banc (NASDAQ:SBSI)
Owens & Minor (NYSE:OMI)
CSX
Illinois Toolworks (NYSE:ITW)
Microsoft (NASDAQ:MSFT)
Harris Corp (NYSE:HRS)
Intel
BHP Billiton (NYSE:BBL)
Sempra Energy (NYSE:SRE)

High Yield (3.5%+)

Darden (NYSE:DRI)
Alliance Resource Partners (NASDAQ:ARLP)
Novartis (NYSE:NVS)
Lockheed Martin
Greif Inc (NYSE:GEF)
UGI Corp (NYSE:UGI)

Hasbro (NASDAQ:HAS)
Conoco Phillips (NYSE:COP)
CNOOC (NYSE:CEO)
Tower Group (NASDAQ:TWGP)
Astrazeneca (NYSE:AZN)
Raytheon
Textainer Group (NYSE:TGH)
NTT DoCoMo (NYSE:DCM)
China Mobile (NYSE:CHL)

Next Steps

I have created a virtual portfolio with the holdings as of the closing prices on December 31, 2011. I will continue to track this portfolio and report on its performance relative to the S&P (NYSEARCA:SPY), S&P Dividend ETF (NYSEARCA:SDY), and the other DG model portfolios.

Unlike with my other DG models, I decided to not apply my -20% stop-loss rule to the selections from this portfolio. With the payout average below 40%, I'm not convinced that the rule will apply in the same way as for higher payout stocks. Also, the reason some of these stocks are now high yielders is because of a price drop. The research study rebalanced its portfolio quarterly, so changes in earnings or dividends should get caught relatively quickly. I am hesitant to have a high level of turnover, though, so I am thinking about only replacing a stock if:

  • The dividend is cut, or the stock falls off of the CCC list.
  • The yield falls below 2.1% (low yield cutoff) or the payout exceeds 65% (high payout cutoff).
  • The stock slips into the Medium-Medium group AND there is an alternative with a higher score in one of the preferred categories.
  • Another stock in the same category has a score 2 or more points above a current holding -- still debating this one.

A full rebalance will occur annually, which will flush out any medium-mediums at that time and redistribute funds equally across all holdings.

I welcome feedback on this model and its process, as I continue to refine it based on comments, observations, and new learning. I hope SA members find the model and the recommended list useful for identifying potential candidates for their portfolios.

Disclosure: I am long COP, ARLP, CSX, INTC.

Source: A High-Dividend-Growth, Low-Payout-Ratio Portfolio