High Dividends, Inferior Returns

Jul.23.12 | About: SPDR Dividend (SDY)

If ever there has been a time to own companies that pay above-market dividends, this would seem to be one of the better ones. The dividend yield of the S&P 500 (SPDR S&P 500 Trust ETF: SPY), while relatively low in the absolute sense, stands out against intermediate generational-low Treasury and Corporate yields. At 2.1%, the yield is 30 bps above the median over the past two decades and almost double the 1.1% low as we entered this century. Not surprisingly, many investors—starved for income on their investable assets—have been transitioning out of fixed-income into alternatives, such as dividend-paying stocks.

Stocks are not bonds, so the strategy can add price volatility to one's portfolio, but it is one that I have been writing about for a couple of years now, sharing ideas over time about REITs, Utilities, BDCs, and dividend-growth stocks. Last fall, I warned about chasing very high yields in an article that was an "Editor's Pick" but that razzed many readers. The bottom-line is that some higher-yielding stocks deserve to be higher-yielding—they are riskier. My conclusion was that dividend yield should never be a primary consideration, as one must evaluate other metrics of valuation and the financial strength of the company.

Today, I want to point to what must be a frustrating experience for those invested in the SPDR S&P High Yield Dividend (NYSEARCA:SDY), which is based on the S&P 500 High Yield Dividend Aristocrats index (SPHYA). According to S&P:

The S&P High Yield Dividend Aristocrats index is designed to measure the performance of companies within the S&P Composite 1500 that have followed a managed-dividends policy of consistently increasing dividends every year for at least 20 years.

According to State Street, which manages SDY:

The S&P High Yield Dividend AristocratsTM Index is designed to measure the performance of the highest dividend yielding S&P Composite 1500 Index constituents that have followed a managed-dividends policy of consistently increasing dividends every year for at least 20 consecutive years.

Note that the S&P definition seems to leave out the most important aspect: The focus on high yield within a subset. Also, the number of years required for increases in dividends is fewer than what has been required historically for the Aristocrats. S&P describes the S&P 500 Dividend Aristocrats index (SPDAUDT):

The S&P 500® Dividend Aristocrats index measures the performance of large cap, blue chip companies within the S&P 500 that have followed a policy of increasing dividends every year for at least 25 consecutive years.

Note that they just lowered the bar, changing the minimum to 20 years from 25 years. I couldn't find the press release directly from S&P, but here is a link to a Barron's article that describes it. These changes just hit and aren't reflected yet on the S&P website, so I am working with the older list.

So far this year, SPHYA has returned 5.72%, which includes over 2% from dividends. The Dividend Aristocrats, though, has returned 9.57%, just below the S&P 500's 9.65% return through 7/20. Pursuing a relatively high-quality dividend strategy (as the companies in SDY can only be described this way) has been inferior to both a dividend-neutral Large-Cap strategy (S&P 500) as well as the plain Aristocrat strategy.

The latter has been the case over longer time-frames, as the High Yield Dividend Aristocrats index has returned 1.98% over the past five years (through 6/30) and 17.95% over the past three years compared to 5.21% over the past five years and 21.05% over the past three years for the Dividend Aristocrat index. Thus, a lower yield, but higher total return for the Aristocrats compared to the High Yield Aristocrats.

In order to understand the differences in this year's performances for the two indices, I downloaded the constituents from S&P and pulled out the common names, focusing on the extra names from outside the Aristocrats that are included in the High Yield Aristocrats (17 companies) and those excluded (9 companies) and ignoring the 42 common companies:

Click to enlarge

Click to enlarge

The extra stocks tend to be smaller. The average market cap is $2.5 billion, with a range from about $1 billion to as high as $4.2 billion. The average dividend yield for this group is 3.9% (3.6% for the index, so these are higher than average), and the net debt to capital is 33%. The group has grown dividends by a compounded 3% per year over the past 5 years. The average total return in 2012 through 7/20 is just 1%, with a price decline of 1.1%. I highlighted stocks returning more than 10% relative to the S&P 500 in green and marked in red those lagging by more than 10%. There were 2 winners, 9 losers and 6 within the range.

The excluded stocks have an average market cap of $11.8 billion, substantially larger than the extra stocks. The smallest is $4.9 billion, while the largest is $23.7 billion. The average dividend yield for this group is 1.3%, which is below the average of the S&P 500 and significantly lower than the yield of the extra stocks. The balance sheets appear to be stronger too, with a 22% net debt to capital and four of the names with less than 10% net debt to cap. The group has grown dividends by a compounded 9% per year over the past five yearstriple the growth of the extra stocks. The excluded stocks have returned 18% so far in 2012, with price accounting for 17.3%. In contrast to the 4.5:1 ratio of laggards to leaders in the extra stocks, the excluded stocks have two big winners and just one big loser. The other six have returns ranging from 8.2% to 19.5%, so all doing reasonably well.

As an aside, I own Franklin Resources in my Top 20 Model Portfolio and my Conservative Growth/Balanced Model Portfolio at Invest By Model. I also follow C.R. Bard (BCR), Family Dollar (FDO) and Hormel (HRL) very closely (on my 100-stock watchlist) and am quite familiar with the others that have been excluded. I like HRL right here, after the corn-spike induced pullback.

So, what's going on with the lagging performance of SDY? There is a modest negative impact due to market cap perhaps. I doubt the stronger balance sheets on average are making much of a difference. I think it's growth! 3X the average growth in dividends over the past five years. In an environment where the only thing more scarce than yield is growth, growth is valuable. I should also point out a potential bias among those pursuing dividend strategies that may be penalizing smaller companies to a greater extent than the overall market.

I am not advocating avoiding SDY, but rather trying to illustrate a very simple point: There's more to investing than going with the highest yield. In the long-run, the dividend paid today is a lot less important than the dividend the company will pay in five to ten years, as the dividend streams will ultimately equalize and the price return could be higher due to a higher earnings level, if that is the case.

The dividend growth is influenced by future earnings growth and the payout ratio. Quite simply, the lower the payout and the higher the growth, the higher potential dividends over time. Many others on Seeking Alpha have written about the topic of dividend-growth investing, which encompasses this mindset. Hopefully, this discussion provokes you to think about your income-enhancing strategies.

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

Additional disclosure: BEN is held by one or more models managed by the author at InvestByModel.com