Picking Stocks And Printing Profits

by: Bennington Investment Ideas

The stock market is a fickle beast and with good reason. It is the reflection of collective greed, fear, and best efforts of millions of investors. Some adhere to a belief that the market is efficient and passive investing is the only sound approach, while others believe active and disciplined approaches can yield profits. Still others have abandoned the market's turbulence and perceptions of corruption. Whatever the case, those who have held on through the past five years have recovered losses and are now largely ahead. Investors who added to positions during its depths of decline in late 2008 and early 2009 have made significant profits.

Wall Street has often been criticized for its copious number of buy ratings. The height of the internet bubble typified this exuberance. Subsequent legislation required disclosure of the percentage of types of ratings issued. Seeking Alpha has no such requirements and offers a enormous array of articles covering a range of viewpoints on what can seem like every single stock. It would not surprise me, if you could find a positive viewpoint on pretty much every significant stock in a given month. And by significant, I'd almost be willing to drop the bar to stocks possessing ticker symbols. The articles augmented with comments can provide a wealth of information, new ideas, and tickers to investigate.

The current bull market has not been fully embraced and there are many good reasons to remain skeptical. However, the past eleven months have been undeniably good, as long as Apple Inc. (NASDAQ:AAPL) wasn't your complete portfolio. Just how good has it been? I worked through 5,282 stocks for which I had basic metrics from May 18, 2012 and compared their performance since that time. This list excludes stocks with a market capitalization below $10 million. Among these stocks 70% had a positive return. The market capitalization weighted average total estimated return was 21.0%. Take away AAPL and that return estimate creeps up to 21.9%.

Performance by Market Cap Grouping
Market Capitalization (May 2012) Stocks with Positive Total Return Number of Stocks Percent Total Return Estimate
$20+ Billion 257 302 85% 19.6%
1000-20000 million 1424 1755 81% 23.5%
500-1000 million 388 547 71% 19.5%
250-500 million 357 545 66% 21.6%
100-250 million 457 710 64% 23.9%
10-100 million 795 1423 56% 84.9%
Total 3678 5282 70% 21.0%

Source: Data provided by Zacks.com for May 18, 2012 and April 18, 2013, Author Calculations. Total return is calculated as dividend yield at May 2012 plus price appreciation.

So the case for mega cap stocks is even stronger, it was pretty hard to pick a loser eleven months ago. In fact, if you chose five stocks with market capitalizations over $20 billion, these statistics show that there was only .01% chance that all five would be losers. However, the ease of doing so increases as the market capitalization declines. But for those investigating the micro caps, the rewards can be enormous. The second screen is to group stocks by dividend yield.

Performance by Dividend Yield Grouping
Dividend Group (May 2012) Stocks with Positive Total Return Number of Stocks Percent Number with Price Appreciation Percent Total Return Price Appreciation
No Dividend 1771 3018 59% 1771 59% 15.8% 15.8%
0 -1% 226 263 86% 225 86% 25.9% 25.3%
1 -2 % 395 488 81% 387 79% 20.0% 18.5%
2 - 5% 889 1042 85% 834 80% 22.3% 19.0%
5 - 7.5% 223 260 86% 214 82% 22.9% 17.2%
7.5 - 10% 98 116 84% 90 78% 29.0% 20.6%
10% + 75 95 79% 62 65% 17.7% 4.6%

Source: Data provided by Zacks.com for May 18, 2012 and April 18, 2013, Author Calculations. Total return is calculated as dividend yield at May 2012 plus price appreciation.

This second table is interesting for several reasons and is also important for highlighting a challenge in the methodology. The first observation is that dividend paying stocks outperform non-dividend paying stocks. Note that many of the smaller market capitalization stocks fall into this category. The next observation is that with performance, especially in terms of price appreciation, there is some bias towards higher yielding stocks. This does raise the issue of whether there is systematic bias towards higher dividend yields. If people are creating more demand for these stocks than others, it might result in an overvaluation. The nice counter is that the 1-2% dividend yield stocks actually had the highest level of price appreciation and the second highest total return estimate.

The final observation is also linked to a methodology concern. As noted, the total return estimate is based upon the dividend yield in May 2012 plus the price appreciation. If the dividends are not paid as expected, whether it is cut or increased, the actual total return would be different from the estimate used. This would also include stocks that began paying dividends since May 2012.

AAPL is a notable company in this group; however, its dividend would not offset the stock price decline. Annaly Capital Management, Inc. (NYSE:NLY) is an example of a company that has since cut its dividend. On May 18, 2012, the stock closed at $16.15 and had been paying a quarterly of dividend of $0.55 per quarter for a yield of 13.6% - very attractive. However, the company subsequently cut the dividend to a current rate of $0.45 per quarter for an estimated annual yield of 11.4%. This means that the actual return was 9.5% instead of the estimated return of 11.1%. In some cases, this would shift the percentages of stocks with positive returns a little, but not much. It should also be noted that some stocks, like AAPL, have estimated returns that are below their actual returns.

This issue is important when one looks at the last group of stocks with 10+% yields. Most of these stocks had relatively low overall returns and most of that return was embedded in the dividends. This highlights the risk of chasing yield. I've long been a skeptic of companies like Frontier Communications Inc. (NYSE:FTR) for these reasons.

Lessons for Investors

I had initially started doing this analysis to try to see if there has been bias towards dividend yield stocks. Are they becoming overvalued? I raised this question in an earlier article, and subsequently markets have performed quite nicely. Since that article, the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) is up from $139.35 to Friday's close of $155.48, a gain of 12% before dividends. Johnson & Johnson (NYSE:JNJ) climbed from $69.12 to $84.49 for a nice gain of 22% and delivered $1.83 of dividends (3 quarterly payments since August 6, 2012). In contrast, International Business Machines Corporation (NYSE:IBM) is down about 4%, but did pay $2.55 in dividends, with another dividend coming shortly. While this analysis notes some concern, I definitely would not consider it to show a conclusive bias towards higher yields. I found a very low correlation between returns and yields based on the data pulled with a linear regression despite the averages noted earlier.

Beware of very high yields - I do think the very highest dividend yields should raise concerns though, and require a thorough examination of how sustainable that dividend is and appreciation for the notion that your principal might not appreciate very much and in fact, could very easily decline. A simple question to ask is whether the yield is high because the stock price is declining or because the dividend is growing.

Risk and return - If you threw a dart at the Wall Street Journal on May 18, 2012, you most likely picked a winning stock. However, this doesn't necessarily mean that you were adequately compensated for the risks you took. Nor does it say anything about the future performance of that stock. Picking individual stocks is tough and requires good research. Warren Buffett espouses his margin of safety - this is an approach designed to manage investing risk.

Euphoria and caution - The stock market has done quite well recently and there is still a lot of money on the sideline, meaning that there is still upward fuel. However, I still think there are challenges ahead for investors. Over the next year, there might be upward pressure from money entering the market that results in price outpacing fundamental performance. This would be a concern. In my own investing, I've been letting my cash reserves grow with very limited additions to stocks. I had even sold some positions back in the Fall of 2012.

Over the past eleven months, investors have been able to print profits. It almost didn't matter whether they bought dividend stocks, high yield, low yield, no yield or any range of sizes of stocks. Any reasonably diversified portfolio since May 18, 2012 has performed well. However, the word printing was used deliberately since it links to paper. Paper profits are nice, but they can also disappear as some AAPL investors have been learning.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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.