2 Tips For Better Dividend Stock Selection

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Includes: ADT, ANTM, CCEP, CF, DE, DNR, EV, F, GAS, GME, HES, IBM, INTC, JNJ, JNPR, K, LYB, MAC, MIC, MUR, NAVI, T, VZ, WEC, XL
by: Kurtis Hemmerling
Summary

Dividend yield alone is a poor predictor of future stock returns.

Two research papers highlight simple methods to enhance returns.

I turn these concepts into S&P 500 portfolios along with historical backtesting.

Dividend yield is an important factor to many investors when selecting stocks to be held in a portfolio. Yet, dividend yield alone is not a great predictor of future returns as borne out by various research studies (see tip#2).

My relatively short-term test confirms this. The chart below depicts the relationship between yield and return for all dividend stocks in the Russell 1000 index from 1999 until mid-2015.

What is this chart telling us?

  • The first bar represents the equal-weight return of the entire S&P 500 index (which would be 1%-2% higher if you include dividends).
  • The following 10 bars represent annualized returns based on relative dividend yield. The lowest dividend yielding stocks are represented by the second bar (blue) and the highest dividend yielding stocks are represented by the last bar (green).

If dividend yield is a strong predictor of returns, you should see the average annualized return increase with each bar. As you can see, there is only a weak relationship between dividend yield and future return.

What additional analysis can be done to enhance dividend yield investing? We will consider a two findings that have the potential to improve our dividend stock selection.

Tip #1: High Yield / Low Payout Ratio

The High Yield, Low Payout white paper by Credit Suisse is well-known by many. The paper outlines the improvement of returns by adding a low payout filter to the high yield category. It also shows that high yielding stocks with medium to high payout ratios performed rather poorly between the years 1995 and 2006.

There are a few ways to create a high yield/low payout ratio system. I will focus on the one that I have found to be superior. Using the Portfolio123 platform I can create a fuzzy logic ranking system that scores stocks based on dividend yield and the trailing 12 month payout ratio. The relative scores are combined and the highest total scoring stocks are retained in a portfolio.

There is a clear and definite enhancement when factoring in the payout ratio to dividend yielding stocks in the Russell 1000 index since the year 1999. If you created a 25 stock portfolio that replaced holdings every 3 months, this would have been your return since 1999.

I mentioned that there is more than one way to construct this type of portfolio. In this regard I encourage you to use caution. For example, you could define rules that filter stocks in the highest one-third of dividend yields as well as in the lowest one-third of payout ratios. Using the high yield/low payout ratio principle in this way would have been rather devastating.

Although a low payout ratio can enhance returns of high yielding stocks, the way in which you construct your strategy makes the difference between success and devastation.

Interestingly enough, some of the highest ranked stocks using the first high yield / low payout ratio method are also stocks with at least 5 consecutive years of dividend increases.

Ticker

Name

Yield

PayRatioTTM

(NYSE:MIC)

Macquarie Infrastructure Corp

4.92

28.64

(NYSE:MAC)

Macerich Co (The)

3.22

26.69

(NYSE:MUR)

Murphy Oil Corp

3.2

28.23

(NYSE:IBM)

International Business Machines Corp

3.08

27.9

(NASDAQ:INTC) *

Intel Corp

3.01

37.63

*Intel Corp only maintained the dividend between 2013/2014.

Why might high yield / low payout ratio investing work? Really, it is pushing you towards high yielding stocks with deep value. If the dividend yield is large compared to the share price, yet relatively small when compared to the earnings, you are buying a stock with a low P/E ratio.

For instance, if the dividend yield is 10% and the payout ratio is at 50%, then the earnings yield must be 20% (or a P/E ratio of 5).

Tip #2: Total Payout Yield

The second enhancement relates to the paper, On The Importance of Measuring Payout Yield. The researchers re-iterate recent studies that state dividends have little predictive power of stock returns. They also note that total payout yield has a higher correlation to future returns than yield alone. The higher the total payout yield the higher the future stock return.

What is total payout yield? We know what dividend yield is. Total payout yield combines equity used to pay dividends as well as share repurchases. The underlying concept is that a firm can return value to the shareholder through dividends or share reduction. This combined ratio is referred to as total payout yield.

What is the advantage of total yield? As an example, take 2 companies of the same size and market capitalization.

  • One company pays $100 million in dividends and $50 million for share repurchases.
  • The other company pays $50 million in dividends and $200 million for share repurchases.

If you only consider dividend yield, you would be passing over the company that returned more value to the shareholder compared to the share price.

To create a total yield ranking system I use the following formula:

  • (Dividends paid (trailing 12 months) + net share repurchase value (trailing 12 months) )/ Enterprise Value

Using enterprise value (EV) instead of market capitalization is my personal twist to reward companies with less debt and/or more cash. Thus, if all other variables are equal (dividends, net share repurchase and market capitalization), the stock with less net debt will achieve a higher total yield.

The relationship between total yield and performance is much stronger than dividend yield or even the high dividend / low payout ratio system.

The total yield system may pose a problem, however, if you require high income yield since the highest ranked stocks represent the combined value of net share repurchases and dividends compared to enterprise value. The most desirable stocks could have a small dividend, or none at all, in some instances.

A Sample Portfolio

Finally, I will create 2 sample portfolios for those of you who want to implement some of these tactics.

These are the rules we hold in common for both portfolios:

  • S&P 500 stocks
  • Dividend yield greater than 0
  • Only one stock per sector (the one with the highest rank)
  • Re-balance and replacement of stocks once per year
  • Test runs from January 1999 to June 2015

This list represents the stocks selected by the total payout yield formula at the beginning of this year.

Total Yield Portfolio 2015

Ticker

Name

Yield

(NYSE:JNPR)

Juniper Networks Inc

1.9

(NYSE:LYB)

LyondellBasell Industries NV

3.97

(NYSE:HES)

Hess Corp

1.5

(NYSE:ADT)

ADT Corp (The)

2.62

(NYSE:GME)

GameStop Corp.

4.09

(NYSE:XL)

XL Group Plc

1.84

(NYSE:ANTM)

Anthem Inc

1.43

(CCE)

Coca-Cola Enterprises Inc

2.32

(NYSE:T)

AT&T Inc

5.72

(NYSE:WEC)

Wisconsin Energy Corp

3.35

This next list represents the high yield / low payout ratio portfolio starting in January 2015.

High Yield / Low Payout Ratio Portfolio 2015

Ticker

Name

Yield

(NYSE:DNR)

Denbury Resources Inc.

3.91

(NYSE:CF)

CF Industries Holdings Inc

2.41

(NASDAQ:NAVI)

Navient Corp

2.88

(NYSE:F)

Ford Motor Co

3.34

(NYSE:DE)

Deere & Co

2.78

International Business Machines Corp

2.83

(NYSE:VZ)

Verizon Communications Inc

4.83

(NYSE:GAS)

AGL Resources Inc.

3.83

(NYSE:K)

Kellogg Co

2.99

(NYSE:JNJ)

Johnson & Johnson

2.68

Final Thoughts

The message that I pick up loud and clear is that I cannot be overly focused on dividend yield when selecting stocks. While the high yield / low payout ratio concept has merit, my preference is to use the total payout yield formula as it stays relevant regardless of a firms' preference for paying dividends or share repurchasing.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.