Yield Cycle Theory
Although dividends are not guaranteed, institutions like banks, insurance companies, pension funds and retirees act as if they are and view dividends as a predictable source of income. The cumulative effect of these institutions and individuals buying yield creates demand for divided paying stocks, such as Stanley Black & Decker (NYSE:SWK). Their goal is simple, produce as much income in the shortest period of time, without taking on too much risk.
Since dividends are not guaranteed, however, these investors often wait for a dividend yield large enough to compensate for the risk they take. Once the yield becomes attractive, this investment community starts buying. The result is upward pressure on stock prices. This upward movement in stock price then leads to falling yields, eventually reaching a point where investors believe the risk is too great for the low return, and they start selling. This selling creates downward pressure on stock prices and eventually leads to a high yield once again, thus beginning a new dividend yield cycle.
Case Study: Stanley Black & Decker
Tracing its roots back to 1843, Stanley Black & Decker has been providing customers with power & hand tools, products & services for industry, and security & monitoring devices for over a century.
Dividend Yield History
Examining Stanley Black & Decker's historical dividend yield, one will notice a typical range of 2%-4%. Because unique growth rates and profit margins, institutions may find buying Stanley Black & Decker attractive at a 4% dividend yield, yet find Realty Income unattractive when it is also at a 4% dividend yield.
Observing yield alone, however does little good.
Margin of Safety Identification
It can be seen that buying at these high yield extremes were when substantial gains were made.
For Stanley Black & Decker, the high price low yield area has often occurred near 2%. Examine the performance of buying when SWK was yielding 2% in 2003.
It is often at these low yield extremes when fortunes were lost.
Identifying this low price high yield, high price low yield range, value ranges based on investor psychology are established.
By no means is the yield cycle an exact science. Deteriorating business conditions, low commodity prices or high interest rates, among other causes, may lead to dividends being reduced or even eliminated. Because dividends are not guaranteed, this methodology should not be a simple buy or sell rule. When a company merges, new growth rates, profit margins, and payout ratios may change historical yield ranges. These factors require users of this theory to perform additional investment analysis.
An important aspect of this theory is that each company has a unique yield level where institutions find buy and sell opportunities. Simply buying because the yield is high relative to other stock or bond rates does not indicate a safe buy opportunity. Unfortunately, too many fall for the yield trap, as those investing in Master Limited Partnerships fell prey to in 2015.
In early 2015, when ten year treasury rates were 1.91%, a dividend yield of 5.57% with MLPs looked relatively attractive. What followed, however, was a catastrophic 62.3% downturn. As with a dating pool full of unattractive individuals, picking the least unattractive does not mean you will be happy with the end result.
Current Situation & Opportunity
After an almost threefold price increase since the most recent 4% dividend yield, Stanley Black & Decker is now yielding only 1.84%, a near record low. Evidenced through years of successful reinvesting earnings and increasing dividends, Stanley Black & Decker is one of America's great companies. According to the dividend yield theory, however, this low yield is currently offering an unattractive reward for the risk institutions may take. Unless a merger occurs, or revenue and margins increase substantially for Stanley Black & Decker, might this low yield indicate a good time to take some profits?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.