Russell Index Recap II: 'Safer' Russell 2000 Small-Cap Dogs Fetch Long-Term Gains

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Includes: AI, BBOX, BLX, CMO, CYS, DX, FSAM, IVR, MDLY, MITT, MTGE, NRZ, NYLD, ORC, PDLI, RAS, SIR
by: Fredrik Arnold

Summary

The power of the dog is in the pack, The power of the pack is in the dog. Dogs of Russell 2000 Index (R2K) prove the point.

47 of 100 Top (R2K) stocks with positive annual returns showed free cash flow yields greater than dividend yields 3/21/17. Those 47 were tagged "safer".

Top 10 "safer" March R2K annual yields ranged 9.61% to 17.54% from MTGE; MDLY; IVR; FSAM; MITT; NRZ; DX; RAS; CYS; AI. Their cash flow yields ranged 11.4%-62.57%.

Matched against top ten Dow Dogs, the "safer"  R2K ten produced 366% more dividend returns from $1k invested at 12.27% of the top ten Dow Dog aggregate single share price.

Analyst one year targets revealed top ten "safe" R3K stocks cast 33.36% more gain from $5k invested in the lowest priced five than from $5K invested in all ten.

The Dividend Dogs Rule

The "dog" moniker was earned by stocks exhibiting three traits: (1) paying reliable, repeating dividends, (2) their prices fell to where (3) yield (dividend/price) grew higher than their peers. Thus, the highest yielding stocks in any collection became known as "dogs." More specifically, these are, in fact, best called, "underdogs."

FTSE Russell states:

The Russell Indexes are a family of global equity indices that allow investors to track the performance of distinct market segments worldwide.

Using a rules-based and transparent process, Russell forms its indexes by listing all companies in descending order by market capitalization adjusted for float, which is the actual number of shares available for trading. In the United States, the top 3,000 stocks (those of the 3,000 largest companies) make up the broad-market Russell 3000 Index. The top 1,000 of those companies make up the large-cap Russell 1000 Index, and the bottom 2,000 (the smallest companies) make up the small-cap Russell 2000 Index.

Which Sectors Hold "Safer" Dogs Of The Russell 2000 Index?

Eight of eleven Morningstar sectors were represented by the 47 R2K firms who made money for the year and paid dividends bolstered by adequate cash as of March 21. The sector representation broke-out, thus: Financial Services (11); Real Estate (24); Communication Services (1); Utilities (4); Technology (2); Industrials (2); Consumer Cyclical (2); Consumer Defensive (1); Basic Materials (0); Energy (0); Healthcare (0).

Top ten R2K "safer" money making dogs showing the highest yields with a safety margin of cash to cover dividends by this screen as of March 21 represented the first two sectors on the list above.

Russell 2000 Index Firms With "Safer" Dividends

Periodic Safety Inspection

You see grouped below the list of 47 that passed the R2K index dog "safety" check with positive returns and sufficient annual cash flow yield to cover their anticipated annual dividend yield. The margin of cash excess is shown in the bold face "Safety Margin" column.

Corporate financial solvency however is readily overturned by a spendthrift or tightwad board of directors promoting company policies cancelling or varying the payout of dividends to shareholders. On the list above, for example, Dynex Capital (DX) has scaled down dividends the last four years. October 3, 2013 DX reduced its $.29 quarterly shareholder payout to $0.27, then April 2, 2014 cut it to $0.25, and April 1, 2015 cranked the payout down to $0.24, and March 30, 2016 sliced the quarterly payout to $0.21. What will Spring of 2017 bring? Similarly, Orchid Island Capital (ORC) slashed a $0.18 monthly dividend to $0.14 s of July 23, 2015. Finally, RAIT Financial Trust (RAS), brought it's distribution down 50% as of January, 2016 from $0.18 per share per quarter to $0.09.

All three examples were REITs whose dividends are tied to net profit per U.S. tax law.

Additional columns of financial data, listed after the Safety Margin figures above, reveal payout ratios (lower is better), total annual returns, and dividend growth levels for each stock. This data is provided to reach beyond yield to select reliable payout stocks. Positive results in all five columns after the dividend ratio is remarkable as a solid financial signal.

Dividend vs. Price Compared To Dow Dogs

Ten top "safer" R2K Index dividend dog stocks by yield were graphed below as of 3/21/17 and compared to those of the Dow. Annual dividend amounts from $1000 invested in each of the ten highest yielding stocks and their aggregate single share price created the data points shown in green for price and blue for dividends.

Actionable Conclusions: (1) Safer Top Ten Russell 2000 Index Dog Dividends Exceed Price 91% While (2) Safer Dow Dogs Price Exceeds Dividend 74%

Ten top "Safer" R2K Index dogs aggregate single share price for top ten yielding dogs was 9% of the dividend derived from $10k invested as $1k in each of the top ten stocks.

Meanwhile, "Safer" Dow dogs aggregate single share price for top ten yielding dogs was 74% of the dividend derived from $10k invested as $1k in each of the top ten stocks.

As a result, the Dow dogs overbought condition (where aggregate single share price of the ten exceeded projected annual dividend from $10k invested) created as a huge pricing disadvantage for new investors seeking long-term income.

The Overbought Dow

The Dow Dogs remain overbought and overpriced. Meaning, these are low risk and low opportunity Dow dogs. The "Safer" Dow top ten average price per dollar of annual dividend was $31.60 March 21.

In sharp contrast to the Dow, "Safer" R2K dividend dog top ten average price per dollar of annual dividend was $8.54 as of 3/21/17. That's about 27% of the price per dollar of Dow annual dividends.

To quantify top dog rankings, analyst mean price target estimates provided a "market sentiment" gauge of upside potential. Added to the simple high yield "dog" metric, analyst mean price target estimates provided another tool to dig out bargains.

Actionable Conclusion (3): Wall St. Analysts Predicted A 8.55% 1 yr. Average Upside and 13.26% Net Gain From the Top 30 "Safer" Russell 2000 Index Stocks

Top dogs on the "Safer" R2K stock list were graphed above to compare relative strengths by dividend and price as of March 21, 2017 with those projected by analyst mean price target estimates to the same date in 2018.

Historic prices and actual dividends paid from $10,000 invested as $1K in each of the ten highest yielding stocks and the aggregate single share prices of those ten stocks created the data points applied to 2017. Projections based on estimated increases in dividend amounts from $1000 invested in the ten highest yielding stocks and aggregate one year analyst mean target prices as reported by Yahoo Finance created the 2018 data points in blue for dividend and green for price. Note: one year target prices from one analyst were usually not applied (n/a).

Analysts projected an 7% lower dividend from $10K invested as $1k in the top ten February R2K "Safe" dogs while aggregate single share price was projected to increase by 7.5% in the coming year.

The number of analysts contributing to the mean target price estimate for each stock was noted in the next to the last column on the above chart. Three to nine analysts were considered optimal for a valid projection estimate. Estimates provided by one analyst were usually not applied (n/a).

A beta (risk) ranking for each stock was provided in the far right column. A beta of 1 meant the stock's price would move with the market. Less than 1 showed lower than market movement. Higher than 1 showed greater than market movement. A negative beta number indicated the degree of a stock price movement opposed to market direction.

Actionable Conclusion (4): Brokers Projected Top Ten Russell 2000 Index "Safe" Dog Stocks to Net 16.5% to 44.24% Gains By March, 2018

Four of the ten top "safe" dividend R2K dogs (tinted gray in the chart above) were verified as being among the Top ten gainers for the coming year based on analyst 1 year target prices. Thus the dog strategy for this R2K group as graded by analyst estimates for February proved just 40% accurate.

Ten probable profit generating trades were illustrated by YCharts analytics for 2018:

Fifth Street Asset Mgmt (OTC:FSAM) netted $442.37 per estimates from two analysts, plus dividends less broker fees. A Beta number was not available for FSAM.

Quad/Graphics (PDLI) netted $396.00 based on estimates from two analysts plus dividends less broker fees. The Beta number showed this estimate subject to volatility 39% more than the market as a whole.

Medley Management (MDLY) netted $288.64 based on a median target price from one analyst combined with projected annual dividend less broker fees. The Beta number showed this estimate subject to volatility 35% less than the market as a whole.

RAIT Financial Trust (RAS) netted $242.24 based on dividends plus the median of annual price estimates from three analysts less broker fees. The Beta number showed this estimate subject to volatility 68% more than the market as a whole.

NRG Yield (NYLD) netted $207.22 based on mean target price estimates from seven analysts plus dividends less broker fees. The Beta number showed this estimate subject to volatility 86% more than the market as a whole.

Arlington Asset Investment (AI) netted $194.04 based on target price estimates from seven analysts, plus dividends less broker fees. The Beta number showed this estimate subject to volatility 4% more than the market as a whole.

Black Box (BBOX) netted $184.60, based on dividends plus target price estimates from one analyst plus dividends with broker fees subtracted. The Beta number showed this estimate subject to volatility 30% less than the market as a whole.

Banco Latinoamericano (BLX) netted $175.81, based on dividend, plus a median target price estimate from three analysts, less broker fees. The Beta number showed this estimate subject to volatility 59% more than the market as a whole.

Select Income REIT (SIR) netted $166.41 based on dividends plus median target price estimate from five analysts less broker fees. The Beta number showed this estimate subject to volatility 34% less than the market as a whole.

NRG Yield (NYSE:NYLD.A) netted $165.27 based on median target estimates from three analysts, plus dividends, less broker fees. A Beta number as not available for NYLD.A.

Average net gain in dividend and price was 24.6% on $1k invested in each of these ten "Safe" R2K dogs. This gain estimate was subject to average volatility 21% more than the market as a whole.

Actionable Conclusion (5): (Bear Alert) Analysts Expected One "Safer" Russell 2000 Index Dog To Make A 3% Loss By March, 2018

A probable losing trade revealed by Thomson/First Call in Yahoo Finance for 2018 was:

Capstead Mortgage (CMO) projected a loss of $30.53 based on dividend and a median target price estimate from three analysts including $20 of broker fees. The Beta number showed this estimate subject to volatility 65% less than the market as a whole.

Dog Metrics Found Bargains In Lowest Priced "Safer" Dividend Russell 2000 Index Stocks

Ten "Safe" R2K firms with the biggest yields March 21 per YCharts data ranked themselves as follows:

Actionable Conclusions: (6) Analysts Predicted 5 Lowest Priced, of Ten "Safe" Dividend High Yield Russell 2000 Index Dogs, To Deliver 24.9% VS. (7) 18.67% Net Gains from All Ten by March, 2018

$5000 invested as $1k in each of the five lowest priced stocks in the "safe" ten R2K pack by yield were determined by analyst 1 year targets to deliver 33.36% more net gain than $5,000 invested as $.5k in all ten. The second lowest priced safer dividend R2K dog, Fifth Street Asset Mgmt (OTC:FSAM) showed the best net gain of 44.24% per analyst targets.

Lowest priced five "safer" R2K dogs as of March 21 were: RAIT Financial Trust (RAS); Fifth Street Asset Mgmt; Dynex Capital (DX); CYS Investments (CYS); Medley Management (MDLY), with prices ranging from $2.86 to $8.10.

Higher priced five "Safe" Dividend R2K Index dogs as of March 21 were: Arlington Asset Investment (AI); Invesco Mortgage Capital (IVR); MTGE Investment (MTGE); New Residential Investment (NRZ); AG Mortgage Investment (MITT), with prices ranging from $14.25 to $17.51.

This distinction between five low priced dividend dogs and the general field of ten reflects the "basic method" Michael B. O'Higgins employed for beating the Dow. The added scale of projected gains based on analyst targets contributed a unique element of "market sentiment" gauging upside potential. It provided a here and now equivalent of waiting a year to find out what might happen in the market. Its also the work analysts got paid big bucks to do.

Caution is advised, however, as analysts are historically 20% to 80% accurate on the direction of change and about 0% to 20% accurate on the degree of the change.

The net gain estimates mentioned above did not factor-in any foreign or domestic tax problems resulting from distributions. Consult your tax advisor regarding the source and consequences of "dividends" from any investment.

Author's note: See my instablog for specific instructions about how to best apply the dividend dog data featured in this article and this instablog to aid your safe investing.

Stocks listed above were suggested only as possible starting points for your safe dividend S&P500 dog stock research process. These were not recommendations.

Two of these Russell 2000 Index dividend pups qualified as a great catches! Find them among the now 52 Dogs of the Week (DOTW) I or among 31 DOTWII found on The Dividend Dog Catcher premium site. Click here to subscribe or get more information.

Sources: Graphs and charts were compiled by Rydlun & Co., LLC from data derived from ycharts.com; finance.yahoo.com; analyst mean target price by Thomson/First Call in Yahoo Finance. Dog photo: flickriver.com.

Disclaimer: This article is for informational and educational purposes only and should not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security. Prices and returns on equities in this article except as noted are listed without consideration of fees, commissions, taxes, penalties, or interest payable due to purchasing, holding, or selling same.

Disclosure: I am/we are long VZ, PFE, GE, CSCO.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.