Sometimes it’s a stock picker’s market and sometimes it isn’t — such as last year, when correlations among and within markets soared. But one equity investment strategy seems to offer investors an increased chance of outperforming the broad stock market: owning stocks of companies that offer a combination of better-than-average dividend yields, and below-average payout ratios. And despite the fact that Apple, Inc. has finally it announced it will begin paying a quarterly dividend, this is one portfolio that doesn’t include the Apple name. There are 73 other companies on our list of large-liquid stocks that fit the strategy, however. Collectively, they make up our 2012 High Yield and Low Payout model portfolio, refined using StarMine filters to reduce the chance of an individual stock blow-up.

WHY OWN HIGH YIELD/LOW PAYOUT COMPANIES?
Various studies have shown that high yield and low payout (HI LO) portfolios have outperformed other combinations of strategies since 1980. The chart below portrays the performance of a simple market-cap weighted version of this strategy, including stocks that offer dividend yields that are high but not the highest in the market, and dividend payout rates of up to 65% of the company’s earnings. While so far this year, this “high-low” strategy has underperformed the market, the valuations of these stocks remain attractive (see see High Yield, Low Payout Stocks Remain Appealing)

Chart 1. A SIMPLIFIED HIGH YIELD, LOW PAYOUT STRATEGY VS. S&P 500

Source: QA Studio

One might imagine that the “average” HI LO company is more conservative, offering investors a higher yield and lower forecast earnings growth than does a growth stock, and that it is therefore less volatile than the “average” stock in a large cap index. One would think that combining these factors would make it easier for investors to get a good night’s sleep. Of course, real life is more complicated: when financial markets were in full blown panic mode in 2008, the good, bad and ugly were jettisoned as investors moved to the sidelines. And even in the “junk” rally, when the market suddenly revived after hitting bottom on March 9, 2009, the portfolio slightly outperformed the overall market, according to our research. An observer would consider such a “conservative” investment approach to be an underperforming one.

Our 2010 model portfolio beat the S&P 500 by 250 basis points. The 2011 model portfolio did so by more than1300 basis points, as the investment world embraced the relative safety and income traits of higher-yielding stocks.

REFINING THE BASIC APPROACH
The 2012 Portfolio may enhance the original approach by using a variety of tools to screen out potential underperformers, with the aim of improving the odds that the portfolio will outperform. The four factors:

• StarMine SmartEstimates of forward 12-month earnings were used, to make sure that companies have sufficient income to keep their dividend payouts below 65% of earnings, thereby retaining a healthy percentage of their available cash to reinvest in the growth of their businesses. The 2012 HI LO’s dividend payout rate of 47% leaves the other 53% of earnings available for creating value through investments.
• We added an Earnings Quality (EQ) filter, proven to be an able forecaster of a company’s ability to sustain earnings. We excluded companies whose EQ scores put them in the bottom 20% of their universe. Among the stocks excluded were some like buyout giants KKR & Co (KKR.N) and Blackstone Group (BX.N), despite their dividend yields of 5% or more.
• Companies that appeared to be experiencing signs of financial distress, such as low interest coverage, high leverage, etc., also were eliminated. General Electric (GE.N) and Cablevision Systems (CVC.N) were among those companies excluded.
• Finally, we wanted to be sure that the remaining companies offered enough liquidity to make it possible for investors to readily execute purchases and sales. Therefore, we excluded any company whose trading volume fell below 300,000 shares daily. Indeed, in the portfolio listed in the attached link, all but two companies can boast average daily trading volumes of more than 400,000 shares.

SECTOR WEIGHTS
High dividend payers tend to be clustered mostly in the “boring” Consumer Staples and Health Care sectors, as seen in the chart below. The 2012 HI LO model portfolio sector weights (red bars) are compared to those of the S&P 500 (blue bars). Investors view these U.S. industries as being less “growth-y” and therefore able to pay a larger percentage of their earnings in the form of dividends. At the bottom of the chart is the most underweight sector, Information Technology; within it, only the largest companies pay dividends at all with most companies choosing instead to plow earnings back into the firm to finance new investment and future growth.

Chart 2. SECTOR WEIGHTING OF 2012 HIGH YIELD, LOW PAYOUT VS. S&P500 RANKED BY DIFFERENCE

Overall, the 2012 HI LO model portfolio yields about 3.4% versus 1.9% for the S&P 500. That difference is about the same as that seen in the 2011 model portfolio, and a bit lower than the 1.7 percentage point spread between the 2010 model portfolio and the market.

Within the 2012 HI LO portfolio, there are three companies now lagging behind their peers when it comes to investment returns that may be attractive to investors who are looking for value:

Insurance and risk management consulting firm Willis Group Holdings (WSH.N) reported earnings that fell short of analysts’ estimates in the latest quarter; its stock price dropped more than 10% the next day and is still down about 8% year to date. Willis currently yields 3.1%.

The stock price of agricultural products giant ConAgra (CAG.N) is roughly flat so far this year, while the S&P 500 has climbed 12%. It is possible that ConAgra’s next quarterly earnings report, scheduled for release in the coming days, may send the stock in either direction. ConAgra currently yields 3.6%.

Pfizer (PFE.N), one of the bellwethers of the pharmaceutical industry, moved higher recently along with other pharma firms, and again after a presentation at a broker-sponsored conference. The company announced it was parting ways with a partner in India related to a business the two had been engaged in involving developing generic medications for developing nations. Pfizer currently yields 4.0%

Year to date, the 2012 portfolio lags the S&P 500 by almost 8 percentage points. A significant part of that underperformance is due to the rally in banking and other financial stocks as well as the explosive gain in Apple and other technology companies, all of which are under-represented in the portfolio. If this pattern continues, then we expect the HI LO model portfolio will continue to underperform, as the “risk on” attitude prevails. When uncertainty rears its head once again, a portfolio similar to the one illustrated here may well outperform.

 
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