The third quarter – historically a difficult time for stocks – has begun; maybe it’s time to revisit companies with high dividend yields and low payout ratios?

Released: July 11 2012
Length: 3 Minutes

As we approach September, which on average can be the worst month for stocks, watch the three minute video to see how a model portfolio in Datastream Professional with Portfolio Analytics picks stocks with the most desirable factors—and may be what you want to include in your own holdings over the next 90 days.

It’s official: the second quarter is over, and we’re now venturing – gingerly – into the third quarter of 2012, the three-month period that will wrap up with what has historically been the worst month for stock prices: September. That begs the question of where an investor can turn in search of refuge in the months to come.

One possible answer: stocks that generate higher than average dividend yields for investors, but are able to do so by using a relatively smaller proportion of their earnings to make those payments. These high yields/low payout companies had begun attracting attention and cash inflows from investors during the second quarter, and as we’ll explain, they offer some attractions during periods like this.

StarMine analysts constructed a model portfolio of over 70 stocks with the above characteristics. That leaves those companies with plenty of leftover cash to use to fuel growth. That Hi-Lo portfolio, which our analysts create annually since 2010, offers many characteristics of companies that are in a stronger financial position than the market as a hole, among them being higher scores on StarMine’s measure of earnings sustainability, also called Earnings Quality. During the first quarter the S&P 500 extended the market rally that began late in 2011, and the Hi-Lo portfolio lagged until March 23, when the performance spread peaked. At that point, the total return of the S&P 500 was 11.6%, compared to 4.4% of the Hi-Lo model portfolio. But during the second quarter, that pattern slowly began to change, ending with the S&P 500 total return at 8.8%, and the Hi-Lo at 5.8%.

The characteristics of these companies – proven cash generators, healthy dividend payers with lots of retained earnings for reinvestment in the business – are obviously becoming attractive. That isn’t surprising: StarMine models show that more than 40% of the stocks in the model portfolio possess the same fundamental factors that institutional investors appear to prize and are most likely to look for in the coming 90 days. Moreover, none of the companies in the Hi-Lo portfolio score in the bottom 20%; none of them is tarnished with the label “utterly undesirable”. Given that government bond yields spent the second quarter edging to fresh lows, the above-average dividend payments look alluring, too.

One of the companies in the portfolio, asset management firm Waddell & Reed Financial (WDR.N), offers a dividend yield of 3.1%. Analysts believe it will be able to generate enough cash to cover that dividend 2.5 times. Moreover, the company has an Analyst Revisions Model (ARM) rank of 87, meaning that it is more likely than the vast majority of other U.S. stocks in the StarMine universe to see upward earnings revisions in the future. As well, the ARM score is an indicator of the direction of potential earnings surprises. An extra boon: free cash flow significantly exceeded net income at Waddell & Reed in 2011, another positive sign.

Looking for high-yield, low-payout companies has been proven to pay off over the long haul, such as the period from 2006 until mid-March. It’s worth considering this as a strategy to ride out what could well prove to be some tumultuous months during the third quarter of 2012.

More details about the model portfolio can be found in our article published earlier this year, only days before the spread between the Hi-Lo group of companies and the broader market peaked and began to contract once more.

 
Learn more about how StarMine analytics can help you pinpoint critical developments in your portfolio or watch list.
Request a free trial today.