Idea of the Week: Dividends Still Matter

January 16th, 2013 by

The fourth quarter of 2012 may have witnessed a rush to the exit with respect to dividend stocks, but many high-quality names still managed to outperform the S&P 500. A dividend stock strategy based on an intelligent system of excluding potentially troublesome holdings may be the basis of a thoughtful dividend investment strategy in 2013.

Released: January 16 2013
Length: 3 Minutes

Over the last several weeks, the prospect of paying more in tax on their dividend income has soured some investors on the idea of owning dividend-yielding stocks. If you listen to the media, you would imagine that this had produced an across-the-board rush to unload dividend payers and a widespread resolution on the part of investors to avoid this group. But this gives the group a bad rap. For one thing, some dividend payers fared better than others in spite of this selling pressure; for another, there are three solid reasons why dividends still matter.

Some high-quality dividend payers outperformed the S&P 500 for the third year running. As shown in the chart below (represented by the blue line), the S&P 500 has generated a total return of 7.6% since last March, when we first published our list of stocks offering a combination of high yields and low payout ratios. This list (represented by the orange line in the chart below) was made up of companies that passed muster on StarMine’s tests of credit quality and dividend sustainability. These companies as a group not only outperformed the S&P 500 index for the third year in a row, with an 10.2% gain that is depicted in the orange line in the chart below, but also beat the popular Vanguard Dividend Appreciation ETF (VIG.N), which, as represented by the green line in the chart below, itself generated a total return of 8.7%.

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There are several reasons why dividend stocks are likely to remain very important to investors, even if that dividend income is taxed at a higher rate. Beside the fact that the ‘great dividend exit’ – the rush to sell in the fourth quarter of 2012 and especially in 2012, in light of the debate over the ‘fiscal cliff’ and the possible end of Bush-era tax reductions – was widely telegraphed in advance. That gave investors plenty of opportunity to sell, and with that selling pressure removed, cleared the way for a new round of investor interest in dividend stocks. Secondly, yield-hungry investors simply don’t have much in the way of choices: yields on fixed income investments simply aren’t attractive enough on either an absolute or relative basis and the Federal Reserve has shown no signs of taking its foot off the stimulus gas pedal. Any competition for yield outside the equity market isn’t much competition at all. Finally, U.S. investors still have access to an array of tax-advantaged accounts in the form of IRAs, 401(k) plans and other vehicles, all of which enable them to defer any taxation of their income for years, if not decades.

If the main point is that there are still plenty of reasons to own dividend-paying stocks, the next logical question becomes which ones to hold in your portfolio. We created our own StarMine list of dividend-paying stocks from a disciplined process that has delivered a higher rate of total return than the S&P 500 since we first put it together in 2010. Rather than starting by adding one company after another to that list, it is built by deciding what stocks not to include – a process some call ‘outdexing’ and that involves eliminating companies that have undesirable or less desirable characteristics.

In the case of this dividend stock portfolio, we began with a list of all U.S. publicly traded companies that pay dividends. The first elimination round removed all names from this universe except those that score in the 8th and 9th deciles in terms of yield. (One exception to this rule is Verizon (VZ.N), which isn’t in these two deciles but which meets every other requirement on the list.) This eliminates the highest-yielding companies (where companies with ‘junk’ credit ratings are more likely to be found) and also those with lower yields. From that second, smaller list, we go on to eliminate all companies that pay out more than 50% of their earnings in dividends, to ensure that the companies that we select retain enough funds to reinvest in their businesses for future growth. This step ends up removing many utility companies: only NextEra Energy (NEE.N), with its commitment to renewable as well as traditional energy, survives this round of cuts.

From there, we move on to identify the companies with the strongest earnings sustainability by using StarMine’s Earnings Quality (EQ) Model to ‘outdex’ those companies that rank in the bottom 20% when their earnings sustainability is graded. This is the point where we bade farewell to stocks issued by private equity management company Blackstone Group (BX.N) and packaging company Sealed Air Corp (SEE.N).

Then comes a test for financial credit risk, in which we use the SmartRatios Credit Risk Model to identify those companies that rank in the bottom decile. Here it was time to bid farewell to widely held General Electric (GE.N), whose score in this category ranked it among the bottom 10%. The final step was to check StarMine’s SmartEstimates and see what analysts are saying about the earnings forecasts for each of the companies that has survived each of the previous “outdexing” rounds. The goal here is to maximize the chances of companies keeping 50% or more of their earnings by comparing the dividend payments to the SmartEstimate for earnings over the coming 12 months. High-yield and low-payout stalwarts like Procter & Gamble (PG.N) and Lockheed Martin (LMT.N) were among the companies that made it all the way through this rigorous process only to fall short at the last stage.

This year, this process produced a list of 59 companies with financial stocks – banks and insurance companies – dominating. There are a total of 16 companies on our list that fall into this category, including JP Morgan Chase (JPM.N), one of the country’s largest banks, six other banking companies and six insurers, among them Travelers (TRV.N) and AFLAC (AFL.N). The list also includes six companies in the Thomson Reuters Technology sector – led by Microsoft (MSFT.O), Intel (INTC.O) and, more controversially, Hewlett-Packard (HPQ.N).

Although the “outdexing” process ended up removing Lockheed Martin from our final list, several other defense industry stocks make the cut, including Northrop Grumman (NOC.N), Raytheon (RTN.N), General Dynamics (GD.N) and L-3 Communications (LLL.N). Currently they’re celebrating a period of outperformance, having generated a total return of 13.5% in the six months ended January 14, 2013, compared to 9.7% for the S&P 500 index.

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The full list of the 59 companies that survived this “outdexing” process and appear to offer the best characteristics amongst dividend-paying stocks can be found here, sorted by sector.

This kind of outperformance is one example of the kinds of gains that can flow from a rigorous and disciplined investment process. In the case of dividend stocks, that kind of process may be successful when it focuses as much or more on excluding potentially troublesome portfolio companies than it does on including potential outperformers, and uses reliable quantitative models such as those developed and tested by StarMine to drill down into the reasons that underlie a particular model score.

 
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  • http://twitter.com/PlunkettDonnie Donnie Plunkett

    I think dividends matter a lot and a lot of good dividend payers already issues special dividends at the end of 2012 to avoid higher tax rates.  Those that did not and have capacity to pay a higher dividend in 2013 are going to trade up big time.