The stream of income offered by dividends provides some comfort in volatile market conditions. Treasury yields have begun to rise from the all-time lows seen throughout 2020. As of March 14, 2022, the yield on the 10-year note was above 2% for the first time since 2018. As Treasury rates surpass the average dividend yield of stocks in the S&P 500 index, some investors may flee from individual stocks to lower volatility investments. However, dividend-paying stocks can offer comparable yields with the possibility of dividend growth and capital appreciation. In this article I present AAII’s strategy that uses the dividend-yield approach to invest during volatile markets. Our High Relative Dividend Yield screening model has shown solid long-term performance, with an average annual gain since 1998 of 8.8%, versus 6.3% for the S&P 500 over the same period.
Dividends contribute to returns in any market situation, while the income appeal of dividend-paying stocks helps to limit steep losses if the market declines. A dividend-yield strategy can help you find potentially undervalued stocks with reduced downside risk, provided the dividend is secure.
Not all dividends are created equal, however. Many companies have either cut or eliminated their dividends since 2020. Therefore, it is important that investors pay attention to how committed management has been to ensuring dividends are paid and whether the dividend payment has increased, stayed the same or been cut.
High Relative Dividend Yields
A stock’s dividend yield is computed by taking the indicated dividend—the expected dividend over the next year—and dividing it by the share price. For most stocks, the indicated dividend is the most recent quarterly dividend multiplied by four. If a stock is paying an indicated dividend of $1 per share and is trading with a price of $40, its dividend yield is 2.5% ($1 ÷ $40 = 0.025, or 2.5%). If a stock’s price rises faster than its dividend, the dividend yield will fall, indicating that the price may have been bid up too far and may be ready for a decline. Conversely, if the dividend yield rises to a high level, the stock may be poised for an increase in price if the dividend can be sustained. However, very high yields, especially relative to historical levels, can be a warning of a dividend cut or suspension.
AAII tracks a high-yield screen that seeks companies with characteristics that include:
- An established history of rising dividends,
- A high dividend yield relative to its historical norm,
- Earnings growth that outpaces industry norm and
- Liabilities below the industry norm.
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A history of rising dividends implies that management has historically maintained a focus on providing an increasing level of income to shareholders.
The relative dividend yield is a measure of valuation. It is used to signal whether a company is trading at a discount compared to its historical range. Higher yields signal a lower valuation, though other measures such as the price-earnings ratio should also be considered. A higher yield can also signal concerns about the company’s business or financial status; therefore, thorough research is required.
Earnings growth above the industry average suggests that the company’s profitability should be able to support higher dividends in the future. Both characteristics increase the possibility that dividends may be raised in the future, but they do not guarantee it. Lower levels of debt allow for more cash to be available for dividend payments as less cash needs to be used to service debt. Comparing debt levels to the industry median allows the strategy to adjust to differing capital requirements.
Like all basic value-oriented techniques, the dividend-yield strategy attempts to identify investments that are out of favor. Screening is the first stage in this process, and it involves scanning a group of securities to find those that merit further in-depth analysis. Absolute or relative levels may be used in screening for high-yield stocks. For example, a screen requiring an absolute level might look for a minimum dividend yield of 3% before an investment is considered.
Screens based on relative levels compare the yield against a benchmark that may fluctuate, such as the current dividend yield for the S&P 500. In this case, the investor does not require that the yield meet some minimum level, but instead that it maintains its historical relationship with the benchmark figure. Common screens examining relative yields include comparisons against some overall market level, industry level, historical average or even some interest rate benchmark. This screen is performed using a historical average as the benchmark.
Applying the Screen
The first filter excludes companies that trade on the over-the-counter (OTC) market. This filter helps to establish minimum levels of liquidity.
The screen then requires that a company have seven years of both price and dividend records. When screening against a historical average, remember to include a time period that covers both the up and down periods of a market and economic cycle.
Selecting a time period is a balance between using one that is too short and only captures a segment of the market cycle and one that is too long and includes a time period that is no longer representative of the current company, industry or market. Periods of between five and 10 years are most common for these types of comparisons.
The screen then looks for companies that have paid a dividend for each of the last seven years and have never reduced their dividend.
Dividend levels are set by the board of directors based on consideration of the current company, industry and economic conditions. Because dividend cuts are tantamount to an announcement that the firm is financially distressed, dividends are set at levels that the company should be able to afford throughout the economic cycle.
A lack of dividend growth or a decline in the dividend growth rate can also be troubling, especially after a period of regular annual dividend increases. Investors such as Benjamin Graham required that stock dividends at least keep pace with inflation. The screen is even more aggressive and demands an annual increase in the per-share dividend payout for each of the last six fiscal years.
The next filter requires that the company’s current dividend yield be higher than its seven-year average dividend yield. This filter seeks out companies whose dividends have increased faster than increases in share price, or whose current share price has declined recently.
Payout Ratio
While it might seem that the screening process should be over with this last filter, before a company can be considered for purchase the security of the dividend must be examined. A high dividend yield may be a signal that the market expects the dividend to be cut shortly and has pushed down the price accordingly. A high relative dividend yield is a buy signal only if the dividend level is expected to be sustained and increased over time.
Measures exist that help to identify the safety of the dividend. The payout ratio is perhaps the most common of these and is calculated by dividing the dividend per share by earnings per share. Generally, the lower the number, the more secure the dividend. Any ratio above 50% is usually considered a warning flag. However, for some industries, such as utilities, payout ratios around 80% are common. A 100% payout ratio indicates that a company is paying out all of its earnings in the form of dividends. A negative payout ratio indicates that a firm is paying a dividend even though earnings are negative. Firms cannot afford to pay out more than they earn in the long term. The screen requires a payout ratio of between 0% and 85% for utilities and between 0% and 50% for firms in other sectors.
Financial Strength
Dividends are paid in cash, so it is also important to examine the liquidity of a company. Financial strength helps to indicate liquidity and to provide a measure of safety for the dividend payout. One must consider both the short-term obligations of the company along with long-term liabilities when testing for financial strength. Common measures of the longer-term obligations of the company include the debt-to-equity ratio (which compares the level of long-term debt to owner’s equity), debt as a percent of capital structure (long-term debt divided by capital, which includes long-term sources of financing such as bonds, capitalized leases and equity) and total liabilities to total assets.
The screen uses the ratio of total liabilities to assets because it considers both short-term and long-term liabilities. Acceptable levels of debt vary from industry to industry, so the screen looked for companies with total liabilities to assets below the norm for their industry. The higher the ratio, the greater the financial leverage and the higher the risk. The financials and utilities passing have much higher values than the stocks in the consumer sectors.
Earnings Growth
It is also important to examine the historical record of earnings. Dividend growth cannot deviate for very long from the level of earnings growth, so the pattern of earnings growth will help to confirm the stability and strength of the dividend. Ideally, earnings should move up consistently. The final screen requires that growth in earnings over the last three years be greater than the norm for the industry.
Conclusion
This High Relative Dividend Yield screen identifies companies with strong dividend credentials that are trading at relatively high yields. Screening for relative high dividend yield is based upon the time-honored rule of buying low and selling high. Examining a stock’s dividend yield provides a useful framework to identify potential candidates.
To succeed at this strategy, you need to develop a set of tools to not only identify which stocks have relatively high dividend yields, but also which of those stocks have the strength to bounce back.
As is true for any screen, the list of passing companies represents only a starting point for further in-depth analysis.
Stocks Passing the High Relative Dividend Yield Screen (Ranked by Dividend Yield)
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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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