Selecting Dividend-Paying Stocks—Can You Do Better?

Key Points

  • Dividend-paying companies have generally been known for stability and cash flows. 
  • But lately their stock performance has suffered.
  • We look at three alternative ways to screen these types of stocks. 

Dividend-paying companies have generally been known for stability and cash flows. And, earlier last year, their stocks had some pretty impressive price returns. This was in large part due to investor demand for income and stability, spurred by low interest rates and economic and political uncertainties.

Fast forward six months. Performance has suffered, and many investors may be wondering what happened to their "boring" dividend-paying stocks. Investors may be asking themselves: Is there anything I could have done differently? Are there any steps that might improve an equity income strategy's total return?

In investigating these questions, we uncovered several adjustments to an equity income strategy that may help. Specifically, our research found that dividend-paying stocks with low payout ratios (dividends per share/ earnings per share), low price/earnings (P/E) ratios (market value per share/ earnings per share) or an A-rating by Schwab Equity Ratings would have generally had better total returns than dividend-paying stocks that don't meet at least one of these criteria. Let's look at why that might be and how you can find these types of stocks.

Recent equity income performance

Last May, Federal Reserve Chairman Ben Bernanke mentioned tapering the Fed's purchase of mortgage-backed securities—and caused a dramatic jump in interest rates. Our research shows that this has subsequently had a significant impact on higher-yielding stock returns.

We researched the impact of higher rates on several hypothetical equity income strategies. To form these portfolio strategies, we followed these steps:

1. We started with a universe of stocks that included the top 1,500 stocks ranked by market capitalization. We divided this universe into two groups—dividend payers (companies that had paid a dividend in the past quarter) and non-dividend payers—and took a snapshot of each at the end of every month from October 2012 to September 2013.

2. Leaving the non-dividend payers aside (on average, close to 600 stocks from the top 1,500 were omitted each month), we segmented the dividend payers according to four selection criteria measured at the end of each month: a stock's current yield, payout ratio, price/last twelve-month earnings (P/E) and Schwab Equity Ratings.

  • For the first three criteria (a stock's current yield, payout ratio, price/last twelve-month earnings (P/E)), we created two equal segments, a high and a low group. For example, the stocks in the top 50% of the dividend-paying universe based on a stock's current yield are considered high-yielding stocks. Stocks in the lowest 50% based on a stocks' payout ratio are considered low payout stocks.
  • With the Schwab Equity Ratings, we created five groups, based on Schwab Equity Ratings grades A through F. 
  • To see how these different segments interact, we formed four distinct portfolios that represented four hypothetical income strategies. Table 1 below defines each of the four portfolios. 
Table 1
Portfolio Name Description Average number of stocks
I High-dividend yield The 50% highest-yielding dividend-paying stocks. 450
II High-dividend yield and low payout ratio The 50% highest-yielding dividend-paying stocks and the 50% with the lowest payout ratio. 80
III High-dividend yield and low P/E ratio The 50% highest-yielding dividend-paying stocks and the 50% with the lowest P/E ratio. 310
IV High-dividend yield and A-rated The 50% highest-yielding dividend-paying stocks and those rated "A" by Schwab Equity Ratings. 25

3. We averaged the monthly total returns of all the stocks in each portfolio strategy and calculated the cumulative return for each portfolio during two recent six-month periods:

  • "Before taper talk"—November 2012 through April 2013 
  • "After taper talk"—May 2013 through October 20131

4. We compared these cumulative returns to the cumulative return of our entire starting universe of 1,500 stocks to determine the cumulative excess return.

The results

The impact of higher interest rates on dividend-paying stocks has been significant; see Table 2. After slightly outperforming the overall universe (comprised of the top 1,500 stocks by market capitalization) before taper talk, dividend-paying stocks significantly underperformed the overall universe by 5.5% after taper talk. 

For perspective, given the average current yield of 3.5% for the high-dividend yield portfolio, it would take close to two years of compounding to make up for the 5.5% price decline, all else being equal. These clearly weren't the relatively "stable, boring" total returns that many investors have come to expect.

Table 2: The effect of taper talk on strategies' cumulative excess returns
  Cumulative excess return vs. overall universe
Portfolio Strategy Before taper talk After taper talk
I 0.80% -5.50%
II 1.60% 3.90%
III 0.70% -1.20%
IV 0.60% 2.10%

What could have been done differently?

High-dividend yield strategies with the added qualifications of low payout, low P/E and A-rating tell a slightly different story. Generally, all three appear to have provided better returns than the high-dividend yield segment alone during the after taper talk period.

Especially impressive were the recent positive cumulative excess returns to the low payout (Portfolio II) and A-rated overlays (Portfolio IV). When faced with the prospect of higher rates, investors appear to have rewarded higher-yielding stocks that were fundamentally more attractive.

What about longer term?

To determine how these strategies would have performed longer term, we took end-of-month snapshots for each from December 1989 through October 2013. The subsequent 12-month return for each portfolio was then calculated and compared to the return over the same period for the overall universe (excess return). We then averaged these overlapping twelve-month excess returns (275 returns) over the entire test period.

Table 3 shows the hypothetical average 12-month return, average hit rate, and average dividend yield of each strategy. The hit rate—the percent of positive 12-month excess returns—allows us to compare the consistency of each strategy's returns over time. 

Table 3: High-dividend yield strategies with low payout ratios, low P/E ratios or A-ratings would have had better historic performance
Hypothetical Portfolio Strategy Average 12-month excess return vs. overall universe Hit rate Average dividend yield
I 0.25% 50% 4.0%
II 3.75% 66% 2.9%
III 0.85% 54% 4.1%
IV 4.50% 71% 3.7%

It appears that screening high-dividend yield stocks for a lower payout ratio, a lower P/E ratio or an A-rating would have provided stronger, more consistent excess returns than high-dividend yield stocks alone, while still providing, on average, a relatively attractive dividend yield. The average dividend yield for the overall universe over this time range was 2.5%.

Also noteworthy is the strong performance of the Schwab Equity Ratings A-rated stock overlay. Schwab Equity Ratings' comprehensive approach in assessing a company's fundamental strength and the stock's current valuation may help explain its better performance compared to the single factor overlays. 

What clients can do

Clients interested in pursuing one of these high-dividend yield with fundamental overlay strategies can screen for stocks by following these steps on schwab.com:

  1. Create your universe: Use our screeners, select the drop-down menu for "Basic Criteria" and click on "Market Capitalization." Choose Large-Cap and Mid-Cap. Screen for higher-yielding stocks by selecting the drop-down menu for "Dividends" and clicking on "Annual Dividend Yield." Choose Range, select "Greater than or equal to" and type 2.5 next to the drop-down box.
  2. Now, you can apply screens for the strategies we discussed:

a. To screen for lowest payout, select the drop-down menu for "Dividends" and click on "Payout Ratio - TTM". Choose Range, select " Less than or equal to," and type in 50 next to the drop-down box. Then select "View Matches."
b. To screen for lowest P/E, select the drop-down menu for "Valuation" and click on "Price/Earnings (TTM)." Choose Range, select "Lowest x% of the Market," and type 50 next to the drop-down box. Then select "View Matches."
c. To screen for A-rated stocks, select the drop-down menu for "Analyst Rating" and click on "Schwab Equity Rating." Choose "A" and select "View Matches."

I hope this enhanced your understanding of dividend paying stocks. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts.

Next Steps

For more on the research behind Schwab Equity Ratings and how to use them, read Schwab Equity Ratings® Foundations and Managing a Stock Portfolio Using Schwab Equity Ratings.

For additional help and information, contact a Schwab representative at 800-435-9050.

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