Selecting Dividend-Paying Stocks—Can You Do Better?
- 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.
|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 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|
Source: Schwab Center for Financial Research as of October 31, 2013. These returns are simulated historical results from November 2012 through October 2013, calculated with the benefit of hindsight, no transaction costs and are not intended to be replicable by individual investors. Past performance is no guarantee of future results.
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|
Source: Schwab Center for Financial Research as of October 31, 2013. These returns are simulated, historical results from December 1989 through October 2013 calculated with the benefit of hindsight, and are not intended to be replicable by individual investors. Past performance is no guarantee of future results.
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:
- 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.
- 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.
1. Note that the portfolio construction dates are different than the portfolio performance dates because we used the month-end snapshot to calculate the subsequent month's return.
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.
Schwab Equity Ratings® are assigned to approximately 3,000 of the largest (by market capitalization) U.S. headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Each of the approximately 3,000 stocks rated in the Schwab Equity Ratings universe is given a score that is derived from several research factors. The assignment of a final Schwab Equity Rating depends on how well a given stock scores on each of the factors and then how that stock stacks up against all other rated stocks.
Schwab Equity Ratings and the general buy/hold/sell guidance are not personal recommendations for any particular investor or client and do not take into account the financial, investment or other objectives or needs of, and may not be suitable for, any particular investor or client. Investors and clients should consider Schwab Equity Ratings as only a single factor in making their investment decision while taking into account the current market environment.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Accordingly, Charles Schwab & Co., Inc. does not assess the suitability (or the potential value) of any particular investment. Schwab Equity Ratings are generally updated weekly, so you should review and consider any recent market or company news before taking any action. Stocks may go down as well as up and investors may lose money, including their original investment. Past history is no indication of future performance and returns are not guaranteed.
Past performance is no guarantee of future results.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
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