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Reaching for Yield Without Getting Burned by John Wightkin, Director of Equity Research Applications, Schwab Center for Financial Research August 11, 2009 Key points
To answer these questions, we investigated the risk and return patterns of stocks with high dividend yields. Here, we take you through a few of the problems associated with high-yield investing that we uncovered. Even better, we provide what we think is a smarter way to invest in higher-yielding stocks (jump straight to how to put this strategy to work). Problems with high-yield investing Your total return on a stock is made up of two components: your gain (or loss) plus dividend yield. As our research shows, the highest-yielding stocks historically haven't provided the best total return. In the chart below, we show the average annual total return on the top 1,500 stocks by market capitalization over the past 20 years (currently, the lowest market cap for this group is around $500 million). We divided the stocks into five groups. Group 0 includes all the stocks that didn't pay a dividend. For the stocks that paid a dividend, we divided them equally into four groups based on dividend yield. Group 1 contains the stocks with the lowest yield while Group 4 holds the highest-yielding stocks. The best yield doesn't mean the best performance  Click to enlarge Source: Charles Schwab & Co., Inc. You can see that the stocks yielding the highest dividends (Group 4) performed worse than the two preceding, lower-yielding groups. In fact, Group 4 stocks barely edged out the average stock return of 10%. So concentrating only on the highest-yielding stocks may not be the best investment strategy, since as a group these stocks provide less total return than lower-yielding stocks. One reason for this, our research found, is that the highest-yielding stocks had twice as many dividend cuts as the other dividend-paying groups. A smarter way to pick high-yield stocks Given these facts, you might be inclined to just avoid stocks that have the highest dividend yields. However, for investors seeking dividend income, these yields are just too attractive to ignore. Instead, let's focus on a strategy that helps you identify the likely winners among the highest-yielding stocks over the next 12 months. For this strategy, we narrowed our research to the top 25% of the dividend-paying stocks within the top 1,500 stocks by market capitalization—in other words, Group 4 in the chart above. Historically, these stocks have typically had yields at least 1.5 times greater than the S&P 500's average yield. We tested a number of strategies and discovered one that was very promising: six-month price momentum. What is price momentum? Price momentum is a well-known stock indicator based on the idea that stocks that have been outperforming in the past will continue to do so in the future. Many competing explanations exist for the superior performance of stocks that exhibit strong price momentum, the most common being that the market tends to respond only gradually to new information. Investors often underreact to information about a firm's short-term prospects, and often overreact to information about long-term prospects—which provides opportunities in the intermediate term. Using price momentum In our study, we defined price momentum as a stock's most recent six-month price change, as a percentage. For example, if a stock's closing price at the end of last month was $12 and its closing price was $10 six months ago, its six-month price momentum would be ($12 ÷ $10) - 1 = 0.2, or 20%. We ranked our highest-yielding stocks into five equal clusters based on their six-month price momentum. The stocks with the lowest price momentum comprised Segment A while those with the highest price momentum made up Segment E. As this second chart shows, stocks with the highest price momentum (Segment E) outperformed all other segments—and the return to Group 4 overall. What's more, these stocks beat all the other dividend-paying groups in the first chart above. Stocks with the highest price momentum came out on top  Click to enlarge Source: Charles Schwab & Co., Inc. These results clearly indicate that applying a simple six-month price momentum strategy to the highest-yielding stocks can help you pick the best performers within this group. What's driving these superior returns? To understand what was driving these returns, we tracked several fundamental characteristics over the 20-year period. As the table below highlights, compared to the stocks with the lowest price momentum (Segment A), stocks with the highest price momentum (Segment E) had substantially more dividend increases, a third as many dividend cuts, slightly more net increases in analyst earnings estimates, and substantially fewer net reductions in analyst earnings estimates. A look at the fundamentals
As a reminder, dividend yield is the ratio of dividends over price, so as a stock's price falls, its dividend yield rises. Typically, stocks with the highest dividend yields have had a large price drop—an indication of trouble with the stock's fundamentals. Simply stated, the highest-yielding stocks are usually companies with fundamental problems, and are often headed for a dividend cut. However, with our price-momentum strategy, we were able to identify stocks with improving fundamentals, even among the highest-yielders—which helps explain the superior performance of Segment E in the chart above. How to put this strategy to work As we've shown, naively reaching for dividend yield is a less effective approach to investing for income. To more profitably capture high dividend yields, we introduced a strategy—six-month price momentum—that can help you identify which high-dividend yielding stocks are likely to be the best performers over the next 12 months. To implement this strategy yourself, take the following steps using Schwab's online stock screener.
Schwab Equity Ratings use a scale of A, B, C, D and F, and are assigned to approximately 3,000 stocks headquartered in the United States and certain foreign nations where companies typically locate or incorporate for operational or tax reasons. 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 during the next 12 months. Schwab Equity Ratings are not personal recommendations for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. Schwab Equity Ratings should only constitute one component in your own research to evaluate stocks and investment opportunities. From time to time, Schwab may update the Schwab Equity Ratings methodology. The information provided is for general informational purposes only and should not be considered as an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Past performance is no guarantee of future results. (0809-9850) Return to Top |
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