The income stream offered by dividends provides some comfort in volatile market conditions. On the other hand, yields on treasury bills remained at low levels. During the week ended June 11, 2021, the yield on the 10-year note was less than 1.5%. Dividend paying stocks can offer comparable (and often higher) returns with the potential for dividend growth and capital appreciation.
Dividends contribute to returns in any market situation, while the attractiveness of income from dividend-paying stocks helps limit large losses in a market downturn. A dividend yield strategy can help you find potentially undervalued stocks with reduced downside risk, provided the dividend is secure.
However, not all dividends are created equal. Many companies have reduced or eliminated their dividends since 2020. Therefore, it is important for investors to pay attention to management’s commitment to guarantee the payment of dividends and whether the amount of the dividend has increased, remained the same. same or has been reduced.
High relative dividend yields
A share’s dividend yield is calculated by taking the stated dividend (the expected dividend over the next year) and dividing it by the share price. For most stocks, the dividend shown is the most recent quarterly dividend multiplied by four. If a stock pays an stated dividend of $ 1 per share and trades at a price of $ 40, its dividend yield is 2.5% ($ 1 Ã· $ 40 = 0.025 or 2.5%). If a stock’s price is rising faster than its dividend, the dividend yield will drop, indicating that the price may have been up too high and may be ready for a drop. Conversely, if the dividend yield reaches a high level, the stock may be on the verge of a price increase if the dividend can be sustained.
AAII follows a high-performance screen that searches for companies whose characteristics include:
- An established history of rising dividends,
- A high dividend yield compared to its historical norm,
- Profit growth above industry standard and
- Liabilities below industry standard.
A history of growing dividends implies that management has always 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 if a company is trading at a discount from its historical range. Higher yields signal a lower valuation, although other metrics, such as the price-earnings ratio, should also be considered. Higher performance can also signal concerns about the business or financial condition of the business; therefore, a thorough research is necessary.
Above-industry earnings growth suggests that the company’s profitability should be able to support higher dividends in the future. These two characteristics increase the possibility that dividends will be increased in the future, but they do not guarantee it. Lower debt levels provide more cash for dividend payments, as less cash has to be used for debt service. Comparing debt levels with the industry median allows the strategy to adapt to different capital requirements.
Like all basic value-driven techniques, the dividend yield strategy attempts to identify investments that are not in favor. Filtering is the first step in this process, and it involves scanning a group of headlines to find those that deserve further analysis. Absolute or relative levels can be used to find high yielding stocks. A filter requiring an absolute level might seek, for example, a minimum dividend yield of 3% before an investment is considered.
The screens based on relative levels compare the return to a benchmark that can fluctuate, such as the current dividend yield for the S&P 500. In this case, the investor does not require the return to reach a minimum level, but rather than maintain its historical level. relation to the reference figure. Common screens looking at relative returns include comparisons to a certain overall market level, industry level, historical average, or even an interest rate benchmark. This screen is performed using a historical average as a reference.
The first filter excludes companies that trade in the over-the-counter (OTC) market. This filter is used to establish minimum levels of liquidity.
Next, the filter excludes closed-end mutual funds, which have unique financial characteristics that require them to be analyzed separately.
The screen then requires a company to have seven years of price and dividend records. When filtering against a historical average, remember to include a time period that covers both the rising and falling periods of a market and an economic cycle.
Selecting a period is a balance between using a period that is too short and captures only a segment of the market cycle, and one that is too long and includes a period that is no longer representative of the market cycle. current business, industry or market. Periods between five and ten years are the most common for this type of comparison.
The screen then searches for companies that have paid a dividend for each of the past seven years and have never reduced their dividend.
Dividend levels are set by the board of directors based on current business, industry and economic conditions. Because dividend cuts amount to an announcement that the company is in financial difficulty, dividends are set at levels that the company should be able to afford throughout the business cycle.
A lack of dividend growth or a declining rate of dividend growth can also be troubling, especially after a period of regular annual dividend increases. Investors like Benjamin Graham have demanded that stock dividends at least keep pace with inflation. The screen is even more aggressive and demands an annual increase in the dividend payment per share for each of the last six years.
The next filter requires that the company’s current dividend yield be greater than its seven-year average dividend yield. This filter searches for companies whose dividends have grown faster than the stock price increases, or whose current stock price has fallen recently.
The payout ratio
While it may appear that the selection process should be completed with this last filter, before a company can be considered for purchase, the security of the dividend must be considered. A high dividend yield can be a signal that the market expects the dividend to be reduced shortly and has lowered the price accordingly. A high relative dividend yield is only a buy signal if the dividend level should be maintained and increased over time.
There are metrics that help identify the security of the dividend. The payout ratio is perhaps the most common of these and is calculated by dividing the dividend per share by the earnings per share. In general, the lower the number, the safer the dividend. Any ratio above 50% is considered a warning signal. However, for some industries, such as utilities, ratios of around 80% are common. A payout ratio of 100% indicates that a company pays out all of its profits as dividends. A negative payout ratio indicates that a company pays a dividend even though profits are negative. Businesses cannot afford to pay more than they earn in the long run. The screen requires a distribution rate of between 0% and 85% for utilities and between 0% and 50% for companies in other sectors.
Dividends are paid in cash, so it’s also important to look at a company’s liquidity. Financial strength helps indicate liquidity and provide a measure of security for the payment of dividends.
Both short-term business obligations and long-term liabilities must be considered when testing financial strength. Common measures of a company’s long-term obligations include debt-to-equity ratio (which compares the level of long-term debt to equity), debt as a percentage of capital structure (long-term debt divided by capital, which includes long-term funding sources 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 takes into account both current and long term liabilities. Acceptable debt levels vary by industry, so the screen searched 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. Financial stocks and passing utilities have much higher values ââthan stocks in the consumer sectors.
It is also important to examine the earnings history. Dividend growth cannot deviate from the level of earnings growth for very long, so the pattern of earnings growth will help confirm the stability and strength of the dividend. Ideally, income should increase steadily. The end screen demands that profit growth over the past three years be above the industry standard.
This High Relative Dividend Yield screen (which has shown an average annual gain since 1998 of 9.0%, compared to 6.5% for the S&P 500 index over the same period) identifies companies with strong dividend benchmarks that are trading at relatively high returns. Selecting a relatively high dividend yield is based on the age-old rule of buying low and selling high. Examining a stock’s dividend yield provides a useful framework for identifying potential candidates.
To be successful with 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 with any screen, the listing of visiting companies is only a starting point for further analysis.
Stocks passing the high relative dividend yield screen (sorted by dividend yield)
Stocks that meet the criteria for the approach do not represent a ârecommendedâ or âbuyâ list. It is important to exercise due diligence.
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