Diversification With Dividends
Conventional wisdom holds that dividends reduce the risk of a stock. The presence of the cash flows from the dividend should at least partially offset the effects of periods of weak price action.
While conventional wisdom is not always wise, in this case perception truly matches reality. As the table below illustrates, dividend-paying stocks in the S&P 1500 Index are less volatile, as measured by standard deviation. Standard deviation considers how widely returns (in this case, monthly returns) deviate from the average for a set period (in this case, 10 years). Dividend payers average a standard deviation of 10%, versus 14% for stocks that don't pay dividends.
Those numbers beg the question: Is that volatility disparity driven by sector forces? For example, utility and consumer-staples stocks are more likely to pay dividends than technology or energy stocks, and the first two sectors are less sensitive to economic and business cycles. On average, utility and consumer-staples stocks have the lowest volatility of any sector, so the large number of dividend-payers in those two sectors does skew the average. But there's more to the story.
As the table below shows, in all 10 sectors, dividend-payers average lower standard deviations than nonpayers in the same sector. For example, dividend-paying technology stocks tend to be less volatile than tech stocks that don't pay a dividend. In fact, even among tech stocks, which average the highest volatility of any sector, dividend-payers average a standard deviation below the average for nonpayers in every sector, even those generally considered less volatile.
Within the S&P 1500 Index, dividend-payers also average lower price/earnings ratios and slightly higher QuadrixÂ® Overall scores. Does that mean the Forecasts will stop recommending stocks that don't pay dividends? No, because we look at each stock individually, and many nonpayers have excellent investment potential. But we do like stocks that pay yields, and 74% of the stocks in our buy lists pay a dividend.
While dividend stocks may appeal to risk-averse investors on their own merits, the table below takes risk management a couple steps further. We can also reduce portfolio volatility — along the way juicing returns — by diversifying based on sector and company size. The table presents a well-diversified portfolio of 30 stocks, with no more than 20% (six stocks) in any given sector.
In addition, we required that at least one-third of the portfolio (10 stocks) be invested in small-cap and midcap stocks. As an added bonus, we considered the stocks' payout dates and structured the portfolio such that investors would receive dividends every month. Below, we profile three appealing dividend-paying stocks.
American States Water ($37; AWR), a utility serving more than 255,000 water customers and 23,000 electric customers in California, earns a QuadrixÂ® Overall score of 80, tied for the highest in our Utility Update. Utilities tend to score poorly in Quadrix, hurt by slow growth and high debt levels. And American States earns at least 96 in both of our sector-specific scores, ranking it among the most appealing utilities. In the 12 months ended September, the company grew sales 13%, per-share profits 54%, and operating cash flow 34%.
Growth will slow in the year ahead, and the consensus projects flat profits in 2012. However, the company topped the consensus by at least 15% in the June and September quarters and could keep surprising. American States is expected to declare December-quarter earnings March 12, with analysts projecting a 9% rise. American States, which has raised its dividend in 57 straight years, is a component of our Top 15 Utilities portfolio.
Oil giant Chevron ($109; CVX) yields 3.0% and has grown its dividend at an annual rate of 29% over the last decade. Operating cash flow rose 31% last year and nearly 14% annually over the last 10 years, and we expect Chevron to continue its 24-year streak of higher payouts. Chevron is also investing its generous cash flow in exploration projects, particularly a deepwater field in the Gulf of Mexico and two massive fields off the coast of Australia.
Chevron is just starting to reap the benefits of more than $102 billion spent on capital projects over the last five years. The company seems capable of growing production at an annualized rate of more than 2% through 2017, with the bulk of that growth occurring after 2013. Chevron's production is more heavily weighted toward oil than that of most peers, good news during this prolonged period of depressed natural-gas prices. At just eight times trailing earnings, Chevron trades at a discount of 23% to its peer group and 17% to its three-year average P/E ratio. Chevron is a Focus List Buy and a Long-Term Buy.
Department-store operator Macy's ($37; M), which yields 2.1%, doubled its quarterly dividend to $0.10 per share last May. While another 100% increase is unlikely, Macy's can afford another hike this year, given its growth of more than 35% in operating cash flow and per-share profits over the last year.
Operationally, Macy's has performed well in recent months. Same-store sales rose at least 4.8% in each of the three months of the January quarter, then continued the trend in February with a 4.6% increase. The consensus projects per-share-profit growth of 16% in the fiscal year ending January 2013 and 13% in fiscal 2014, with both annual estimates up at least 2% over the last 30 days. Macy's shares trade at 11 times the fiscal 2013 consensus, 26% below median for department-store stocks in the S&P 1500 Index. Macy's is a Buy and a Long-Term Buy.