Diversification With Dividends

3/12/2012


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.

SECTOR ANALYSIS
--------------- Sector Average, Dividend Payers ---------------
Sector Average, Nonpayers
Sector (No. Of Cos.)
No. (And %) Of
Dividend Payers
Yield
(%)
Div.
Payout
Ratio
(%)
5-Yr.
Dividend
Growth
(%)
P/E
Ratio
Quadrix
Overall
Score
10-Year
Standard
Deviation
(%)
P/E
Ratio
Quadrix
Overall
Score
10-Year
Standard
Deviation
(%)
Cons. Discretionary (252)
133
(53)
2.1
34
5
17
61
11
20
57
15
Consumer Staples (78)
60
(77)
2.5
41
10
17
51
8
18
56
12
Energy (91)
49
(54)
1.7
21
7
19
57
11
20
56
14
Financials (263)
229
(87)
3.1
54
(5)
21
48
9
22
55
13
Health Care (155)
48
(31)
1.8
27
14
15
65
8
19
60
13
Industrials (221)
163
(74)
1.9
32
7
18
62
10
18
63
13
Materials (93)
77
(83)
1.8
33
6
18
58
11
14
44
16
Technology (263)
79
(30)
2.0
31
12
16
61
11
20
56
14
Telecommunications (17)
10
(59)
6.8
81
8
16
42
8
30
51
17
Utilities (67)
65
(97)
4.0
61
6
16
39
6
23
49
16
S&P 1500 Index (1500)
913
(61)
2.5
39
4
18
58
10
19
57
14
Note: Averages exclude payout ratios, growth rates, and standard deviations above 200% and P/E ratios below 0 or above 75.

Within the S&P 1500 Index, dividend-payers also average lower price/earnings ratios and slightly higher Quadrix® 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.

DIVERSIFIED DIVIDENDS EVERY MONTH

All 30 of the stocks below yield at least 1.4%. A portfolio consisting of equal-dollar amounts of each stock would yield 2.8%, allocate 27% in small-cap or midcap stocks (market capitalizations below $10 billion), and pay dividends every month. For diversification purposes, we limited the maximum sector weighting to 20% of the portfolio.

To populate the portfolio, we tapped into our sister newsletter Upside, which focuses on small-cap stocks, and our Top 15 Utilities portfolio. Upside stocks are presented in bold, while Forecasts recommendations are listed in green. Why 11 stocks in two groups and eight in the third? Because relatively few stocks pay their quarterly dividends in February, May, August, and November, and we found a greater number of attractive stocks that paid on other cycles.

Company (Price; Ticker)
Div.
($)
Yield
(%)
Stock
Size
Div.
Payout
Ratio
(%)
5-Year
Annual.
Dividend
Growth
(%)
P/E
Ratio
Quadrix
Overall
Score
Sector
Dividends paid January, April, July, and October
Aetna ($46; AET)
0.70
1.5
Large
14
77
9
99
Health Care
AmTrust Fin'l ($26; AFSI)
0.36
1.4
Small
13
55
9
94
Financials
Cascade ($51; CASC)
1.00
2.0
Small
23
10
12
96
Industrials
Cisco Systems ($19; CSCO)
0.32
1.6
Large
19
NM
11
97
Technology
Comcast ($29; CMCSa)
0.65
2.2
Large
41
NM
18
91
Discretionary
Macy's ($37; M)
0.80
2.1
Large
28
16
13
91
Discretionary
MTS Systems ($49; MTSC)
1.00
2.0
Small
29
26
14
97
Technology
Philip Morris Int'l ($84; PM)
3.08
3.7
Large
63
NM
17
82
Staples
PPL ($28; PPL)
1.44
5.1
Large
52
11
10
60
Utilities
Rogers Com. ($38; RCI) e
1.59
4.2
Large
52
87
13
79
Telecom
Sempra Energy ($58; SRE)
2.40
4.1
Large
53
21
13
77
Utilities
Dividends paid February, May, August, and November
Abbott Labs ($56; ABT)
2.04
3.6
Large
44
11
12
72
Health Care
American Express ($52; AXP)
0.72
1.4
Large
18
4
13
91
Financials
Caterpillar ($106; CAT)
1.84
1.7
Large
24
9
14
95
Industrials
CMS Energy ($21; CMS)
0.96
4.5
Midsize
66
57
15
50
Utilities
CVS Caremark ($45; CVS)
0.65
1.5
Large
23
28
16
83
Staples
Deere ($79; DE)
1.84
2.3
Large
27
17
12
91
Industrials
Gen. Dynamics ($71; GD)
1.88
2.7
Large
26
14
10
74
Industrials
Plains All Amer. ($80; PAA)
4.10
5.2
Large
79
6
15
90
Energy
Dividends paid March, June, September, and December
Aflac ($45; AFL)
1.32
2.9
Large
21
14
7
93
Financials
Amer. States ($37; AWR)
1.12
3.1
Small
50
4
16
80
Utilities
Chevron ($109; CVX)
3.24
3.0
Large
24
9
8
88
Energy
CSX ($20; CSX)
0.48
2.4
Large
29
27
12
71
Industrials
Exxon Mobil ($86; XOM)
1.88
2.2
Large
22
7
10
80
Energy
Intel ($27; INTC)
0.84
3.2
Large
33
15
10
95
Technology
KLA-Tencor ($47; KLAC)
1.40
3.0
Midsize
30
24
10
98
Technology
Microsoft ($32; MSFT)
0.80
2.5
Large
29
15
11
90
Technology
Qualcomm ($62; QCOM)
1.00
1.6
Large
26
11
18
94
Technology
RPC ($14; RES)
0.48
3.4
Midsize
24
34
7
96
Energy
Wisc. Energy ($34; WEC)
1.20
3.5
Midsize
55
20
16
61
Utilities
30-stock Portfolio Average
2.8
35
23
12
85
NM Not Meaningful because stock didn't pay dividends five years ago.     e Estimated.
Note: Quadrix scores are percentile ranks, with 100 the best.  

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 Quadrix® 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.


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