Are High-Yield Stocks Expensive?

10/8/2012


High-yield stocks are performing well. The top quintile, or one-fifth, of dividend-paying stocks in the S&P 500 Index as measured by yield has outperformed the average stock in the index in five of the last six calendar months. And in rolling 12-month periods since the start of 2009, the top-yielding quintile has outperformed by an average of 5.8%.

Unfortunately, when a group of stocks performs well, it often becomes expensive. So, how do high-yielders look today?

The top-yielding stocks in the S&P 500 Index still look fairly attractive relative to stocks with lower yields. On average, stocks in the highest-yielding quintile tend to be cheaper. The second and third quintiles also seem reasonably valued, while the two quintiles with the lowest yields are pricey on most metrics.

However, viewed through the prism of history, high-yielders look more expensive. The highest-yielding stocks average Quadrix® Value scores of 56 — not bad, but well below their averages of 65 over the last five years and 71 since 1994.

Since top-yielding stocks have historically traded at a discount, investors shouldn't expect their valuation ratios to rise to match those of lower-yielding stocks any time soon. And based on price/earnings, price/cash flow, and price/sales ratios, the average stock in the top quintile of the S&P 500 on yield is more expensive today than its average valuation since 1994.

In contrast, stocks in the three quintiles with the lowest yields tend to trade at discounts to their average valuations since 1994. Stocks of all stripes look expensive relative to five-year averages, but none of the other four quintiles saw their valuation ratios expand as much as the high-yielders did.

When you reach beyond value, high-yielders don't measure up. The top quintile of S&P 500 dividend-payers based on yield averages a Quadrix Overall score of 47, the lowest of any quintile. In fact, high-yielders are also at the bottom of the pile in Quadrix Momentum, Quality, Financial Strength, and Performance.

Higher-yielding stocks also fall short on the growth front. On average, stocks in the top-yielding quintile saw profits fall 1% over the last 12 months and are expected to deliver five-year annual profit growth of 6%. As the table below illustrates, every other quintile looks substantially better. And in general, the lower the yield, the higher the expected growth.

HIGH YIELDS, LOW OVERALL SCORES
---- Dividend Yield ----
Div.
Payout
Ratio
(%)
12-Month
---- Growth ----
LT Est.
EPS
Growth
(%)
--- Biggest Sector Weightings ---
Avg. Quadrix
----- Scores -----
S&P 500 Yield Grouping (No. Of Stocks)
Avg.
(%)
Mini-
mum
(%)
Maxi-
mum
(%)
Sales
(%)
Profits
(%)
Top
(% of Stocks)
Second
(% Of Stocks)
Value
Overall
Quintile 1 (80)
4.7
3.5
11.0
69
4
(1)
6
Utilities
(31%)
Financials
(13%)
56
47
Quintile 2 (79)
3.1
2.6
3.5
47
4
3
9
Financials
(22%)
Industrials
(18%)
59
57
Quintile 3 (80)
2.3
2.0
2.6
36
6
6
10
Financials
(29%)
Cons. Disc.
(18%)
64
62
Quintile 4 (79)
1.6
1.3
2.0
27
8
14
12
Cons. Disc.
(19%)
Industrials
(18%)
58
64
Quintile 5 (80)
0.7
0.1
1.3
14
11
11
13
Financials
(19%)
Cons. Disc.
(16%)
55
66
All Dividend
Payers (398)
2.5
0.1
11.0
39
7
7
10
Financials
(19%)
Cons. Disc.
(15%)
58
59
Nonpayers (102)
0.0
0.0
0.0
0
13
12
15
Technology
(31%)
Cons. Disc.
(21%)
54
61
Entire Index (500)
2.0
0.0
11.0
31
8
8
11
Financials
(16%)
Cons. Disc.
(16%)
57
60
Note: Quadrix scores are percentile ranks, with 100 the best. Averages exclude growth rates above 100% and payout ratios above 200%.

One of the chief reasons the Forecasts doesn't recommend many high-yield stocks is the nature of the stocks themselves. High-yielders tend to be concentrated in low-growth industries, and their large dividends leave companies less cash to invest in growth initiatives or save to cope with market downturns.

Utilities comprise 31% of stocks in the S&P 500's high-yield quintile, about five times the percentage in the broad index. The S&P 500 Utility Sector is expected to post 7% lower profits this year, with a gain of just 3% next year. Energy, health care, materials, industrials, and technology stocks — which have better profit-growth potential than utilities — combine to account for just 29% of the highest-yielders, though they make up more than half of the S&P 500 Index.

For most of the last decade, utility and financial stocks have made up at least 45% of the top quintile. But outside of those stalwarts, the high-yield quintile has diversified quite a bit over the last decade. Ten years ago, technology, telecom services, energy, and health care combined to make up just 4% of the stocks in the portfolio. Today, each of those four sectors accounts for at least 3.5% of the quintile on its own.

TOP-YIELDING STOCKS PRICEY VERSUS HISTORY
Average Valuation Ratio For One-Fifth Of S&P 500
------ Dividend-Payers With the Highest Yields ------
Quadrix Scores
Measurement
Period
Enterprise
Ratio
Price/
Earnings
Price/
Book
Price/
Cash
Flow
Price/
Sales
Value
Overall
Current
8.6
16.6
2.6
8.9
2.0
56
47
Last 5 years
8.8
15.3
2.9
8.6
1.8
65
51
Since 1994
8.7
16.4
2.6
8.5
1.6
71
53
Note: Averages exclude all ratios below 0, P/E ratios above 75, price/book and price/sales ratios above 20, and price/cash flow and enterprise ratios above 35.   Quadrix scores are percentile ranks, with 100 the best.

But while the improved diversification is a positive, it isn't enough to get us excited about high-yield stocks as a whole. The average stock in the highest-yielding quintile pays out more than two-thirds of its profits in dividends — versus an average of 39% for all of the index's dividend-payers. With such a high percentage of profits going directly to shareholders, the top quintile's poor growth numbers shouldn't surprise us.

Subpar fundamentals aren't the only cause for concern about dividend stocks. While high-yielders have been outperforming for more than three years, the excess returns have eroded in recent months. During the last dozen rolling 12-month periods, high-yielders' outperformance has averaged just 0.4%.

These stocks also face some political risk, though in this case perception is worse than reality. The Bush tax cut on dividend income is set to expire next year, which has plenty of investors spooked. If the tax cut isn't renewed, dividends will be taxed at ordinary-income rates instead of the current 15% maximum. However, pundits calling for a bloodbath in dividend stocks are probably overstating the case.

First, a cold-turkey cutoff of the tax break is far from certain, even if Obama wins the election. Second, dividend stocks have performed well even during periods when tax rates were higher. They could show some short-term weakness in the event of a tax increase, but the long-term appeal of income is unlikely to erode.

The Forecasts likes dividend stocks, but we have historically advised readers not to chase the highest yielders. Given the weak Quadrix scores and mixed valuation trends for high-yield stocks, our advice has not changed. That said, we cover plenty of reasonably valued stocks with robust dividends. We advise income investors to focus on solid stocks with attractive valuations. Seek out companies capable of growing both profits and dividends over time. In other words, rather than high-yield stocks, look for attractive stocks that also pay high yields.

The table below lists seven reasonably valued stocks with yields of at least 2.6%, enough to qualify them for the top two quintiles of dividend-paying stocks in the S&P 500 Index. To avoid stocks cheap for a reason, we required Overall scores of at least 70.

ATTRACTIVELY VALUED HIGH-YIELD STOCKS
All seven of the A-rated stocks below pay dividend yields of at least 2.6% and earn Overall scores of at least 70. All of the stocks look like good values, trading at or below their five-year average in at least four of the five valuation ratios presented in the table. Stocks recommended for purchase are presented in bold.
---------------------------------------- Valuation Ratios ----------------------------------------
Quadrix
---- Scores ----
Company (Price; Ticker)
Div.
($)
Yield
(%)
Price/
Earnings
5-Yr.
Avg.
Price/
Sales
5-Yr.
Avg.
Price/
Book
5-Yr.
Avg.
Price/
Cash
Flow
5-Yr.
Avg.
Ent.
Value/
EBITDA
5-Yr.
Avg.
Value
Overall
Aflac ($48; AFL)
1.32
2.8
8.7
13.2
0.9
1.2
1.6
2.5
NA
NA
6.5
8.2
98
100
Baxter International
($60; BAX)
1.80
3.0
14.1
15.3
2.4
2.6
5.1
4.9
11.1
12.9
9.3
9.8
60
73
Cisco Systems
($19; CSCO)
0.56
3.0
12.3
16.4
2.2
3.0
2.0
3.0
9.4
13.0
5.3
8.7
89
97
Intel ($23; INTC)
0.90
3.9
9.4
14.3
2.1
2.8
2.3
2.7
6.0
9.3
4.5
6.0
87
73
J.P. Morgan Chase
($41; JPM)
1.20
2.9
9.8
15.2
1.5
1.3
0.8
1.0
6.8
9.3
5.7
12.1
90
83
Merck ($45; MRK)
1.68
3.7
17.3
13.1
2.9
2.9
2.5
2.9
10.1
10.4
7.7
8.5
56
78
Microsoft
($30; MSFT)
0.92
3.1
10.7
12.9
3.4
3.7
3.7
5.3
12.5
11.5
6.4
7.6
80
82
Note: Averages exclude all ratios below 0, P/E ratios above 75, price/book and price/sales ratios above 20, and price/cash flow and enterprise ratios above 35.   Quadrix scores are percentile ranks, with 100 the best.

 


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