Another Way To Look At Income

10/13/2014


Suppose Spacely Sprockets and Cogswell Cogs have similar fundamentals, and we project Spacely shares to rise 8% and pay a 2% dividend while Cogswell gains 10% with no dividend. We wouldn't necessarily prefer one over the other.

Some income-oriented investors argue with that approach, but please don't misread us. We like dividends quite a bit — as a component of strong total returns.

For the purpose of this discussion, we broke 12-month returns down into capital gains and income return, which reflects dividends and any compounding of those dividends.

Proponents of income stocks like to point out that dividend-payers have historically outperformed nonpayers. That contention is both true and false, as we address in a story below.

One fact is irrefutable: In only two of the last 10 years ending September, as shown below, did the weakest performers from the S&P 1500 Index see higher income returns than top performers. But before you buy a bunch of high-yield stocks, look closer at the data.

• Among the stocks with the highest total returns, average income return never topped 1.7% in the 10 periods we considered. This suggests that the best investment options don't come from the segments of the market with the highest dividend yield.

• Over the last 10 years, the top 150 stocks averaged 12-month total returns of 65%, versus negative returns of 32% for the bottom 150. The extra income return generated by the strongest stocks accounted for a tiny fraction of their outperformance.

Conclusion: Don't let dividend yields dominate your decision-making.

The table below presents appealing stocks capable of delivering market-beating capital gains, augmented by a dependable, growing stream of income. Four are reviewed below:

Halliburton's ($60; HAL) dividend yield of 1.0% is among the lowest in the table below, and unlike most of the companies featured, the oilfield-services giant doesn't have an impressive dividend-growth history. However, after more than five years of flat quarterly dividends at $0.09 per share, Halliburton raised the payout twice last year and currently pays out $0.15 per quarter. That dividend accounts for less than 15% of the company's earnings, leaving plenty of room for additional hikes.

In the 12 months ended June, Halliburton managed per-share-profit growth of 26% and operating-cash-flow growth of 27%. The consensus projects profit growth of 35% in the second half of this year and 32% in 2015. Halliburton is a Buy and a Long-Term Buy.


After an 18-year hiatus, Kroger ($54; KR) restarted its quarterly dividend in 2006, boosting the payout every year since then, most recently a 12% bump in September. Dividends have provided investors with an income return of 2.2% annualized over the last five years. Kroger has also deployed its cash flow for share repurchases, reducing the stock count by 6% over the last year and 18% over the last three.

While Kroger shares have risen fairly steadily since the start of March, tacking on 29% during that period, they remain attractively valued. At 17 times trailing earnings, Kroger trades 22% below its industry median; it also fetches a discount based on price/sales and price/operating cash flow ratios. The grocery chain is growing faster than most of its rivals, with estimates for fiscal 2015 ending January and fiscal 2016 (up 15% and 11%, respectively) edging higher over the last month. Kroger, yielding 1.4%, is a Focus List Buy and a Long-Term Buy.


Over the last decade, UGI ($34; UGI) saw its shares rise in price at an annualized rate of 10.6%, versus a total return of 14.0%. If you purchased $1,000 of UGI a decade ago and held it until the end of September 2014, your shares would now be worth $2,745 — and you would have collected $442 in dividends. Reinvesting those dividends would have yielded an extra $527 on top of the dividends' cash value, growing your $1,000 investment into a $3,714 position.

UGI, which generates about two-thirds of its profits from distributing propane, has delivered non-utility-like growth of 17% in sales and 25% in per-share profits over the last year. The consensus projects a 3% decline in profits in fiscal 2015 ending September, hurt in part by tough comparisons to an unusually cold winter. However, the stock seems reasonably valued at less than 18 times the 2015 estimate. UGI, yielding 2.5% is the only utility on our Buy and Long-Term Buy lists.


Over the last 10 years, Union Pacific ($108; UNP) has raised its dividend at an annual rate of 21%, including four hikes in the last two years. The current quarterly payment of $0.50 per share equates to an annual yield of 1.9%.

Union Pacific managed an annualized income return of 2.5% over the last decade, well above its average yield of 1.7%. Credit the generous income return to both dividend increases (which kept the payout rising almost as fast as the share price) and strong capital gains (which generated an excellent return on reinvested dividends). Union Pacific is a Focus List Buy and a Long-Term Buy.

TOTAL-RETURN LEADERS
All 10 of the Buy-rated stocks below seem capable of market-beating total returns over the next two to four years, with a solid income return augmenting capital gains. Each stock has grown its per-share dividend at least 10% over the last year and annually over the last five and 10 years, if they have paid dividends that long.
Last 12
---- Months ----
Last 5 Years
-- (Annualized) --
Dividend Growth
----- (Annualized) -----
Company (Price; Ticker)
Div.
($)
Yield
(%)
Payout
Ratio
(%)
Total
Return
(%)
Income
Return
(%)
Total
Return
(%)
Income
Return
(%)
Last
Year
(%)
Last 5
Years
(%)
Last 10
Years
(%)
Quadrix
Overall
Score
Sector
Ameriprise Financial
($121; AMP)
2.32
1.9
29
37.0
2.7
29.3
2.6
12
28
NA
92
Financials
Comcast ($55; CMCSa)
0.90
1.6
33
28.7
2.2
32.2
2.6
15
27
NA
79
Discretionary
CVS Health ($83; CVS)
1.10
1.3
25
46.8
2.2
19.5
1.6
22
29
24
88
Staples
EOG Resources
($95; EOG)
0.67
0.7
13
10.8
0.5
16.8
0.7
79
18
27
82
Energy
Halliburton ($60; HAL)
0.60
1.0
18
25.4
1.3
17.2
1.2
20
11
9
84
Energy
Kroger ($54; KR)
0.74
1.4
24
38.1
2.1
22.2
2.2
23
16
NA
84
Staples
Packaging Corp.
($64; PKG)
1.60
2.5
38
15.6
2.7
28.5
3.5
28
22
10
95
Materials
Schlumberger
($98; SLB)
1.60
1.6
31
13.7
1.7
11.1
1.6
28
14
16
77
Energy
UGI ($34; UGI)
0.87
2.5
43
37.5
3.5
19.7
3.8
15
10
8
85
Utilities
Union Pacific
($108; UNP)
2.00
1.9
39
44.7
2.8
32.0
2.5
45
30
21
89
Industrials
Notes: Quadrix scores are percentile ranks, with 100 the best.     The payout ratio reflects the percentage of earnings paid out in dividends.     NA Not available because company didn't pay dividends 10 years ago.

Do high-yield stocks outperform?

If you wish to pick a fight with other investors, tell everyone that high-yield stocks tend to underperform the average stock. Or tell them that high-yielders deliver superior returns.

Either way, you can stir up controversey. And either way, you can honestly claim to be right.

We looked at average 12-month returns since the end of 1994 and discovered non-dividend-payers outperformed the average stock in a variety of universes (S&P 500 Index, S&P 1500 Index, and our Quadrix universe of nearly 5,000 stocks excluding the S&P 1500).

For example, the average nonpayer in the S&P 1500 outperformed the average stock in the index by an average of 1.5% in 12-month periods, while stocks yielding above 4% lagged by 0.8%.

High-yield perspective
Based on median returns, high-yield stocks have outperformed since 1994. Based on average returns, high-yield stocks have underperformed.
------------ Dividend Yield ------------
0%
Up to
2%
2% To
4%
Above
4%
S&P 500
Average Outperformance
Since End of 1994
1.9
(0.9)
(0.2)
(0.5)
Median Outperformance
Since End of 1994
(3.8)
(0.3)
1.4
1.7
S&P 1500
Average Outperformance
Since End of 1994
1.5
(1.2)
(1.2)
(0.8)
Median Outperformance
Since End of 1994
(4.1)
0.6
2.2
3.1
Quadrix universe excluding S&P 1500
Average Outperformance
Since End of 1994
1.4
(3.6)
(3.2)
(2.1)
Median Outperformance
Since End of 1994
(7.8)
8.9
12.3
14.1

However, median returns tell a different story. The median S&P 1500 stock that pays no dividend underperformed the median stock in the index by an average of 4.1% since 1994, while dividend-paying stocks outperformed, the higher the yield the better.

Yield-oriented strategies mean more with small stocks than with large ones. The smaller the stocks in the universe, the more extreme the median outperformance of dividend stocks.

What does all this mean? We can sum it up in two points:

1) Money managers have a saying, "You can't eat medians." By definition, half of the returns in a group of stocks are above the median and half below it. Compared to other statistics such as human height or intelligence, stock returns are lopsided, with more high and low numbers, as well as some extremely big returns at the top end that tend to skew average returns higher than medians. Strategies that take the high outliers into account generally hew closer to reality.

2) Our focus on total return rather than yield makes sense. The power of Quadrix lies in its use of many statistics, not just yield.


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