Rising Yields Not Always Good

4/11/2016


In theory, the idea sounds great. Why not buy stocks with yields way above their normal level? Doesn't that mean you get more income?

Yes and no.

• Yes: Gilead Sciences ($97; GILD) yields 1.8%, about six times its five-year average yield of 0.3%. The ratio makes sense when you consider the biotech giant initiated the dividend in February 2015. Before then, the yield was 0%. We'll take that kind of dividend growth every day.

• No: The yield of energy producer Murphy Oil ($25; MUR) has ballooned to 5.7% after averaging 2.6% over the last five years. Murphy's dividend has remained steady for seven straight quarters, but the shares have fallen 51% over the last year. Such a haircut makes the yield look great on paper.

Like a lot of energy stocks, Murphy yields more than it has in the past. But the consensus projects operating losses this year and next year, the perfect recipe for a dividend cut. Call it a yield trap.

Yield is in some ways a proxy for risk, and if the market is suddenly willing to pay out triple the normal yield, consider the reason.

Dividend yields shed some light on valuation, and many investors see high yields as a sign of deep value. However, we don't consider yields particularly good measures of value. They reflect a company's payout policy; and if a company has sufficient cash, it can boost the yield as high as it desires, setting its own "value."

For example: Gilead yields 1.8%, while rival AbbVie ($60; ABBV) yields 3.9%. Of course, to deliver that fat yield, AbbVie must pay out more than half of its earnings in dividends, compared to Gilead's less than one-sixth of earnings. AbbVie also trades at a higher multiple of earnings than Gilead, and it's hard to call AbbVie cheaper than Gilead despite its higher yield.

The table below lists recommended stocks that came by their higher-than-normal yields the right way: Dividend growth supported by higher profits, such that the payout ratio remains reasonable.

STOCKS WITH HIGHER YIELDS THAN USUAL
Payout ratio measures indicated year-ahead dividends as a percentage of trailing 12-month earnings. Dividend and payout-ratio growth for big banks reflects rebounds from financial-crisis-related dividend cuts.
--- Dividend Yield ---
Initiated Or
Reinstated
Dividend
In Last
5 Years
3-Year Annualized
-------- Growth --------
Company (Price; Ticker)
Div.
($)
Indicated
Year
Ahead
(%)
5-Year
Average
(%)
Payout
Ratio
(%)
Per-Share
Dividends
(%)
Per-Share
Earnings
(%)
Alaska Air
($80; ALK)
1.10
1.4
0.5
Yes
17
NA
44
Apple ($111; AAPL)
2.08
1.9
1.4
Yes
22
11
14
CDW ($42; CDW)
0.43
1.0
NA
Yes
15
NA
25
Gilead Sciences
($97; GILD)
1.72
1.8
0.3
Yes
14
NA
88
Goodyear Tire
($31; GT)
0.28
0.9
0.4
Yes
8
NA
20
Owens Corning
($49; OC)
0.72
1.5
0.7
Yes
28
NA
36
Skyworks Sol.
($78; SWKS)
1.04
1.3
0.3
Yes
19
NA
59
Wells Fargo
($48; WFC)
1.50
3.1
2.5
No
36
19
6
NA Not available because of a lack of history.

How does yield work in Quadrix?

We consider yield in our Quadrix score because of the metric's importance in the eyes of investors, but regular readers know we advise against selecting stocks purely on yield. On average, stocks in the top quintile (one-fifth) for dividend yield have underperformed the average stock in the S&P 1500 Index by 0.5% in rolling 12-month periods since 1994.

Relative yield has a bit more predictive power than absolute yield, but not enough to warrant our using it in the Quadrix calculation. As shown in the table on page 1, the top quintile as measured by yield divided by three-year median yield outperformed by an average of 0.7%, while stocks with the best yields relative to five-year medians delivered 0.1% outperformance. However, despite their outperformance over the long term, stock with high yields relative to historical norms lag more often than they lead. These stocks have performed terribly in recent months, with the top quintile lagging by more than 7% in the year ended February.

The irregular performance of relative yield shouldn't surprise us, as other relative-valuation metrics (such as price/sales versus historical norms) also tend to have low winning percentages. However, most of the traditional relative-valuation metrics also generated better returns.


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