Don't start with dividends

6/8/2009


For the market as a whole, dividend-related statistics are of only modest help in selecting winning stocks.

The top one-fifth of S&P 1500 stocks as measured by dividend yield averaged a 12-month return 1.0% below that of the average stock since 1994. While portfolios containing the top stocks as measured by dividend growth averaged performance similar to or higher than that of the average stock, they didn’t do nearly as good a job as the Quadrix Overall score..

However, while neither yield nor dividend growth is an effective stock-selection tool for the market as a whole, they do work fairly well in some sectors. We back-tested returns of S&P 1500 stocks in the last 161 rolling 12-month periods and unearthed several interesting facts about dividend-related metrics.

• Portfolios containing stocks with the highest current yields and yields relative to their three-year averages generated superior returns and outperformed the average stock more than half of the time in only two sectors: consumer staples and telecommunications services. Conspicuously absent from the short list of sectors are financials and utilities, favorites of income investors. We don’t recommend any telecom companies that pay dividends, and our top consumer-staples picks are retailers Wal-Mart Stores ($51; WMT), yielding 2.2%, and CVS Caremark ($31; CVS), yielding 1.0%.

SECTOR ANALYSIS
While Quadrix Overall and Value scores are effective at identifying winning stocks within most sectors, yield and dividend growth do not work as well. Average outperformance represents the average 12-month return of the top one-fifth of stocks in a sector as measured by a certain statistic minus the average return of all stocks in a sector. Winning percentage reflects the percentage of periods when the top one-fifth outperformed the average stock. For example, within the consumer-discretionary sector, the top-yielding stocks averaged a return 2.4% below that of the average stock and outperformed the average stock only 42.2% of the time. All data is based on a back-test of rolling 12-month periods since 1994.
Quadrix
—— Scores * ——
Div. Growth
—– (Annual.) —–
S&P 1500 Index Sector
Performance
Overall
(%)
Value
(%)
Indicated
Dividend
Yield
(%)
Yield
vs. 3-
Yr. Avg.
(%)
3
Yrs.
(%)
5
Yrs.
(%)
Cons. Discretionary
Average Outperformance
6.1
1.1
(2.4)
(2.1)
(0.6)
(1.6)
Winning Percentage
75.8
50.9
42.2
32.9
39.8
34.8
Consumer Staples
Average Outperformance
(0.5)
3.8
2.0
1.6
0.8
(0.2)
Winning Percentage
44.1
53.4
54.0
54.7
56.5
53.4
Energy
Average Outperformance
2.1
2.5
(2.4)
1.5
2.0
2.2
Winning Percentage
54.7
52.8
45.3
45.3
49.7
50.9
Financials
Average Outperformance
2.6
3.0
0.6
(0.9)
1.3
1.3
Winning Percentage
60.9
65.8
48.4
39.8
52.8
60.2
Health Care
Average Outperformance
(0.3)
1.8
(0.5)
(2.1)
(3.3)
(1.3)
Winning Percentage
49.7
58.4
46.0
37.3
37.9
37.3
Industrials
Average Outperformance
(0.4)
2.2
(0.4)
0.3
0.3
(0.5)
Winning Percentage
43.5
64.0
55.3
47.2
50.3
41.0
Information Technology
Average Outperformance
4.7
2.4
(3.0)
(1.2)
(0.7)
(0.5)
Winning Percentage
69.6
62.7
44.1
52.2
42.9
42.9
Materials
Average Outperformance
4.2
5.5
(2.0)
0.8
2.3
1.3
Winning Percentage
72.0
67.7
42.2
40.4
55.3
52.2
Telecom Services
Average Outperformance
(1.5)
3.5
1.8
7.5
6.7
5.6
Winning Percentage
49.7
60.9
57.8
65.8
68.9
68.9
Utilities
Average Outperformance
0.6
2.7
(0.2)
(0.1)
(0.4)
(1.5)
Winning Percentage
55.9
59.0
44.1
52.2
41.6
44.7
* Quadrix scores are percentile ranks, with 100 the best.

• Dividend-growth factors work better than yield factors but still fail to add value in many sectors. Portfolios containing the top three-year and five-year dividend growers generated above-average returns in four sectors: energy, financials, materials, and telecom services. Attractive dividend growers in these sectors include Airgas ($45; ARG), Chevron ($69; CVX), Schlumberger ($59; SLB), and Aflac ($37; AFL).

• In the financial and utility sectors, Quadrix Overall and Value scores delivered better performance than the yield or dividend-growth factors we considered. When fishing in sectors known for their yields, investors should look beyond dividend-related statistics to differentiate individual stocks.

To our way of thinking, dividend yields and growth rates should be considered after you have already identified a basket of stocks with strong fundamentals.

Over the last year, British drugmaker AstraZeneca ($42; AZN) paid $2.05 per share in dividends; $1.50 in March, up 11% from the year-earlier payment, and $0.55 in September. The company plans to keep paying a dividend equal to one-third to one-half of earnings, hiking the payout in line with earnings growth.

Emerging markets, which contain 85% of the world’s population, are key to the company’s growth. Representing nearly 14% of revenue in 2008, AstraZeneca’s sales to emerging markets increased 16% at constant currency for the year.

Driving sales higher are three important drugs: Symbicort (asthma), Crestor (cholesterol), and Seroquel (antipsychotic). Seroquel has made headlines lately, with lawsuits claiming it caused patients to develop diabetes. The first three cases have been dismissed. In the fourth, AstraZeneca won a judgment to exclude testimony from a medical expert. AstraZeneca is a Buy and a Long-Term Buy.


Energen ($38; EGN) offers a somewhat safer alternative to pure plays for investors seeking exposure to the energy market. Operations are partially insulated from volatile energy prices, with 76% of expected 2009 production hedged.

Energen Resources, the production unit (65% natural gas, 25% oil, 10% natural gas liquids), fueled 88% of net income in 2008. In May, the business agreed to buy about 13,000 acres and 500 wells in the Permian Basin of West Texas.

The rest of Energen’s profits come from Alagasco, a natural-gas utility in Alabama. Alagasco provides a consistent income stream and pays out more than 65% of that profit to fund Energen’s dividend. Energen has boosted its dividend in each of the past 27 years, rising at a compound rate of 6% since 2004. Energen, yielding 1.3%, is a Long-Term Buy.


General Dynamics ($60; GD) has grown its quarterly dividend at an annualized rate of 17% over the last five years. The latest increase, declared in March, raised the quarterly payout 9% to $0.38 per share. Strong operational performance has funded dividend growth, with sales, earnings per share, and free cash flow climbing steadily over the past five years.

While General Dynamics’ Gulfstream line of large business jets is suffering, the recession has been much harder on makers of smaller planes. The aerospace segment represents 29% of General Dynamics’ $71.1 billion backlog. Corporate spending on luxuries such as jets has drawn investor scrutiny, and demand could remain weak in coming quarters. But public companies represent only 27% of General Dynamics’ backlog, while private companies and individuals, presumably less concerned about public scrutiny, comprise 68%.

At less than 10 times trailing earnings, General Dynamics trades at a wide discount to its five-year average P/E of 17. A return to the historical average P/E could push the stock above $100 by the end of the year. While such a gain is unlikely, the stock seems capable of reaching $75 over the next 12 months. General Dynamics is a Buy and a Long-Term Buy.


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