High-Yield Stocks Not A No-Brainer

11/28/2011


Perhaps because prices for the Dow Industrials and S&P 500 Index have gone virtually nowhere this millennium, more investors are approaching stocks with a cash-on-the-barrelhead mentality. They want dividends now, and they're willing to pay up to get them.

Companies are responding with broad-based dividend increases but are wary of giving up too much financial flexibility, partly because of fears of another seizure in the credit markets. The percentage of earnings being distributed in dividends is low relative to historical norms, and cash as a percentage of corporate assets is near 50-year highs. Only one-half of the large stocks in the S&P 500 Index yield at least 1.8%, while only one-fifth yield at least 3.2%.

Still, a 3.2% yield compares very favorably with the 1.9% offered by 10-year Treasury bonds. Even relative to the 4.0% to 5.0% offered by investment-grade corporate bonds, a 3.2% yield is very competitive considering the potential dividend growth and share-price appreciation offered by stocks. Using this logic, many see high-yielding stocks as a no-brainer, and investment companies have responded with a slew of new dividend-oriented funds.

We see two reasons for concern. First, stocks are not bonds, and high- yielders can be just as vulnerable as other stocks during market declines. If you are shifting from bonds to stocks based on yield, make sure you have the fortitude and diversity required to ride through stock-market downturns. While we are confident stocks will outperform bonds over the next decade, we expect a volatile ride.

Second, because of increased demand for dividends, high-yielding stocks are unusually expensive relative to other stocks. Consider:

• Among all stocks in the S&P 500, the median trailing price/earnings ratio is 14.5, well below the 17-year norm of 18.1. For the top one-fifth of S&P 500 stocks based on dividend yield, the median P/E of 14.1 is roughly in line with the 17-year norm of 14.3. For the 202 month-ends since December 1994, the P/E of high-yielders has never been as high relative to the P/E of all S&P 500 stocks.

• Much the same holds for valuation comparisons based on enterprise ratio and price/cash flow. For Quadrix Value score, which reflects a variety of valuation measures, the median S&P 500 stock earns a 61, in line with the long-term norm of 59. But the median for high-yield stocks is 58, well below their norm of 74. Until August of this year, the median Value score of the high-yielders had exceeded the median of all S&P 500 stocks every month since 1994.

• The same basic story, with high-yielding stocks expensive relative to other stocks, holds for nonfinancial stocks in the S&P 500 — and for broader indexes like the S&P 1500 and our Quadrix universe of more than 4,400 stocks. For S&P 1500 stocks, the relative valuation of the top one-fifth on yield is near the highest levels since 1994 based on enterprise value/EBITDA, price/earnings, price/cash flow, and price/sales ratios.

Implications for investors

The drop in Quadrix Value scores has coincided with a drop in Quadrix Overall scores. That suggests the richer relative valuations of high-yielding stocks reflect investors' thirst for yield — not an improvement in the fundamentals of high-yielding stocks.

Among S&P 500 stocks, the top one-fifth based on yield earns a median Overall score of 47, below the 17-year norm of 54. By contrast, the median for all S&P 500 stocks is 64, above the norm of 61. For S&P 500 stocks with no dividend, the median of 64 is well above the norm of 57.

While you should continue to look for opportunities in high-yielding stocks, now seems an especially bad time to chase richly valued stocks simply because of their yield. If income is a big consideration, widen your search to include lower-yielding stocks with attractive dividend-growth potential.

Listed in the table below are 10 A-rated stocks with dividend yields of at least 0.8%, higher than at least 59% of U.S.-traded stocks. Despite healthy dividend growth in recent years, all 10 have dividend payout ratios below 35%, leaving ample room for dividend growth. All 10 earn above-average scores based on all of the relative valuation measures used in Quadrix, such as P/E relative to the median P/E over the past five years. Especially attractive names include Exxon Mobil ($77; XOM), Microsoft ($25; MSFT), and Oracle ($30; ORCL).

As a partial hedge, we still think it makes sense to hold 21% to 22% of your stock portfolio in a short-term bond fund like Vanguard Short-Term Investment-Grade ($10.64; VFSTX). While the fund's 1.8% yield is not especially attractive relative to higher-yielding stocks, the fund has a good record of holding up in volatile market environments.

DIVIDEND GROWERS WITH ATTRACTIVE VALUATIONS
Listed below are 10 A-rated stocks with superior dividend-growth potential and attractive valuations. All 10 trade at a discount to historical norms based on all of the relative valuation measures used in Quadrix. For example, the ratio of current trailing P/E to five-year median trailing P/E for Baxter International is 0.80, lower than about 67% of U.S.-traded stocks. Stocks recommended for purchase are in bold.
Quadrix Scores
Dividend Yield
Trailing
P/E Ratio
P/E Vs. 5-Yr.
Median
Price/Cash
Flow Vs. 5-Yr.
Median
Dividend Yield
Vs. 5-Yr.
Median
Company (Price; Ticker)
Overall
Value
Yield
(%)
%
Rank
Ratio
%
Rank
Ratio
%
Rank
Ratio
%
Rank
Ratio
%
Rank
Baxter International
($49; BAX)
82
63
2.3
74
12.7
65
0.80
67
0.81
67
1.20
86
Cisco Systems
($18; CSCO)
93
78
1.3
64
14.6
54
0.77
72
0.78
71
NM
NM
Exxon Mobil ($77; XOM)
94
85
2.4
75
9.4
81
0.80
67
0.78
71
1.13
81
General Dynamics
($63; GD)
83
84
2.9
79
9.1
83
0.83
63
0.81
67
1.29
89
Hewlett-Packard
($27; HPQ)
75
99
1.8
69
6.3
92
0.45
97
0.43
96
2.33
98
J.P. Morgan Chase
($30; JPM)
64
98
3.3
82
6.7
91
0.55
93
0.53
92
1.17
84
Microsoft ($25; MSFT)
91
86
3.2
81
9.5
81
0.66
86
0.67
83
1.60
95
Oracle ($30; ORCL)
95
58
0.8
59
17.6
40
0.88
56
0.86
60
2.70
99
St. Jude Medical
($36; STJ)
75
77
2.4
75
12.1
68
0.74
76
0.56
90
NM
NM
Walgreen ($31; WAG)
77
86
2.8
78
11.9
69
0.74
76
0.65
84
1.86
97
Note: Quadrix scores are percentile ranks.     NM Not meaningful; dividend initiated within five years.

 


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