Limit Risk, Keep The Return

12/12/2011


Any entry-level finance class will teach you that to boost your chances for higher returns, you must take on more risk.

Stocks have historically outperformed bonds, at the price of higher volatility. The relationship is not perfect, but other asset classes tend to follow the same trend. The higher the return, the higher the volatility.

However, within the world of large stocks, the rules appear to change. A number of academic studies in recent years have shown that high-volatility stocks tend to lag stocks with low or moderate volatility. The bottom chart on page 1 illustrates this phenomenon.

Does this mean investors should avoid stocks with volatile returns? Not necessarily. Plenty of high-volatility stocks have performed well. But at least among larger stocks, loading up on high-risk stocks doesn't appear to improve your prospects for high returns. And neither should investors dismiss stocks with low volatility as stodgy laggards. Our Relative Risk ratings can help you assess stocks' volatility. Check out our ratings on about 3,400 stocks at www.DowTheory.com/Go/Risk.

Income stocks less volatile

Volatility differs greatly from sector to sector, as the table below shows. But in every sector, stocks that pay a dividend are on average less volatile than nonpayers. Dividends are not always safe, but can provide a cushion during difficult market periods.

SECTOR CHARACTERISTICS
In every sector, stocks that pay dividends have averaged higher five-year returns and lower return volatility than those that do not pay dividends. We measure volatility using annualized standard deviation of monthly returns, which considers how widely returns have varied over the last five years.
Avg. Dividend
Yield
Avg. Standard
Deviation
Avg. 1-Year
Total Return
Average Quadrix Scores
Sector (No. Of Cos.)
All
Stocks
(%)
Div.
Payers
(%)
No. Of
Div. Payers
(% Of Sector)
No. Of 2%
Yielders
(% Of Sector)
All
Stocks
(%)
Div.
Payers
(%)
All
Stocks
(%)
Div.
Payers
(%)
Momen-
tum
Value
Overall
Cons. Discret. (254)
1.2
2.2
132
(52)
59
(23)
45
42
(0.5)
2.4
52
55
60
Cons. Staples (77)
2.0
2.5
60
(78)
36
(47)
31
27
12.3
13.0
47
47
55
Energy (89)
0.9
1.7
49
(55)
11
(12)
45
40
3.9
5.8
62
51
60
Financials (261)
2.8
3.2
229
(88)
159
(61)
39
38
(2.9)
(3.1)
48
53
48
Health Care (155)
0.6
1.9
49
(32)
18
(12)
36
29
4.4
10.8
53
55
63
Industrials (218)
1.4
2.0
159
(73)
64
(29)
39
37
0.4
0.7
57
55
61
Materials (93)
1.6
1.9
79
(85)
34
(37)
43
41
(0.6)
2.7
54
55
57
Technology (267)
0.5
1.9
76
(28)
30
(11)
43
36
(3.2)
1.1
49
53
60
Telecom Svcs. (18)
3.4
6.9
9
(50)
8
(44)
36
31
(7.6)
(2.6)
44
66
54
Utilities (68)
3.8
3.9
66
(97)
66
(97)
21
21
17.4
17.8
41
46
43
S&P 1500 (1,500)
1.5
2.5
908
(61)
485
(32)
40
36
0.8
3.0
51
54
57
Notes: Quadrix scores are percentile ranks, with 100 the best.   Averages exclude standard deviations and returns above 75%. 

We don't advise chasing the highest-yielding stocks. They often lack the profit-growth potential required to keep the dividend rising over time, and they tend to be concentrated in just a few sectors. Investors who buy only high-yield stocks can end up with deceptively risky, low-growth portfolios. But investors seeking income from their stock portfolios can find a number of attractive stocks with yields of at least 2%, in a variety of sectors.

LOW-VOLATILITY LEADERS
The 20 A-rated stocks below all yield 2% or more, at least comparable to a 10-year Treasury note, and pay out no more than 50% of earnings in dividends. All 20 also earn Low or Below Average Relative Risk ratings and have a five-year annualized standard deviation below the average of 40% for stocks in the S&P 1500 Index. Companies recommended for purchase are presented in bold.
Total Returns
5-Yr.
Monthly
Standard
Deviation
(Annual.)
(%)
Company (Price; Ticker)
Div.
Yield
(%)
Payout
Ratio
(%)
1 Yr.
(%)
5 Yrs.
(Annual.)
(%)
Quadrix
Overall
Score
Sector
Abbott Labs
($55; ABT)
3.5
43
21
6
17
91
Health Care
Accenture ($59; ACN)
2.3
40
36
13
23
90
Technology
Applied Mats.
($11; AMAT)
2.9
25
(13)
(8)
32
83
Technology
Chevron ($104; CVX)
3.1
24
27
11
22
99
Energy
ConocoPhillips
($73; COP)
3.6
33
17
4
30
93
Energy
CSX ($22; CSX)
2.2
30
4
14
32
83
Industrials
Dover ($58; DOV)
2.2
30
2
5
31
82
Industrials
Exelon ($44; EXC)
4.8
49
15
(3)
20
64
Utilities
Exxon Mobil
($81; XOM)
2.3
23
16
3
18
94
Energy
Intel ($25; INTC)
3.3
34
21
7
28
99
Technology
J.P. Morgan
($33; JPM)
3.0
21
(15)
(5)
36
66
Financials
Microsoft
($26; MSFT)
3.1
29
(2)
0
27
91
Technology
Newmont Mining
($67; NEM)
2.1
32
8
9
36
86
Materials
Norfolk Southern
($75; NSC)
2.3
35
22
11
28
94
Industrials
Rogers Commun.
($37; RCI) e
3.8
47
8
7
29
86
Telecom Svcs.
St. Jude Medical
($37; STJ)
2.3
26
(8)
0
30
77
Health Care
Target ($54; TGT)
2.2
28
(7)
0
28
88
Cons. Discret.
Union Pacific
($103; UNP)
2.3
38
11
19
30
85
Industrials
Walgreen ($34; WAG)
2.6
34
(4)
(3)
29
76
Cons. Staples
Wal-Mart Stores
($59; WMT)
2.5
33
11
7
16
86
Cons. Staples
Note: Quadrix scores are percentile ranks, with 100 the best.     e Estimated.

For perspective, the 10-year Treasury note currently yields 2.1%. Of course, even low-volatility stocks are riskier than a government bond, but stocks with low volatility and solid yields have appeal in today's market environment. The table above lists 20 such stocks, and three are reviewed below.

Abbott Laboratories ($55; ABT) yields 3.5%, more than twice the average for S&P 1500 health-care stocks that pay a dividend. Abbott's fat yield looks even more impressive considering its shares have climbed 14% this year, more than doubling the 6% gain posted by the health-care sector index. Abbott has increased its dividend in 39 straight years, with annualized growth of 9% over the past decade.

Abbott plans to split into two companies, spinning off its pharmaceutical operations and retaining the medical-products business. The deal should close by the end of 2012, at which time shareholders will own pieces of both companies. Both smaller stocks may prove more volatile than their progenitor, and some worry about the drug unit's ability to grow revenue once the blockbuster rheumatoid arthritis drug Humira loses patent protection in 2014. While Abbott has yet to provide many details about the spin-off, the new companies are expected to pay dividends that will combine to equal that of the original firm. Given Abbott's dividend-growth history and its ability to generate cash from operations, it seems likely that the company will continue to raise the payout. However, it is too early to project the dividend policies of the two smaller entities individually.

Looking ahead to 2012, Wall Street sees Abbott earning $5.04 per share, implying 8% growth, versus projected median growth of just 4% for pharmaceutical stocks in the S&P 1500 Index. Yet Abbott shares trade at less than 11 times the 2012 estimate, a 16% discount to the health-care sector. Abbott Labs is a Long-Term Buy.


Dover ($58; DOV) sells an array of industrial equipment and supplies, fluid-management products, heating and cooling systems, and electronic devices. By acquiring about 30 companies since 2008, Dover has reduced its cyclicality. In all, the conglomerate operates more than 40 separate business lines sprawled across 17 addressable markets. Dover has some exposure to Europe (17% of 2010 revenue), but emerging markets are expected to drive growth in the next couple years.

For 2011, Dover is on pace to produce record cash from operations. That growth should support continued increases in the dividend, raised for 56 straight years. Over the last 20 years, Dover has grown its dividend at an annualized rate of 9%.

In December, Dover said it anticipates revenue will rise 7% to 10% in 2012, versus the consensus estimate of 6% at the time of the announcement. Over the next three years, Dover expects sales to grow at an annual rate of 10% to 14%, with most of that growth organic. At nine times trailing operating cash flow, Dover trades 24% below its five-year average and a 34% discount to its industry median. Dover, yielding 2.2%, is a Long-Term Buy.


Yielding 3.1%, Microsoft's ($26; MSFT) dividend is generous by its sector's standards. Only 13% of S&P 1500 technology stocks offer yields of 2% or higher, while just 7% yield 3% or more. Microsoft has grown its dividend at an annualized rate of 12% over the past five years. The consensus projects per-share profits will rise 3% in fiscal 2012 ending June and 10% in fiscal 2013.

The company pays out just 29% of earnings in dividends, signaling that Microsoft has plenty of flexibility to keep building up its dividend in coming years. Microsoft also likes to acquire its own stock, lowering the share count by 2% in the past year and 15% over the last five years. Funding both initiatives is Microsoft's operating cash flow, totaling $27.29 billion in the 12 months ended September and rising in six of the last seven quarters.

Microsoft shares have traded in a fairly tight range, spending most of this year between $24 and $29. Similarly consistent is the stock's Quadrix Overall score. The score has exceeded 80 at the end of 24 straight months and is currently 91. Microsoft is a Buy and a Long-Term Buy.


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