December 13, 2012

Idea of the Week: Low-Yielding Stocks Can Also Generate Above-Average Returns

by Alpha Now Research Team

While investors are fretting over whether or not dividend tax rates will rise in 2013, there is an investment approach that they may want to check out, regardless of what happens in Washington. With little fanfare, stocks with low dividend payouts and low dividend yields have outperformed the S&P 500.

Released: December 13 2012
Length: 3 Minutes

One of the biggest market trends right now seems to be finding a way to prepare for what happens if there is an increase in tax rates next year as part of a temporary or permanent solution to the looming fiscal cliff. One key element of this for investors appears to be finding a way to deal with the prospect of having to pay higher taxes than they have in nearly a decade on their dividend income after December 31. (As we discussed in this week’s Earnings Roundup, this has prompted a number of S&P 500 companies to announce special dividends payable before the end of 2012.) The bottom line is that if you own stocks that pay high dividend yields in a taxable account, you could well find yourself subject to a higher tax rate in 2013 and pocketing lower returns as a result.

But there is a relatively little-known strategy to cope with this scenario that will allow you to capture a stream of dividend income in a more tax-friendly manner – and returns on this strategy have exceeded those on the S&P 500 since 1990. This strategy simply involves owning shares in companies that have a low dividend yield – but also a low dividend payout ratio. Focusing on those companies – and filtering out the companies whose earnings historically have been less sustainable – has a solid track record, although it doesn’t rely on traditional valuation, momentum or market cap strategies.

To develop a list of stocks that meet these criteria today, we used StarMine screening to identify U.S. companies in the bottom 20% of whose dividend yields, or roughly 1.4% today. (For purposes of comparison, the current dividend yield on the S&P 500 index stands at about 2%.) We also screened for companies that retain 80% or more of their earnings, with the majority left available for management to reinvest in organic growth. To create an investible universe, we winnowed down the list by eliminating any company with a market capitalization of less than $500 million, and any stock that doesn’t trade at least 200,000 shares per day on average. Finally, we used the StarMine Earnings Quality Model (EQ) to screen for companies with a high probability of being able to sustain their current profitability. Even if the U.S. economy falters or swoons in 2013, these companies are most likely to be able to ride out the storm without seeing a big drop in their earnings.

This series of screens produced a list of 151 companies with a low dividend yield but also a low payout ratio, representing each of the ten major Thomson Reuters Business Classification (TRBC) sectors. We adjust the earnings growth of each stock, multiplying it by its percentage of the market capitalization of the group as a whole, to give us the most accurate reflection of growth than a simple average. On that basis, it seems clear that these companies offer the prospect of higher earnings growth rates over the next five years than does the S&P 500 as a whole. Analysts project that these 151 firms will see earnings rise at an annual rate of 9%, compared to 7.3% for the S&P 500 – a 23% higher growth rate. In addition to capturing premium earnings growth, the valuation of these stocks appears to be more favorable: as a group, they trade at only 11.7 times free cash flow, compared to a slightly more pricey 13.6 for the S&P 500.

The 2013 list of low-yielding, low-payout ratio stocks also seems to provide investors with more exposure to an expanding economy when compared to the S&P 500 index, as may be seen from this StarMine attribution chart.

The lines that depict the sectors that would appear as overweight positions in such a low payout/low yield strategy are indicated in green in the chart above, while the red lines represent those sectors that would be underweighted. Those overweight sectors — Consumer Discretionary and Financials, for instance – tend to be those that tend to do better and to outperform when the economy is growing. Those sectors that are underweighted include the more defensive Consumer Staples and Health Care groups.

The sector that boasts the largest number of companies is the Industrials group. Companies with a low dividend yield and low payout ratio in this sector include Chicago Bridge and Iron (CBI.N), which offers investors a yield of a mere 0.50%, but that scores a perfect 100 score on StarMine’s EQ model. And the portfolio does offer a healthy degree of diversity: although it is underweight relative to other sectors, five companies in the Consumer Staples qualify for inclusion, Weight Watchers International (WTW.N) among them. Weight Watchers carries a higher 73 out of 100 score in StarMine’s Smart Holdings Model, which forecasts the likelihood of future institutional purchase based on a stock’s characteristics as well as the purchasing profile of fund managers.

View the complete list of stocks in our 2013 Low Yield and Low Payout portfolio.

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