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Norm Speaks
Stocks that sport a healthy dividend yield are often derisively called 'widow and orphan' stocks to reflect their stable nature. As it turns out, widows and orphans have been onto a good thing. The desirability of dividends was pointed out by veteran value-investor David Dreman in his recent Forbes article Why Dividends Matter (April 19, 2004). Mr. Dreman updated his long running study of U.S. dividend stocks and, with this new data in hand, I decided to take a second look at a few earlier investigations.
Before diving into the new findings, it is useful to look at the results David Dreman reported in his book Contrarian Investment Strategies: The Next Generation. Here, Mr. Dreman examined high-yield US stocks from January 1 1970 to December 31 1996 and found evidence for outperformance as shown in Table 1. Dreman studied a sample composed of 1,500 of the largest stocks in the US and sorted them into groups of five (quinitiles) based on their price-to-dividend ratio. The price-to-dividend ratio is simply the inverse of a stock's dividend yield. The lowest 20% of price-to-dividend (or highest yielding) stocks were put into quintile one and the highest 20% (or lowest yielders) were put into quintile five. From 1970 to 1996 the best approach was to select the second highest yield group each year which returned 17.5% vs. 14.9% for the market (before taxes and commissions). The highest yielding group also outperformed the market but by a smaller amount.
| Table 1: Annual returns by dividend yield from 1970 to 1996 in the U.S. | ||||||
| P/D Quintile | High Yield | 2 | 3 | 4 | Low Yield | Market |
| Dividend | 8.0% | 5.4% | 3.9% | 2.2% | 0.7% | 4.0% |
| Capital Gain | 8.2% | 12.1% | 11.2% | 11.6% | 11.5% | 10.9% |
| Total Return | 16.1% | 17.5% | 15.1% | 13.8% | 12.2% | 14.9% |
| Data: Contrarian Investment Strategies: The Next Generation | ||||||
After the internet bubble high yielding stocks continued to perform well. In Dreman's Forbes article he once again looked at 1,500 large US stocks and divided the stocks into five groups (or quintiles) based on yield. However, he only revealed the results for the highest, lowest, and average yield groups. As show in Table 2, high yield investors outperformed the average by about 2% annually over several different time periods.
| Table 2: Stocks with high dividend yields have outperformed in the U.S. | |||
| Annualized Total Returns | |||
| Compustat 1500 | 10-Year 1994-2003 | 20-Year 1984-2003 | Since Inception 1970-2003 |
| High Yield | 13.3% | 14.7% | 14.5% |
| Average | 11.1% | 12.6% | 12.6% |
| Low Yield | 9.1% | 9.7% | 8.8% |
| S&P500 | 11.0% | 12.9% | 11.3% |
| Data: Dreman Value Management, Forbes Article (April 18 2004) | |||
It is useful to look at another study before getting too happy about a simple high-yield approach. Here I turn to What Works on Wall Street by James O'Shaughnessy and his broad study of high-yield US stocks from 1951 to 1996. O'Shaughnessy split his universe of stocks into groups of ten (deciles) with the top 10% of yields in decile one and the lowest 10% of yields in decile ten. As seen in Table 3, a slight high-yield advantage was evident but avoiding the very highest yielding stocks was again a better strategy. In this case the difference between the market's return of 13.2% and the 14.0% returned by high-yielding stocks was only 0.8%.
| Table 3: O'Shaughnessy's High Yield Study | ||||||||||
| Decile | High Yield | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | Low Yield |
| Return | 14.0% | 13.8% | 15.1% | 14.3% | 13.4% | 13.5% | 12.6% | 13.0% | 11.7% | 11.8% |
| Data: US companies from 1952 to1996 with a market cap larger than $150M | ||||||||||
One possible reason for the slightly poorer performance of the highest yielding stocks is the increased risk of a dividend cut. Dividend yield is usually based on dividends paid in the previous year divided by the current stock price. Should a company falter, its stock price usually goes down rapidly which pushes up the apparent dividend yield. If the stock is in real trouble then its dividend is often reduced or cut altogether. Suddenly a juicy yield of 10%, based on past dividends, disappears. Dividend investors should try to make sure that their companies are able to earn more than enough to cover their dividends.
Another potential reason for the less than best performance of the highest yielding stocks may be industry concentration. For instance, some industry groups (i.e. utilities) tend to be overly represented in the highest yield group. Here David Dreman provided a very useful follow-up study in his book where he looked at the performance of different dividend-yield groups within each industry and then averaged the performance of these groups across all industries. The results in Table 4 show that buying the highest yielding stocks in each industry has provided better returns than average. It would appear that investors can benefit from a high dividend yield approach and diversification across many industry groups at the same time.
| Table 4: Industry Relative returns by dividend yield (1970 to 1996) | ||||||
| P/D Quintile | High Yield | 2 | 3 | 4 | Low Yield | Market |
| Dividend | 6.5% | 5.0% | 3.9% | 3.1% | 1.6% | 4.0% |
| Capital Gain | 10.4% | 11.0% | 11.0% | 11.0% | 11.1% | 10.9% |
| Total Return | 17.0% | 16.0% | 14.9% | 14.1% | 12.7% | 14.9% |
| Data: Contrarian Investment Strategies: The Next Generation | ||||||
Based on the historical record, it appears that conservative widows and clever orphans get it right by selecting high yield stocks. Other investors can reasonably hope that a diversified high-yield approach will continue to fill their plates, even if they may be somewhat less deserving.
Sources:
Contrarian Investment Strategies: The Next Generation by David Dreman (ISBN 0684813505)
What Works on Wall Street by James O'Shaughnessy (ISBN 0070482462)
Web Sources:
Forbes: Why Dividends Matter
First published in May 2004.
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A Dan Hallett and Associates Inc. publication. Norm Rothery, Ph.D., CFA, is the Chief Investment Strategist at Dan Hallett and Associates Inc. (DH&A) and the founder of StingyInvestor.com. DH&A is registered as Investment Counsel in the province of Ontario. Norm, DH&A, or related-parties may have an interest in the securities mentioned. More...