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Story originally ran in Registered Rep.'s October 2006 issue

During the great buying panic of the 1990s, few seemed to give a darn about dividends. Not a good use of shareholders' money, market mavens argued. Indeed, by the year 2000, the dividend yield on the S&P 500 had dwindled to just 1.1 percent, down from the early 1980s, when the yield averaged around 5 percent.

Of course, a bear market tends to focus the mind, and once again investors have learned that companies that pay a dividend tend to have good cash flow. A recent study (by Rob Arnott, of Research Affiliates, and Clifford Asness, of AQR Capital Management) suggests that a dividend is a good predictor of a company's future earnings. (Meeting regular dividend payments keeps managers from getting lazy.) Ned Davis Research found that from 1972 to 2005 dividend-paying stocks returned 10.1 percent compared to just 4.1 percent for those that didn't. Dividends also reduce volatility in down markets.

While more companies on the S&P are paying dividends now than in the late 1990s (in 2003 taxes on payouts were cut to 15 percent), there still is plenty of room for improvement. Today, the S&P yields around 1.9 percent compared to the 4.1 percent average yield since 1926. Clearly the market is demanding more income (dividend-paying stocks have been outperforming growth companies) and many believe the trend will continue. Demographics (retiring baby boomers) and evidence that dividends do, in fact, do more than buybacks in boosting share price should see to that.

Playing the Dividend Game

There are many ways to get clients exposure to dividend strategies, from new ETFs and closed-end funds to actively managed funds. Or you can build such portfolios yourself.

There are many well-known — and simple — strategies to borrow from. The main trap that most dividend devotees fall into is buying a high dividend-yielding stock that ends up getting its dividend cut. That will crush a stock. For instance, in 2003, Eastman Kodak, trading on the Dow Jones Industrial Average, yielded 5.14 percent. Kodak couldn't sustain that cash payout and was forced to cut its dividend. The stock lost 25 percent of its value and it got tossed from the Dow in April 2004.

We have created a screen out of four proven value strategies that can reduce that risk. The Dogs of the Dow strategy is probably the most well-known dividend-yielding strategy because of its elegant simplicity. It is also a decidedly contrarian bet: You take the 30 stocks in the Dow and rank them by dividend yield, buying equal dollar amounts of the 10 stocks with the highest yield. Remember, since dividend yields move inversely to the price of the stock, these stocks are essentially unloved (hence the name Dogs of the Dow). There have been many studies (and a few books) showing that the Dogs strategy outperforms over long periods with less volatility (of course, it fell out of favor during the tech bubble, but has been reclaiming adherents since the blow up).

The Dow Jones Select Dividend Index strategy is a variant of the Dogs, but the universe from which to choose is far bigger. Further, investors also measure for dividend-paying consistency to eliminate, say, a Kodak surprise. Dow Jones does not release the exact stock selection process. It is believed to include all companies in the Dow Jones U.S. Total Market Index (minimum market cap of $100 million) that have five years of dividend growth, a payout ratio less than 60 percent and trading volume greater than 200,000. Out of those companies, the top 100 dividend-yielding stocks are selected and the portfolio is rebalanced once a year. By examining the recent growth trend of the dividends and looking at the percentage of the company's earnings paid out in cash (called the payout ratio, which must be less than 60 percent), this method tries to avoid companies who may be forced to cut dividends in the near future.

There is no one strategy that will fit all investors, and no one strategy that will work in all markets. Still, the point of both strategies is similar. The Dogs of the Dow strategy picks blue-chip companies that are, momentarily (it is hoped), unloved by investors. The Dow Jones Dividend Select tries to dampen risk by selecting from a larger universe of stocks, all with increasing dividends. The problem with any dividend-yielding strategy is that investors tend to seek growth shares during bull markets, forsaking mature, dividend-paying stocks in the process.

Screening for Names

To create a screen to find the best of the high yielding, we borrow from two other strategies that tend to do well in bull and bear markets. In Joel Greenblatt's book The Little Book That Beats The Market (Wiley, 2005), he showed that companies that have low P/Es and high returns on capital beat the market over long periods of time. We made one modification to Greenblatt's simple “magic formula” (as he calls it): We also throw in a low price-to-book ratio (thanks, Graham and Dodd).

Zacks Investment Research's study combines the Dogs, Dow Jones Select Dividend, the Greenblatt “magic formula” and Graham and Dodd into one strategy. The study, performed from 1995 through 2005, took the largest 1,000 market-cap stocks at each annual rebalancing period and screened for all companies that had been increasing dividends over the last five years with a current payout ratio less than 60 percent. The final step is to buy the top 10 stocks that have the best combination of a low price-to-book and a high return on capital.

The strategy produced a 22.6 percent average annual return, outperformed the S&P by 13 percent annually; it outperformed all down markets and beat 57 percent of up markets, with a beta of less than 0.70. It outperformed the Dow Dogs by an average of 10 percent per year. Its worst performing year? A negative 1 percent, which compares favorably to the S&P's worst year drop of 22 percent during the period. That is what you call strong returns (and income) and preservation of capital.

The Dogs of the Blue Chips

Zacks Investment Research combined four famous value strategies to create one uber value strategy. The screen took elements of the Dogs of the Dow, Dow Jones Select Dividend Strategy, the Greenblatt “magic formula” and Benjamin Graham and David Dodd. Below is a list of the top stocks that passed the screen as of market close on Sept. 8.

Company Ticker Market Cap ($mil) Price/Book Return on Capital Dividend Yield
D R Horton DHI $6,892 1.11 26.92 2.73
ConocoPhillips COP 99,429 1.29 25.48 2.39
Lehman Bros LEH 35,526 2.10 23.31 0.73
W.R Berkley BER 6,527 2.34 23.14 0.47
Home Depot HD 70,856 2.60 23.25 1.75
Masco MAS 10,757 2.32 20.42 3.26
Nucor Corp. NUE 15,314 3.33 33.32 0.50
Comerica CMA 9,217 1.78 16.57 4.15
H&R Block HRB 6,809 3.23 28.92 2.55
Fidelity National Financial FNF 7,341 1.67 16.09 2.79
Hartford Financial Services HIG 25,627 1.661 15.86 1.90
ExxonMobil XOM 397,183 3.49 33.43 1.92
Citigroup C 240,869 2.12 18.49 4.02
First Horizon National FHN 4,722 1.92 17.26 4.72
Fortune Brands FO 10,896 2.44 19.78 2.16
US Bancorp USB 57,208 2.95 23.66 4.10
Chubb Corp. CB 20,709 1.65 15.12 1.98
Gannett Co. GCI 13,176 1.64 15.00 2.08
Washington Mutual WM 40,157 1.51 13.94 4.96
Energen Corp. EGN 3,054 3.01 23.63 1.04
Lincoln National Corp. LNC 17,108 1.50 13.60 2.49
Pfizer PFE 20,1171 2.96 23.27 3.48
Source: TSX.com