So if our last post on how dividends aren’t likely to continue growing in the near future, or that they even might begin to contract, didn’t turn you off on finding some high paying stocks, then you’re probably starting to ask yourself what’s the best way to go about buying them? The rise of passive investing means that most people will simply settle for an ETF or mutual fund instead of building their own portfolio of individual stocks and for many this is as simple as finding the strongest performing fund with the word dividend in its name and/or trying to find the lowest possible fee. Seems easy but that overlooks one very important fact, that you don’t know anything about what’s actually in the fund!
To be fair, ETF names have become more descriptive lately as demonstrated by the Compass EMP U.S. EQ Income 100 Enhanced Volatility Weighted Index ETF (CDC) but that’s just one fund in the 27 that ETFG.com puts in their Equity High Dividend Yield category (and who have a US focus and no leverage) and in the last year they’ve delivered anywhere a return of anywhere from a -6% to a positive 21% so it would seem safe to assume that not all funds are created equal.
But if picking a fund out of a hat is a sure way to wind up losing a lot of money very quickly, then doing a ton of research on every fund is a guaranteed path to riches right? Sort of? One of my favorite parts of the due diligence process is figuring out exactly how each strategy differs from another and whether it’s called “equity income” or “dividend focused” or even “dividend dogs” most dividend strategies employ the same basic philosophy that Benjamin Graham outlined in the 1930’s and 40’s.
- Find the highest dividend payers.
- Determine why they’re cheap and if their payouts are sustainable.
- Buy them.
- Sell them when they stop being cheap.
There are a thousand variations on this strategy; whether you have a rigid set of screening rules, how you weight your investments and most importantly when to sell, but essentially they’re all just better mousetraps of the same basic strategy. We’re saving the reviews of different strategies for parts III and IV so in part II so instead we’ll focus on finding what’s still cheap in this market before finding out which funds out there are invested in those names. Think of it as the exact opposite of how most investors are looking at their investments in 2016.
My own search for value stocks was built around finding names that could meet two very basic criteria that I borrowed from John Train’s “The Money Masters of our Time.” The first was that the current dividend yield must be close to or greater than the AAA bond yield (currently around 3.3%) while the second was that the earnings yield should be 2X greater than that which translates into a TTM P/E of approximately 15x. The logic behind this is straightforward and almost brutal in its simplicity; I want stocks that can offer a yield at least as high as that I can get on an ultra-high quality investment grade bond and at a reasonable price. The last thing I want is to buy a stock yielding 5% only to see it lose 15%-20% of its value in the event the market pulls back. Remember when I said that XLU was trading close to peak valuations? You may want to laugh, but Oneok Inc (NYSE:OKE) is still yielding over 5% with a trailing P/E of over 36x after shooting up 120% in the last six months.
There’s a lot more research involved in this process, but for a quick market screen I used the free scanning tool on Finviz.com which started with a global universe of over 7000 names before I shifted to U.S. only stocks (no closed-end funds or ETF’s.) That left me with 4,093 names to choose from and guess how many were left last Saturday after I set the dividend yield to over 3% and PE below 15%? Only 203 names and once I pulled out the muni funds that had snuck through along with all the energy MLP’s left me with just 141 names. I trimmed the list even further to pull out companies currently paying out more than 100% of their income as dividends which brought it down to an even more manageable 120.
Just 120 stocks out of a universe of over 4000 currently offer a yield above 3% at a reasonable (relative) price and those 120 that made the short-list don’t have a lot of reason to celebrate in 2016. Screening on dividend yield isn’t likely to bring up a list of companies having a great 2016 and these names are all challenged by weak to negative earnings growth but some of the names on this list are truly shocking.
Let’s start by pointing out what isn’t at all shocking which is the strong showing by retailers including national chains like Target (TGT), Macy’s (M) Nordstroms (JWN) and Kohl’s (KSS.) Even specialty retailers like The Gap (GPS), Buckle (BKE) and Gamestop (GME) made the screen although a more stringent set of rules would probably keep them out of almost every dividend-focused fund. Most of the investment greats had rules in place about only buying stocks where the year-over-year EPS were positive and that’d rule out most of the retailers on this list with the exception of Target and Gamestop.
What is truly surprising is that two of America’s most famous industrial concerns are on this list with Ford and GM are trading at LOW P/E multiples, 6.13x and 4.62x respectively, compared to 21.2x for the broader Consumer Discretionary Select Sector SPDR (XLY)! That’s not just cheap, that’s CHEAP for two companies that have approximately 31% of an industry that sold $570 billion worth of products in 2015. To understand just how cheap they are, let’s compare them to the one automotive name that investors still follow, Tesla (TSLA) which has a market cap of over $33 billion compared to $48 billion for GM despite delivering only 50,508 cars in 2015 compared to 9.8 MILLION for General Motors. Nor is the problem unique to America; my own personal favorite remains Toyota Motors (TM) which would’ve been on this list if I hadn’t excluded foreign companies while the international-heavy First Trust NASDAQ Global Auto ETF (CARZ) has a trailing P/E of 7.9 and a dividend yield of 2.3%!
What’s not on the list include a lot of the names that make up highest dividend paying ETF’s or mutual funds. There’s very light exposure to utilities and consumer staples names although 11 REIT’s are on the list although EIT’s typically aren’t included in many dividend funds but in our case we’ll make an exception since the sum of their market caps (around $15 billion) is still smaller than that of Public Service Enterprise Group (PEG), one of only 2 utilities to make it this list! Take that as a sign of just how far the utilities sector has come that only 2 stocks out of the 49 currently tracked by Finviz have a P/E below 15x!
Consumer staples aren’t completely absent with Reynolds American (RAI) as the sole cigarette company that made our screen with a market cap of $74 billion and one food company, Rocky Mountain Chocolate Factory (RMCF) who’s market cap of $60 million is probably roughly what Reynolds spends on jet fuel every year. If we were to take these 120 names and turn them into a market-cap weighted portfolio we’d have just under 8% in consumer staples compared to more than 10.6% for the S&P 500 or almost 24% for one of the largest funds in the space, the Vanguard Dividend Appreciation Index Fund (VIG).
In fact, if you look at the table below you’ll see that what dominates the list, at least in sheer number of companies, is the financial sector with 68 names including those 11 REIT’s we mentioned earlier. Check out the full pivot table at the end of this post and you’ll see that tiny northeastern banks with a micro-market cap make up the largest sub segment but financial behemoth Wells Fargo (WFC) almost singlehandedly drags the sector’s average to over $6.8 billion. Wells Fargo isn’t the only megacap name on the list although they’re in short supply; if we were building a market-cap weighted fund then technology stocks would enjoy top-billing with IBM, Cisco (CSCO) and Verizon (VZ) all making the list and all with a market cap greater than $150 billion. In fact, at its current payout level, Apple (AAPL) just barely misses out on being included in this list with a dividend yield of “only” 2.28% but even without it and sticking with our market cap weighted portfolio, we’d have over 22% in tech stocks versus 17% for the S&P 500 and just 9% for VIG.
So now that we know what’s truly cheap in this market, we have to go about finding who owns it and who’s just holding onto a portfolio of now expensive stocks primed for a fall. Stay tuned for part III where we look for passively managed funds offering smarter ways to access dividend paying stocks.
And here’s that complete pivot table for anyone who’s interested: