Ariston Select: Income Stocks
(Formerly Reuters Select)
Dividends, the mainstay of stock valuation, were out of fashion for a long time. But they are coming back into favor now. But that doesn't mean all income stocks are created equally. This screen targets some of the better opportunities in this group.
Rationale for this screen
Dividends, out of fashion for many years, came back into vogue in a big way in late 2002 and early 2003. To some extent, this reflected a quest for perceived safe havens during the darkest days of a multi-year bear market, the idea being that as stocks fell, yields would rise so high as to attract new buyers, therefore cushioning against future declines. Another catalyst is talk of eliminating or scaling back unfavorable tax treatment accorded to dividends. (The same money is taxed twice; once as income to the corporation, and a second time as income to the individual shareholder.)
Both of the factors referred to above are valid reasons why income stocks merit attention (although the first argument would lose steam if company fundamentals are deteriorating to the point where the directors may find it necessary to reduce or eliminate the dividend). But there's more to the story than that.
Decisions to pay dividends and retain profits for reinvestment are crucial capital allocation decisions made by the corporation. And when push comes to shove, wise capital allocation may well be the premier yardstick for measuring management effectiveness.
During the 1980s and 1990s, we were in what one might refer to as an era of "financial machismo," when it seemed that just about every company out there saw itself as a super-growth vehicle. That led to low dividend payout ratios, as firms retained the lion's share of profits to reinvest in growth ventures. (The double-taxation issue was often cited as justification for high profit retention, but you could easily argue that this was a rationalization for a decision that would have been the same regardless of tax considerations.)
In truth, many companies are mature, and don't have nearly the growth opportunities they and the investment community at large thought they did. There's nothing wrong with this. Humans cease to grow vigorously when they reach adulthood, yet that period is the main portion of their lifecycle. Companies can be productive and valuable even if they don't grow as rapidly as they did in their formative years. But the financial machismo era blinded many investors to such considerations.
Then, after the tech bubble burst starting in 2000, the investment community took notice of the spate of write-offs. Much of the rhetoric centered on efforts to distract investors from those charges by focusing them on pro forma earnings and the like. But another, perhaps bigger, aspect of the story is the extent to which the write-offs reveal the shortcomings of financial machismo. One cannot help but think about the corporate events leading to the write-offs (failed ventures, misguided acquisitions) and wonder how much stronger many companies, and the economy itself, would be had that capital been returned to shareholders as dividends instead of being squandered on futile efforts to show more growth than was really feasible.
In screening for income stocks, we obviously seek yield. But we also seek companies that are less tied to the financial machismo culture; in other words, we're looking for companies that have realistic notions of how much they can grow, how much capital they can productively reinvest in the business, and how much capital they should pay to shareholders. A 2002 study by Reuters of such companies demonstrates that over the long haul, their shares have fared better than many realized at the time.
Specific screen criteria
Here's how the screen was created:
We start with a requirement that the stocks have current yields of at least two percent.
Dividend growth (a different sort of growth from the financial machismo growth culture discussed above) is a key element of an income investment. The fact that dividends grow over time is why investors are usually willing to accept current yields below prevailing rates on fixed income securities. This screen requires that over the past three years, the dividend growth rate was above zero and at least ten percent higher than the industry average dividend growth rate.
Addressing payout ratio (the percent of net income paid to shareholders as dividends) requires a balancing act. On the one hand, we want the ratio to be high; we want capital allocation decisions that have, at the very least, a healthy respect for the benefits of distributing income to shareholders. On the other hand, we don't want payout ratios to be so high as to threaten the ability of the company to properly run the business. This screen addresses the balance by requiring Trailing Twelve Month (TTM) company payout ratios to be no greater than 25 percent above the industry average ratio.
Unlike payments on bonds, maintenance of the dividend is not legally required. So we need to consider tests that reduce the odds we'll wind up with companies that find it necessary or desirable to reduce or eliminate their dividends.
We require that over the past five years, the rate of capital spending growth was greater than zero and no less than 90 percent of the industry average. Companies that have spent in the past are less likely to have pent-up needs that might, in the future, reduce the company's dividend-paying capacity.
Perhaps the ultimate warning about the future of dividends comes in the form of a yield that's too high. The market may not be as efficient as academicians often claim. But it's not stupid either. Often, a yield climbs too far when investors fear that the payout will be reduced or eliminated. We screen out such situations with a test requiring that today's relative yield (company yield divided by industry yield) be no more than ten percent above the five-year average relative yield.
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