Dividend stocks always interest investors, but there never seems to be any new technique available to help pick the right stocks for the job. New investment methods abound for other asset classes.
But when it comes to insightful analysis for dividend stocks, it’s as if investors are stuck in the Mad Men era, looking for dividend payers much like the way Don Draper did, scanning the printed pages of the financial section in the daily newspaper.
About two years ago I introduced a new concept of a “dividend integrity index” in a column entitled Daddy, Where Do High-Yield Dividend Stocks ComeFrom? High-yielding dividend stocks are not instantaneously created, and only a small number of them grow their dividends with “yield integrity,” a property I cooked up to identify the next responsible generation of high yielding stocks.
In researching dividend paying stocks, I also like to keep an eye out for companies whose high dividend integrity may signal improving stock performance, too.
Dividend stocks remain timely for most investors because the interest rate story hasn’t changed much over the past several years. The Fed continues to keep rates down, and income-oriented investors are still frustrated by a scarcity of cash flow instruments. Even if the Fed begins to raise rates (as many investors have started to consider), there will still be a need for dividends.
This situation impacts many of us, as a multitude of Americans find themselves in the category of fixed-income investors and are focused on income generation. Naturally, a search for income leads to high dividend stocks—equities that pay a large dividend while providing the holder with capital appreciation potential as well.
I’m a fan of high-paying dividend stocks, but I don’t necessarily rule out stocks that pay low dividends either—especially if I think they have potential to raise their dividend. Instead of only buying today’s top yielders, why not try to find low payers that may boost their dividends later in the cycle?
There is a much greater chance that such stocks may be underfollowed, because their low yield slips under a yield hog’s radar. They would definitely “screen out” of a typical stock screen for high dividends, but what if some of those stocks are the next big dividend payers? Think of the extra value of getting in before everyone else recognizes the potential for dividend growth.
I search for the next generation of high-yielding dividend stocks by looking at past dividend growth rates. I also look at dividend payout ratios—the percentage of the earnings the company pays out as a dividend. A small payout means there is plenty of money to reinvest in the company for organic growth or other strategic initiatives. A big payout ratio can sometimes signal trouble.
In some cases a company could simply run out of money by increasing its dividend while decreasing retained earnings. To me it comes down to an integrity issue. The best governed companies will strive to increase their dividends while maintaining a reasonably low payout ratio.
Integrity in the investment community has become very important in evaluating management’s behavior and initiatives. Figuring out a way to measure a company’s commitment to constantly raising the dividend in a fiscally responsible way could help you rank the relative integrity levels of companies’ dividend policies.
My “Dividend Integrity Index” ranks companies according to their potential to sustain high dividend growth while keeping the payout ratio reasonable. The Integrity Index identifies companies that have promising increases in dividends while still honoring a low payout ratio as well. The Dividend Integrity Index simply divides the past five year dividend growth rate by the dividend payout ratio, and lists values greater than one.
I set the lower cutoff of my Integrity Index to one because I want the company to show dividend growth that has been at least as much as its current payout ratio. The higher the index value the better, because it either has a high five-year growth rate tempered by a fairly low payout ratio, or a modest growth history with a very low payout ratio.
The table below lists my results I first published back in September, 2012. I began with stocks that had an S&P quality ranking greater than B, debt to capital less than 50%, and market capitalization greater than $500 million. Starting with roughly 6,000 stocks, only 12 stocks had a high dividend integrity index greater than one.
It is now time to see if the stocks actually raised their dividends, and how their stock prices have fared since then. Of the 12 stocks, only one (
High Dividend Integrity Stocks Beat the S&P 500:
Note: Dividend Integrity Index defined as LTM 5-yr annualizeddividend growth rate/LTM dividend payout ratio. All data from CapitalIQ.
An equally weighted portfolio of these 12 stocks returned 62% versus the S&P 500 return of 42% over the same period.
As noted, all 12 stocks have indeed grown their dividends. In fact, the three year average annualized dividend growth rate for the portfolio was about 30%.
So where are the next dividend growers that may show promising excess returns over the general market?
I ran my Dividend Integrity Screen again with the same restrictions as before. This time there are actually 21 stocks that possess high dividend integrity:
Current High Integrity Dividend Stocks
*Note: Dividend Integrity Index defined as LTM 5-yr annualizeddividend growth rate/LTM dividend payout ratio. All data from CapitalIQ.
This is your starting ground. Some--Aetna, UnitedHealth Group, Reinsurance Group, Equifax, CVS Caremark--reappear in the list. Of course, before considering any of these stocks as serious buy candidates, you should analyze them in far more detail than simply relying on the screen output. For instance
The same applies to
Integrity matters with dividends. But remember not all great companies have a high Integrity Index value. The reasons can be complex and honorable. However, if you are looking for low payers with promise, the Dividend Integrity Index may help you find your next big dividend scores.
