CHAPEL HILL. N.C. (MarketWatch) — When it comes to dividends, more isn’t always better: A company isn’t necessarily more attractive just because it pays a higher dividend.
That is the clear lesson I draw from the dividend-oriented newsletter with the best long-term record among the 200 services in the Hulbert Financial Digest rankings: Investment Quality Trends, edited by Kelley Wright. “Higher” or “lower” for him only have meaning when comparing a company’s current dividend with what it paid in the past. He believes that comparisons with other companies are unhelpful.
Consider CVS Caremark Corp. CVS, +0.71% , the drug retailer, and HCP Inc. HCP, -0.67% , the health-care real-estate investment trust. Wright rates CVS Caremark more highly than HCP, even though CVS’s dividend yield — the annual dividend as a percentage of the stock price — is just 1.6%, while HCP has a 4.1% yield.
Wright believes CVS is the better bet because its current yield is at the high end of the range of its past yields, which have extended from a low of 0.4% to its current 1.6%. HCP’s current yield, by contrast, is at the low end of its historical range, which has gotten as high as 12.4%. So, in terms of relative dividend yield, CVS’s is higher than HCP’s.
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Over the years, Wright has found that high yields come back down to earth and low yields rise back toward the midpoint of their historical range. That would be bad news for HCP, since a likely cause of its yield rising would be a falling stock price — which could lead to losses that more than eliminate the benefit of the high yield.
For CVS, by contrast, Wright believes the path of least resistance is for its yield to decline because its stock price rises.
To be sure, CVS’s yield also would come down if the company cuts its dividend, which would be bad for its stock price. Wright therefore focuses his analysis only on companies with strong balance sheets and a long and consistent pattern of higher earnings and increasing dividends.
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So how has Wright’s strategy performed over time? According to the Hulbert Financial Digest’s calculations, Investment Quality Trends over the past three decades has beaten the dividend-adjusted return of the entire U.S. stock market by an average of 1.2 percentage points a year — while nevertheless incurring less risk.
That is a winning combination: The service is in second place for risk-adjusted performance among the three dozen advisers for which track records extend back that far.
Wright’s strategy is to be distinguished from the traditional approach to picking dividend stocks, which focuses on absolute rather than relative yield.
One popular variant of the traditional approach is the so-called Dogs of the Dow strategy, in which investors buy the 10 stocks among the 30 Dow Industrials DJIA, +0.98% with the highest yields. For example, the three Dow “dogs” that currently have the highest yields are two telecommunication companies, AT&T T, +1.79% (4.7%) and Verizon Communications VZ, +1.55% (4.1%), and tech giant Intel INTC, -2.30% (4.1%).
Despite investing in stocks with yields this high, however, the strategy has disappointed recently. Over the past five years (through March 31), it has produced a 5.0% annualized return, lagging the 5.9% dividend-adjusted return of the S&P 500 SPX, +0.74% and barely half the 10.8% return of a portfolio that is periodically updated to always contain just the 10 stocks that Wright recommends most highly.
Another variant of the traditional focus on absolute yield can be found in the S&P High Yield Dividend Aristocrats index. It contains the 50 highest-yielding stocks among the S&P 1500 Composite index that also have a long history of dividend increases.
The index’s two largest components currently are Pitney Bowes (the mail and document-services company, with a 10.0% yield) and biotech company AbbVie (yielding 3.7%).
Though the performance of the S&P Dividend Aristocrats index in recent years has been better than that of the Dogs of the Dow strategy, it still lags behind that of Investment Quality Trends. Over the past five years, the SPDR S&P Dividend ETF SDY, +1.30% , which is benchmarked to the index, has produced an annual dividend-adjusted return of 9.2% through March 31 — nearly two percentage points a year lower than the portfolio of Wright’s 10 most attractive dividend stocks.
Note carefully that this Wright portfolio currently holds none of the stocks that are at the top of the holdings list for either the Dogs of the Dow or the S&P Dividend Aristocrats. In addition to CVS Caremark, the following nine stocks are in Wright’s portfolio: Air Products & Chemicals APD, +1.46% (yielding 3.3%), Archer Daniels Midland ADM, +3.35% (2.3%), Coca-Cola KO, +0.50% (2.7%), ConocoPhillips COP, +2.26% (4.4%), Occidental Petroleum OXY, +1.35% (3.2%), PepsiCo PEP, +1.09% (2.7%), Reliance Steel & Aluminum RS, +3.77% (1.7%), Texas Instruments TXN, +1.97% (3.1%) and Walgreen US:WAG (2.3%).
The average yield of all 10 stocks is 2.7%, versus 2.0% for the S&P 500 as a whole. And, even better, if Wright is right: These 10 have the potential to outperform the S&P 500 on a price-appreciation basis as well.
