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Yield of dreams

If you think dividend-paying stocks are old-fashioned, you may want to think back over the past few years. During the Internet bubble, investors pushed many companies to ignore dividends and reinvest their profits in new ventures designed to grow earnings. More often than not, the growth never materialized. Instead, the stock market bubble burst, interest rates fell, and dividend stocks especially the highest-yielding ones surged ahead.

The recent strength of high-yield stocks turns out to be no aberration. David Dreman, the money manager and Forbes columnist, discussed the benefits of holding high-yield U.S. stocks in his excellent book Contrarian Investment Strategies: The Next Generation, published in 1998. He updated his work in a recent Forbes article entitled Dividends Matter. In that column, he examined the 1,500 stocks in the Compustat 1500 database and tracked how the 20% of those stocks with the highest dividends did over three periods.

His results make fascinating reading. From 1970 to 2003 the top-yielding stocks outperformed the average stock by 1.9 percentage points a year. Their superiority was even higher if you looked at just the period between 1984 to 2003, when they showed an average annual advantage of 2.1 percentage points. And it was higher still if you focused on 1994 to 2003, when high-yield stocks beat the average stock by an average 2.2 percentage points a year. Not only do high-yield stocks outperform, but the size of their outperformance is getting larger.

Unfortunately, you can't simply buy the stocks with the biggest dividends and expect to wind up with a perfect portfolio. A couple of industries utilities and financials account for many of the highest yielding stocks. If you selected only the highest yielders, you would wind up with a portfolio concentrated on those sectors. That might mean painful periods for your bottom line since both tend to suffer when interest rates rise.

A smarter strategy is to select stocks from many different industries. Not only does this reduce your exposure to the ups and downs of any one sector, it also tends to boost your performance. In his book, Dreman found that from 1970 to 1996 the top yielding 20% of stocks in each industry beat the average stock in their industry by 2.1 percentage points a year, which is even better than the annual advantage you would have gained by simply buying the highest-yielding stocks during the same period.

Intrigued by Dreman's findings, I decided to compile a list of high-yield Canadian stocks by sector. I immediately ran into the fact that our sectors are quite small, especially if you want to stick to the larger-cap stocks in the S&P/TSX Composite Index. Still, I decided to see what each sector might contain. Accordingly, I grouped the S&P/TSX Composite Index into ten sectors. I then ranked the stocks in each sector by dividend yield.

This gave me a list of high-yielding stocks by sector, but high yields can be deceptive. Companies sometimes trim their dividends if the firm isn't earning enough to afford them.

To make sure I wasn't selecting companies on the verge of cutting their dividends, I examined each stock's earnings yield. This is the ratio of its earnings to its share price, expressed as a percentage. For example: a $10 stock with a dollar in earnings has an earnings yield of 10%.

Earnings yields are important because they tell you whether a company is churning out enough profits to afford to pay its dividend. A company with an earnings yield greater than its dividend yield is generating enough profits to pay those dividends. On the other hand, a company with an earnings yield below its dividend yield must borrow or dip into its resources to pay the dividend. If the situation continues, the firm may be forced to eliminate or reduce its dividend.

To ensure an adequate margin of safety, I looked at each company's trailing earning yield (based on its profits over the past year) as well as its expected earnings yield (based on what analysts forecast it will make over the year ahead). To make my list, both a stock's trailing and expected earnings yields had to be larger than its dividend yield.

In Cash cows, I've listed the two stocks in each sector with the highest dividend yields and acceptable earnings yields. In some sectors the choice is limited. MDS is the only dividend payer in the health-care sector while Gennum is the only info-tech company that passed my tests.

I think any company on the list deserves a look. (In the interests of full disclosure, I own modest amounts of both BCE and TransCanada.) But remember that a mechanical screen like this is just the first step in your search. Do your own investigation. If you employ a professional investment adviser, talk things over with him or her. You'll find, for instance, that both Laurentian Bank and Manitoba Telecom are embarking on major business transformations that may make you prefer their safer counterparts.

Will high-yield stocks continue to outperform? Their current popularity and the high probability of interest rate increases over the next year may dampen performance. But history indicates that a diversified portfolio of high-yield stocks should do well over the longer-term.

From the June 2004 issue of MoneySense magazine.

CASH COWS

Looking for stocks that pay a steady stream of reliable dividends? These companies stand at the top of their sectors for both generous yields and margin of safety.


Company Sector Price Dividend Yield Trailing Earnings
Yield
Hudson's Bay (HBC) Consumer discretionary $12.78 2.8% 6.4%
Torstar (TS/B) Consumer discretionary $28.00 2.5% 5.7%
Rothmans (ROC) Consumer staples $33.00 5.3% 8.5%
Molson (MOL/A) Consumer staples $31.34 1.8% 6.5%
Husky Energy (HSE) Energy $25.25 1.9% 11.2%
Enerflex Systems (EFX) Energy $22.35 1.8% 4.7%
Laurentian Bank of Canada (LB) Financials $27.67 4.2% 11.1%
Royal Bank of Canada (RY) Financials $60.95 3.4% 7.4%
MDS (MDS) Health care $22.00 2.1% 1.7%
CAE (CAE) Industrials $5.70 2.1% 5.8%
Canadian Pacific Railway (CP) Industrials $30.50 1.7% 6.6%
Gennum (GND) Information technology $14.30 0.8% 2.5%
Dofasco (DFS) Materials $35.77 3.4% 4.6%
Nexfor (NF) Materials $15.10 2.7% 12.3%
Manitoba Telecom (MBT) Telecommunication services $47.10 2.1% 2.9%
BCE (BCE) Telecommunication services $27.59 4.4% 6.9%
Emera (EMA) Utilities $19.30 4.6% 6.2%
TransCanada (TRP) Utilities $27.15 4.3% 6.5%
Source: tsx.com, globeinvestor.com, www.standardandpoors.com, as of May 1, 2004


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