Thursday, September 25, 2008

The Advantage of Net Payout Yields

The Dogs of the Dow Theory has long interested me in its simplistic nature of eliminating the emotion of the stock market and systematically investing in the out of favor or contrarian stock. What least interested me was that an investor was suppose to buy the 10 highest yielding stocks amongst the 30 stocks in the Dow Jones Industrial average on presumably January 1st and hold them for a year.


While this compelled to my ‘lazy’ nature and was tax beneficial, it seemed overly simplistic and too focused on larger stocks that underperform smaller stocks in the long run. Why not adjust on a monthly if not daily basis? Or buy smaller stocks? If Pfizer (PFE) increases 50% by June and the yield consequently shrinks below the top 10 yields why continue holding till January and potentially give back that gain.


Another compelling concept was to extend the selection beyond the Dow and into the S&P 500 where more growth exists and the selection widens. For this method to work, the underlying stocks have to be fundamentally sound so you don’t want to go too far down the food chain, but it seems logical that the S&P 500 stocks would satisfy that goal while providing for more gains.

Another issue I’ve always had is that a lot of companies now spend a considerable amount of money on stock buybacks instead of dividends. If company X spends 6% on a buyback and 2% on dividends shouldn’t its yield be 8% and considered a higher yield then a company with a 4% dividend only. Afterall, buybacks are more tax friendly and that could be a big benefit if Obama becomes President and raises the taxes on dividends.


A study last year in the ‘Journal of Finance’ On the Importance of Measuring Payout Yield revealed what my thoughts had been all along. Companies with higher Net Payout Yields (net buybacks + dividends) outperform those companies with just Dividends. The company is investing money in shareholders either way so an investor should be focused on the combination. It also showed that the Dogs of the Dow Theory is now dead having underperformed of late.


As with any theory, it must adapt to the changing times. The regulatory and taxing environment over the last couple of decades has made it easier to do buybacks and more beneficial as well. The study showed that Net Payout stocks outperformed the market by nearly 6%, 19.1% to 13.4%, over the last 35 years. It also handily outperformed the highest dividend only stocks.
Unfortunately the study only focused on the Dow stocks nor did it address market timing. Market timing seems more beneficial due to the buyback inclusion. Companies that pay dividends tend to always pay a consistent dividend so the amount paid doesn’t care about the stock price. It does impact the yield though (another slight case for market timing).

With a buyback, the company can dramatically adjust how much it pays each quarter. For example, Home Depot (HD) bought back over $10B of stock during its Q3 last year. That’s over 20% of the outstanding stock, but it’s hardly bought any stock since. As an investor, you’d want to keep an eye on the price HD paid in this case. With a 3.3% dividend, HD now has a whopping 24.5% net payout over the last 12 months. Would you rather own that stock or a 4% dividend payer? That answer seems simple, but you’ll have to keep an eye on the buyback amount and date which makes this theory more complicated yet potentially more rewarding.


Going down into S&P 500 stocks allows for a dramatically larger universe of stocks beyond the limited 30 Dow stocks. Unfortunately I haven’t seen any studies of how performance is impacted. To me it allows you to pick the better yield out of the original Dow stocks plus companies like UPS (UPS) as an example. UPS has a $65B market cap making it a larger company then even some of the Dow stocks. So I think moving into the S&P500 makes the theory less restrictive, but still financially sound as investments. For now though I’ve tried to limit stocks to at least market caps of $20B to remain conservative.


My own results of the last year back up why holding the stocks for one year and then recalculating isn’t exactly ideal. I’ve had several stocks that spiked and consequently the yields fell, but I held onto the stock thinking it was best to hold to avoid churn and expenses. In the end, those stocks fell back to the market and in some cases gave up most of the gains. While not scientific, it does suggest my theory of at least monthly adjustments is more prudent to maximize returns.


Some of my recommendations as of today that have high net payout yields of 7-9% are Caterpillar (CAT), Disney (DIS), UPS (UPS), and Verizon (VZ). It’s amazing that these large companies have such high yields and probably is a sign of the overall value in the market. Other companies with large yields due to large buybacks over the last 12 months include Home Depot (HD) at 26%, Texas Instruments (TXN) at 15%, and WellPoint (WLP) at 25%. These are extremely high yields for such large stocks. The management teams of these companies think their stocks are extremely undervalued to spend that large amount of money on stock. Investing close to the amounts they paid is probably a key in large buyback cases and why buying and holding for 12 months isn’t necessarily recommended.


With so many people approaching retirement, this investing method could be ideal for that group. Especially for an IRA or some tax advantaged account where more trading then the once a year plan isn’t impacted by high taxes. The focus on dividends also would provide income for retirees and plans could be shifted more toward the dividend payers for higher income. Also, the conservative, non-emotional approach is ideal for somebody needing less risk, but still wanting exposure to the stock market.


As with any method of investing, regulatory and tax changes could impact the results in the future just as it has with the Dogs of the Dow Theory. An investor always should test any theory on a regular basis to make sure it continues to work.


So good examples of attractive net payout yields as of the close on 9/10:



Stocks Dividend % Buyback % Net Payout Yield



Caterpillar 2.7 6.9 9.6

Disney 1.1 7.1 8.2

UPS 2.7 4.8 7.5

Verizon 5.3 2.3 7.6


Disclosure: long position in VZ

No comments: