What Mutual Fund Has The Highest Percentage Of Amazon Stock Using Dividend Yield to Identify Stock Bargains

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Using Dividend Yield to Identify Stock Bargains

Question: Can dividend yields help you find bargains in the stock market? Answer: A qualified yes.

You all know what dividends are: Cash payments by companies to their shareholders out of company profits. Paying dividends is one of the four principal things that a company can do with its profits. The other three are (1) building a war chest, (2) reinvesting in the company (organically or by making acquisitions), and (3) buying back its own shares.

Dividend yield is a simple calculation from two pieces of information: Total dividends over the past twelve months divided by the stock’s current price. So if Dividend Co. pays $1-per-share annual dividend, and today’s price is $40, its current yield is 1/40, or 2.5%. Every stock’s current yield is readily available on every financial Web site and in the newspaper.

Current yields change daily. The yield changes any time either of its two components changes. Most dividends are paid quarterly, so most changes in that piece–the annual dividend–happen just four times per year.

But the stock’s price changes continually whenever the market is open. If Dividend Co.’s price goes up to $41 today, its current yield drops to 2.4% (1/41). Just for a benchmark, as I write this, the current yield of the average stock in the S&P 500 is 2.6%. Companies in certain sectors–such as finance and energy–have become known for paying healthy dividends. Other sectors–such as technology–generally pay little if any.

So can dividend yields help you find bargains? Well, there is an entire investment strategy called Dogs of the Dow based on the proposition that the highest-yielding stocks in the Dow Jones Industrial Average at any given time represent the best bargains. The theory, popularized by Michael O’Higgins in 1991, is that large, well-established companies (such as those in the Dow) do not alter their dividend payout policies very much, so therefore their dividends reflect management’s long-term outlook for the company. That is, they can send some money to shareholders rather than plow every cent back into the company.

Therefore, if the yield is high, it must be because the price is “low” (compared to the stock’s real value), and so the stock is a bargain whose price is likely to rise. A popular technique is to invest in the ten highest-yielding Dow stocks (the “Dogs”), hold them for a year, then sell them and buy the new ten highest yielding stocks. Repeat annually. A website devoted to this strategy claims that the strategy has generally outperformed the Dow itself over many years by several percentage points.

In researching my special study (available as an e-book), “The Top 40 Dividend Stocks for 2008,” I did not follow this strategy. It is too mechanical. I found that in using dividends to identify bargains, you must look beyond the yield itself. You must be able to achieve high confidence that in addition to being substantial, (1) the dividend is reliable, and (2) the business model itself is sound. This takes some old-fashioned fundamental analysis–otherwise the best stocks to buy would always be the highest yielders. You can find these on any stock screener, but yield alone does not tell the whole story.

It so happens that financial stocks right now illustrate the point perfectly. Citigroup is the poster child (aka whipping boy). At the end of last year, it had a sky-high yield of 7.3%. It was The Top Dog of the Dow. Say you bought it on January 1, 2008. As Dr. Phil would say, “How did that work out for you?” As of this writing, Citigroup is down about 40% for the year, and to add insult to injury, it slashed its dividend earlier this year. It simply couldn’t afford to pay it any more. (For comparison, the Dow itself is down 14% on the year.)

We know the reason, of course. Citigroup has been one of the hardest-hit banks in the sub-prime mortgage and credit mess. It turned out that it failed both of the criteria: Its dividend was not reliable, and its business model was not sound.

But Citigroup, you say, is an extreme–perhaps unrepresentative–example. And I would agree with you. Most of the time, a high-yielding stock suggests a good bargain. But you can’t stop there. The key is making sure that the other criteria–reliability of dividend and soundness of business–are also in place too. In Citigroup’s case, by the end of last year, both could be seen to be in jeopardy by anyone who did just a little research. But other high-yielding financial businesses, such as JP Morgan Chase (which largely sidestepped the sub-prime mortgage disaster), or high-yielding businesses outside the financial sector, such as Kinder Morgan Energy Partners or McDonald’s, have sailed along pretty smoothly. The latter two have delivered both high yields and decent price appreciation, while JP Morgan Chase has suffered much less than many other financial stocks.

Bottom line: High yields can be a good starting point in locating bargains. But look beyond yield alone. Ask yourself if the dividend is in jeopardy: For example, is it way high compared to what the stock normally yields? (Citibank’s was.) And take a look at the company’s business: Does the company have a good story? Are its numbers trending in the right direction?

Questions such as these will help you decide whether the high yield itself is a good omen or a flashing warning signal of high risk and decay.

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