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How to Pick Dividend-Paying Stocks

There are better ways of picking dividend stocks than automatically going with the Dogs of the Dow.

Analysts are drawing the wrong investment lessons from yet another disappointing year for the so-called Dogs of the Dow Strategy.

This strategy, as many of you no doubt already know, calls for investing each Jan. 1 in the 10 stocks within the 30 Dow Industrials with the highest dividend yields. It is struggling this year: Through Dec. 6, the strategy has gained 13.3%, barely half the S&P 500’s year-to-date total return of 23.9%. The Dow Dogs are also behind the Dow Industrials’ year-to-date total return of 17.1%.

This year is not a fluke, furthermore. Cumulatively over the past 15 calendar years, according to my auditing firm’s calculations, the Dogs of the Dow strategy has produced an annualized total return of just 4.8%, less than half the S&P 500’s and the DJIA’s total returns of 9.8% annualized. The strategy’s year-by-year track record is plotted in the accompanying chart.

Hulbert Chart 120721

Because the stocks chosen by this strategy sit solidly in the value camp, analysts have attributed its disappointing performance to value’s epic battle against growth. As is widely known, value over the last 15 years has not lived up to its historical pattern of coming out ahead.

I don’t buy this explanation, however. Other dividend stock strategies have performed well in recent years, despite the headwinds created by value’s lagging performance. The proper conclusion to draw, in my opinion, is that there are better ways of picking dividend stocks than automatically going with those with the highest yields within the Dow 30.

I devoted a column to one such strategy at the beginning of this year, you may recall. It is recommended by an investment newsletter called Investment Quality Trends, edited by Kelley Wright. His approach has several components:

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  • Only consider companies that meet at least five of the following six criteria of financial quality and safety: Dividend increases five times in the past 12 years, an S&P Quality Ranking in the “A” category, at least 5 million shares outstanding, at least 80 institutional investors, at least 25 years of uninterrupted dividends, and earnings improvement in at least seven of the past 12 years.
  • Among this select subset of high-quality companies, consider a stock undervalued only if its yield is near the high end of the historical range of its yields.

In my January column on this subject, I listed the 10 stocks on Wright’s top-10 list. Through Dec. 6, those stocks on average have produced a 30.7% gain, more than double the 13.3% return of the Dow Dogs. Wright’s top-10 list is also well ahead over the last 15 calendar years, which is roughly the period during which value stocks generally significantly lagged the market. My auditing firm calculates that the list has produced an annualized return of 11.6%, more than double the Dow Dog’s 4.8% annualized.

(Full disclosure: Investment Quality Trends is one of the newsletters that pays my auditing firm a flat fee to calculate its performance. Note that, because of this flat-fee arrangement, there is no incentive to make any newsletter appear better than another.)

In an interview, Wright said that, despite the headlines in recent years that value strategies no longer can beat the market, “value can still work.” The key is to properly define value. “You can’t just buy a stock because it pays a high dividend. It also has to be a great company.”

With this in mind, here is a list of the 10 stocks on Wright’s current top-10 list.

Source: Investment Quality Trends

TickerCompanyYield

OMC

Omnicom Group, Inc.

+4.0%

PM

Philip Morris International, Inc.

+5.5%

FRME

First Merchants Corporation

+2.8%

MMM

3M Company

+3.3%

CAH

Cardinal Health, Inc.

+4.1%

WBA

Walgreens Boots Alliance, Inc.

+4.0%

SJM

J.M. Smucker Company

+3.0%

IBM

International Business Machines Corporation

+5.5%

DOW

Dow, Inc.

+5.2%

RNST

Renasant Corporation

+2.3%

Unlike what was the case in January, when there was no overlap between Wright’s top-10 list and the Dogs of the Dow, no fewer than four of Wright’s top 10 stocks are on a list of the 10 highest yielding Dow stocks: IBM  (IBM) - Get International Business Machines Corporation Report, Dow, Inc.  (DOW) - Get Dow, Inc. Report, Walgreens  (WBA) - Get Walgreens Boots Alliance Inc Report, and 3M Company  (MMM) - Get 3M Company Report.

Perhaps that means that the Dogs of the Dow strategy will perform better this coming year than over the last year.