Dividends have been dropping for the entire market, but dividend yield is very important to the long-term success of the Foolish Four strategy. A blend of Foolish Four and Beating the S&P stocks produces a portfolio with a higher yield.
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There are two principle explanations for the decrease in Foolish Four yields. First, it's no secret that dividend yields for the entire market have been declining steadily over the past few years. The average yield for the stocks in the S&P 500 is near a record low, about 1.1%. Last year the yield for the Dow as a whole was 1.9% compared to an average of 4.4% since 1961.
It's not that dividends have been cut. Most large companies have been increasing their dividends steadily. But they simply haven't increased their dividend payouts sufficiently to keep up with the rapid increase in stock prices. Many newer companies don't have enough earnings to dole out regular dividends to stockholders. Others prefer to save their cash to promote internal corporate growth or to buy back their own stock. Investors often prefer that, since internal growth and share buybacks lead (in theory, anyway) to higher stock price appreciation. These investors prefer to take their profits as capital gains, which are taxed at a lower rate than dividends.
The second explanation for the lower yields of the Foolish Four lies in the recent changes in the composition of the Dow. Stocks that pay little or no dividends, such as Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> and Intel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %>, have replaced traditionally higher-yielding companies such as Sears <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: S)") else Response.Write("(NYSE: S)") end if %> and Goodyear Tire <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GT)") else Response.Write("(NYSE: GT)") end if %>.
It still remains to be seen if the historic low yields for the Dow will have a dramatic effect on the future returns for the Foolish Four. Many have argued that there are better things companies can do with their extra cash than to distribute them to shareholders. We've noted before that the 30 Beating the S&P companies have traditionally had somewhat lower yields than the stocks in the Dow although the strategy has performed quite well since 1987.
Michael O'Higgins, writing almost 10 years ago in Beating the Dow, notes that "historically, dividends have accounted for 40% to 50% of the total return on the Dow stocks as a group, so the cherished continuity of dividends is of more than passing importance to Dow stockholders." Since high yields are one of the major cornerstones for choosing F4 stocks, I don't think we can totally ignore the dramatic drop in dividends.
I think most investors would agree that higher yields are a good thing for stockholders of well-established, multinational companies, assuming we don't have to sacrifice stock price appreciation. The burning question remains: Are there any viable ways to find these dividend-paying companies, without scrimping on the size or quality of the companies we expect for our Foolish Four investments?
There's no doubt that we can find higher yields if we don't restrict ourselves solely to companies in the Dow. Let's not forget that there are many world-class corporations out there -- some even fiscally sounder and larger than those in the Dow. The Beating the S&P (BSP) strategy was designed to find another group of these quality companies. By adding 30 BSP companies to the 30 already in the Dow pot, it's just possible we might increase our dividend yields and maintain high overall FF returns.
Let's go from the theory to practice. The following tables show the top five stocks, listed in RP order, for the Foolish Four, Beating the S&P, and a FF/BSP blend model. This analysis includes data taken from the Foolish Calculator as of the close of the markets last Friday.
Beating the S&P
Bank of America 4.21 0.61
Ford 4.21 0.61
Verizon Comm. 3.11 0.44
Chevron 3.10 0.34
Gillette 1.92 0.33
Dow/BSP Blend
Philip Morris 7.84 1.58
Caterpillar 3.80 0.64
Bank of America 4.21 0.61
Ford 4.21 0.61
International Paper 2.79 0.47
Yield (%) RP Market Cap*
mean median mean median mean median
Dow 4.04 3.08 0.72 0.47 51.0 46.7
BSP 3.31 3.11 0.47 0.44 71.2 55.8
Dow/BSP 4.57 4.21 0.79 0.61 43.5 54.0
*In billions
I've presented the data to include means and median values for the averages, because the high yield for Philip Morris <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MO)") else Response.Write("(NYSE: MO)") end if %> represents a dramatic outlier, tending to skew the mean values. Here's a quick refresher course if you're not familiar with the differences between mean and median.
Reviewing the tables, it seems that adding the BSP universe of stocks to the Dow universe has the potential to raise the yield of such a portfolio, without significantly sacrificing the size or the quality of the companies.
Let's be even more specific. As of Friday, Foolish Four investors, dropping the stock with the highest RP ratio, would have bought Caterpillar <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CAT)") else Response.Write("(NYSE: CAT)") end if %>, International Paper <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IP)") else Response.Write("(NYSE: IP)") end if %>, AT&T <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: T)") else Response.Write("(NYSE: T)") end if %>, and DuPont <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DD)") else Response.Write("(NYSE: DD)") end if %>. If bought in equal dollar amounts, a portfolio of these four stocks would have yielded 3.09%. A Dow/BSP blend would have jettisoned AT&T and DuPont in favor of adding Bank of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %> and Ford <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %>. The yield of such a Dow/BSP Foolish portfolio would have increased from 3.09% to 3.75%. That may not seem like much, but over the course of many years, such an increased yield can add up to many tens, if not hundreds, of thousands of dollars in a portfolio -- assuming again that the higher yield doesn't come with a sacrifice in stock price appreciation.
Now that we've gone through the motions of how to find a portfolio that might increase yields, it's time to put on our skeptic hats. (You know those -- the hats with the large hairy arms crossed above the brim, with a perpetual scowl on the front!) This strategy hasn't been backtested. Since backtesting lies at the very heart of mechanical strategies, it's hard to recommend it at the present time, even though the principles may make sense.
With our newly obtained CRSP database that goes back 50 years, you can bet that we'll be looking at just such strategies like a Dow/BSP blend. In the meantime, enjoy the summer, keep cool, and try your own hand at backtesting -- in a hammock.
Beating the S&P year-to-date returns
Dow Yield (%) RP
Philip Morris 7.84 1.58
Caterpillar 3.80 0.64
International Paper 2.79 0.47
AT&T 2.67 0.46
DuPont 3.08 0.46
(as of 07-18-00):
Bank One <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ONE)") else Response.Write("(NYSE: ONE)") end if %> -3.6%
PepsiCo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %> +22.8%
Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %> -6.2%*
Bank of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %> -5.9%
Fannie Mae <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FNM)") else Response.Write("(NYSE: FNM)") end if %> -15.4%
Beating the S&P -1.7%
Standard & Poor's 500 Index +1.7%
*Includes Visteon <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: VC)") else Response.Write("(NYSE: VC)") end if %> spin-off
Compound Annual Growth Rate from 1-2-87:
Beating the S&P +23.1%
S&P 500 +17.4%
$10,000 invested on 1-2-87 now equals:
Beating the S&P $165,000
S&P 500 $86,900