Why Div Stocks Retain Favor: Smart ETF’s Picks

Recently released IRS data for 2011 tax returns show individuals reported $83.3 billion in interest income. That’s nearly $100 billion less than the interest income earned in 2007, when the Federal Reserve was still a year off from quantitative easing and pushing short-term interest rates from above 5% to the zero bound that is expected to persist at least through the end of 2014.

That of course goes a long way toward explaining why dividend paying stocks and ETFs have seen boatloads of inflows since the financial crisis. The S&P 500 currently derives 2.6% in returns through its dividend payouts.

Until recently that dividend payout was more than the yield for the 10-year Treasury.

Even in the wake of the recent rise in the 10 year Treasury yield to above 2.5%, more than 100 stocks in the S&P 500 still have higher current dividend yields, including Pfizer (PFE), Microsoft (MSFT), General Electric (GE) and Coca-Cola (KO), as seen on the YCharts Stock Screener.

And new inflation data for July suggests the clamor for dividend payers among one key market is not likely to fall off in 2014: senior citizens staring at a meager cost of living adjustment for 2014 Social Security benefits.

The CPI-W is the metric used to determine the annual inflation adjustment in Social Security benefits. The third-quarter average for the CPI-W is compared to the previous third-quarter high (in this case it will be 2012); the difference determines the adjustment.

If the July 2013 CPI-W level holds in August and September, Social Security recipients will receive a 1.4% increase in their 2014 benefits. That would be even less than the core PCE inflation reading that is the Fed’s preferred inflation gauge.

While the dividend gravy train has fed the income starved well since the financial crisis, 2013 has also delivered a fairly benign lesson for indiscriminate yield chasers piling into pricey stocks with alluring yields. For example, both AT&T (T) and Duke Energy (DUK) had 4%+ yields in late May. What seemed to be overlooked was that both had trailing 12-month PE ratios above 20. When the Fed’s taper talk set off all sorts of re-evaluation (both fundamentals and relative values vs. rising long bond rates) stocks that have little more in their camp than that high yield were smacked around.

T Total Return Price Chart

T Total Return Price data by YCharts

Yield alone never made sense as an investment approach. But it is clearly more dangerous today. That we’re all expending so much time and energy trying to divine whether the market is fairly valued or overvalued is a signal of one important fact: it’s clearly not at bargain levels when any approach -- even yield chasing -- benefits from a “rising tide lifts all boats” environment.

Chasing yield gets ever more dicey going forward. The smarter approach is to consider companies that can give you a competitive dividend yield today, combined with a strong balance sheet that will enable them to keep pumping out reliable earnings (and dividend growth). That can give you some income today without compromising on the long-term prospects for the underlying stock as well.

The large cap end of the stock pool is where the quality reliables can be found, and right now that happens to be a pretty good place to find value. The Leuthold Group estimated in early August that the median 2013 PE ratio for the 50 largest companies is 14.2. For the 300 largest the median PE rises to 15.2. Both are snugly below the 17.4-to-18.2 median PE ratio for stocks with market caps ranging from $3 billion all the way to $20.6 billion, Leuthold’s cutoff for the 300 largest firms.

The new iShares MSCI USA Quality Factor ETF (QUAL) provides a great first pass at just the sort of big reliable companies income investors might want to focus additional investment research on. As previously covered at YCharts, the ETF screens for companies with high return on equity, reliable earnings and low leverage.

The well respected GMO investment management firm, with $108 billion under management, expects high quality U.S. firms to be on the relative bright spots over the next seven years, with forecasted annualized real returns of 3.7%; outside of emerging market stocks and timber, that’s the most bullish outlook from GMO. (Both large and small U.S. stocks are forecast to have negative real returns.)

Among the top five holdings for the iShares MSCI USA Quality Factor ETF only Google (GOOG) doesn’t pay out a dividend. Apple (AAPL), Chevron (CVX), Exxon Mobil (XOM), and Microsoft all yield at least 2.2%. More importantly they have rock-solid balance sheets that can keep the dividend growth coming.

There’s not much debt to worry about:

AAPL Debt to Equity Ratio Chart

AAPL Debt to Equity Ratio data by YCharts

Return on equity surpasses the 15.5 average for the S&P 500:

With dividend payout ratios below 35% all four have plenty of room to keep the dividend rising.

If you’re insistent on a current dividend yield of at least 3%, the iShares MSCI USA Quality Factor ETF has a few candidates to research. In addition to their ROE, low debt and earnings reliability, Intel (INTC) and Eli Lilly (LLY) also happen to have below average forward and trailing PE multiples. McDonald’s (MCD) and Clorox (CLX) both have current valuations above the market average, though below the 20+ that many of the highest yields currently trade at.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.

Read more articles about: Investing Ideas  money managers   dividend stocks   dividend growth   

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