Bargains plus juicy yields: A dividend stock picking strategy that has produced monstrous returns

Shell out! Shell out! Halloween is fast approaching and income investors want their dividends. They have bowls of candy to fill for the little witches and goblins who are soon to arrive at their doors.

Thankfully, Canadian dividend investors have a little extra to spend because they’ve done well in recent years. An investor who purchased an equal-dollar amount of the dividend stocks in the S&P/TSX Composite Index and rebalanced at the end of each year, would have gained an average of 10.2 per cent compounded annually from the end of 2001 to the end of 2017. By way of comparison, the market index itself climbed at a 7.5-per-cent annual rate over the same period. (All of the return figures herein include dividend reinvestment, but do not include fund fees, taxes or other trading frictions.)

Dividend investors would have fared even better by focusing on bargain stocks. But, before I reveal their monstrous returns, prepare for a fright.

I started my investigation, like a budding Dr. Frankenstein, by slicing the dividend stocks in the index into two portfolios by dividend yield. Half went into the high-yield portfolio and the other half fell into the low-yield portfolio. I then proceeded to carve them into bits.

But rotting worms popped out in the process. Simply put, dividend stocks with negative earnings fared poorly. Stocks in the low-yield portfolio with negative earnings gained an average of 4.5 per cent annually over the period. Those in the high-yield group gained a mere 1.1 per cent annually. Both produced unhealthy returns compared with the market index.

Dividend stocks with positive earnings provided better results. The low- and high-yield portfolios were each carved up into five portfolios (quintiles) by price-to-earnings ratio (P/E). The 10 resulting (equally weighted) portfolios were fed through the Bloomberg back-tester, which tracked and refreshed them annually over the 16 years to the end of 2017. The results are shown in the accompanying table, which displays the average annual compound return of each portfolio.

Nine of the 10 portfolios beat the market index, and often handily. The only one to lag was the portfolio of low-yielding stocks with the second-highest P/E ratios, which trailed the index by an average of 1.5 percentage points annually.

Five of the 10 portfolios beat the portfolio containing all of the dividend stocks in the index, which climbed 10.2 per cent annually.

Generally speaking, the high-yield portfolios fared better than the low-yield portfolios. Score one for the high-yield team. On the other hand, stocks with lower-P/Es and low-yields beat the lower-P/E high-yield groups.

The lowest-P/E portfolios fared the best. The top return was seen by the lowest-P/E low-yield portfolio with an average annual return of 14.2 per cent. It beat the all-dividend stock portfolio by an average of four percentage points annually and the market index by 6.7 percentage points annually.

You can find a list of the dividend payers in the S&P/TSX Composite Index, sorted by yield, at the end of the online version of this article. Half have yields of more than 3.1 per cent and half pay less.

Roughly speaking, stocks in the lowest-P/E group currently have ratios below 10.9. The second lowest group has ratios between 10.9 and 16.4.

Mind you, the ratios and yields vary from year-to-year as the market climbs and falls.

The ghost of money-manager Benjamin Graham would point out that the ratios of the lower-P/E portfolios are very similar to the rule of thumb he devised for defensive investors decades ago. He advised conservative investors to seek dividend stocks trading for less than 15 times earnings in his book The Intelligent Investor. His ideas might be a little dusty, but they’re still performing well.

The Intelligent Investor still haunts bookstores today because it was reanimated by Jason Zweig in 2005. It would make a great treat for young investors who’ve grown too old to wander the streets this Halloween.

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.