The Just-Released Formula for Predicting High-Yield Winners

Carla Pasternak's picture

Wednesday, September 30, 2009 - 2:43pm

by Carla Pasternak

I doubt you've ever heard of John Wightkin.

He's the Director of Equity Research Applications of the Schwab Center for Financial Research. Sure that's a fancy title, but John is doing some very important work in the field of income investing.

In fact, John Wightkin just confirmed what I've been telling my readers for years. But he also uncovered an exciting way to add a shot of capital gains to income investing by predicting the next high-yielding winners.

The New Study that Leads to Capital Gains
John just published a study last month where he asked the question "Should income investors purchase the highest-yielding stocks they can find?" His answer was a resounding "No!"

I've been telling readers this for years -- suspiciously high yields are typically warning signs -- but John's study was second to none.

He derived his conclusion by dividing the 1,500 largest stocks by market cap into five groups based on yield and studying these groups over a 20-year period. Group 0 paid no dividends, groups 1, 2, and 3 paid progressively higher dividends, and group 4 was composed of the highest yielders.

As you can see from the chart, Groups 2 and 3 handily beat the performance of group 4 (the highest yielders) on an annual total return basis. That's right -- stocks with lower dividends outperformed the higher yielders on a total return basis.

The reason: Group 4 stocks had twice as many dividend cuts as stocks in other groups. Instead of unusually high yields being a sign of fundamental health, it was the opposite. In many cases, a large drop in the share price had occurred and the stock had not cut its dividend -- yet.

But should you completely avoid high-yield stocks? Wightkin rightly points outs it's foolish to avoid them in entirety.

The secret is to find those winners among this group -- those that pay safe high yields. These are the ones that will provide the tasty combination of income and price appreciation.

His key to identifying the best of the best: Look to the stock's price momentum over the last six months.

Momentum itself was measured by a simple formula: Price Today/Price Six Months Ago

If, for example, "High-Yield Darling" is trading at $15 a share now and was $10 six months ago, its momentum would be 50% (($15/$10) -1 = 0.50 or 50%).

John's study showed that high-yield stocks in the top fifth of their peers in terms of six-month momentum returned +11.5% annually over the last 20 years. Those in the lowest fifth returned only +7% annually.

There are many possible explanations why these stocks typically outperform the market going forward. Wightkin's favored hypothesis is that investors often "under react to information about a firm's short-term prospects and often over react to information about long-term prospects -- which provides opportunities in the intermediate term."

Whatever the reason, the point is clear -- stocks that have outperformed in the past six months have a reasonable probability of continuing to outperform over the next year.

Further, stocks with the highest momentum and yields had superior fundamentals to those with lower momentum. These fundamental strengths showed up over time in providing more dividend increases and fewer dividend cuts along with more increases in analysts' earnings estimates and fewer decreases.

Despite John Wightkin's study, I'll always continue drilling down into the nuts and bolts of a company's dividend before investing -- there's simply no substitute for due diligence. But using his metrics does give investors a good place to start their income search.

Carla Pasternak does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.