Lehman Brothers. Enron. Washington Mutual. Fannie Mae.
Four companies now infamous for their demise, but before bankruptcy claimed them they had one thing in common: a high dividend yield.
Now a report from Research Affiliates has identified three indicators it claims could help investors avoid inadvertently selecting such companies in future: profitability (measured by return on assets), financial distress (debt coverage ratio), and accounting quality (growth in net operating assets).
“Simply paying the lowest price for a given dividend is not an optimal strategy,” authors Chris Brightman, Vitali Kalesnik, and Engin Kose wrote. “Identical dividend yields may hide important differences in the quality of companies arising from financial distress, unsustainability of profits, and poor accounting practices, sometimes even extending to fraud.”
The authors took 200 of the highest-yielding US-listed stocks and applied the three screens to them in turn, backtesting for more than 50 years from 1964 to 2014. They split the sample into the 100 best and 100 worst companies according to each metric to illustrate their results. The full set of results are available on Research Affiliates’ website.
The research found that a bias toward each of the three metrics reduced the likelihood of portfolio companies being delisted, while combining all three would have ensured investors avoided all delisted companies in the sample during the period.
“The resulting portfolio of the 100 highest quality equities does not benefit from an immediate income boost, as measured by the realized dividend yield,” the authors wrote. “It does benefit, however, from holding healthier underlying companies with reduced instances of delisting, which leads to a higher average total return, lower volatility, and higher subsequent five-year dividend growth rate.”
Related Content: What Price Yield? Fund Managers ‘Taking Excessive Risk’