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Avoid the mirage of high yields for the oasis of total returns

As financial markets tremble, one U.S. advisory advises investors to pass on high yields for total returns, like those of a top Canadian stock.

On Friday, our report came from an unhappy advisory that claimed the powers in Washington were prepared to bail out the big guys at the expense of the little guys. No kidding. Before the day was over, failing investment bank Bear Stearns was thrown a lifeline by the Federal Reserve Board, backed by credit from JP Morgan Chase.

Even many street insiders aren’t too happy about this one. Bear Stearns, which has a reputation for sharp practice, was an aggressive promoter of subprime mortgages, and was less than candid about its growing financial woes. (A decade ago, when a bailout was organized for the Long Term Capital Investment hedge fund, Bear Stearns refused to contribute.)

In the end (but is this the end?), the Fed doesn’t feel that it can let a major investment house fail, throwing a whole series of mortgage securities and other discredited assets on the market. The question is, how many other major big houses are in much worse shape than they seem?

As the markets work their way through the deepening muck of this crisis, we turn to the question of just where equity investors can find secure income with their investments these days.

According to one leading U.S. advisory, the answer may be with dividends paying stocks, but not necessarily with high dividend yields.

Dow Theory Forecasts illustrates its premise with three chosen stocks, including a Canadian financial firm that is a beacon of stability and strong performance in a sea of instability.

A big mistake

You will see a number reports touting the high dividend yield of certain stocks as one of their most attractive qualities. But this may not be the time to be chasing such yields.

This advisory is blunt about it: “Income-seeking investors take note: Buying only high-yielding stocks is not wise.”

Remember what a high yield implies. A company that is paying out a greater amount of its income in dividends is usually a company that no longer expects to accumulate significant capital gains.

There’s nothing wrong with collecting income from your stock portfolio, concedes the advisory, that’s one reason you buy the shares. “But, for several reasons, it’s a big mistake to restrict your portfolio to high-yielding stocks.”

Screening out growth potential

The first reason for being wary of high-yielding stocks is quite simply that there aren’t that many of them. Of the 5,000 U.S. traded stocks that this advisory covers, only 12 per cent pay yields of more than 4 per cent, “and stock selection is difficult enough without limiting your options.”

But there’s an even bigger reason. Many high-yielding stocks come from one sector: financials stocks. That should set off an alarm bell right away. About half the 1,320 stocks that pay yields of 2 per cent or more are financial firms. Less than 4 per cent come from the health care and technology sectors combined — and that is where you find growing capital gains.

“If you focus on yield while selecting stocks, you automatically screen out many of the companies with the highest growth potential,” states the advisory.

For the third and final reason, the advisory turns to its ratings system, which has evolved from the original theories of Charles Dow. Known as the Quadrix® system, it judges equities based on more than 100 variables in six categories — Momentum, Quality, Value, Financial Strength, Earnings Estimates, and Performance.

The advisory back-tested portfolios based on yield against portfolios based on Quadrix scores. “Not only did the highest-yielding stocks substantially underperform Quadrix leaders even with dividends taken into account, they underperformed the average stock as well.”

In short, a stock’s strengths in areas other than dividend yield proved to be a better guarantee of good performance.

Dividends are still good

“Don’t misunderstand us,” says the advisory. “We aren’t telling you to sell all your dividend-paying stocks. Companies generally pay dividends regardless of the direction of the market, and those dividends reduce the volatility of stock returns.”

In fact, stocks that pay dividends yield higher on this advisory’s scorecard than those that don’t. “But the higher the yield, the lower the average score.” Stocks with yields of 4 per cent or higher do much worse than stocks with yields of less than 2 per cent.

The advisory feels it can’t make the point too strongly. “We don’t have a problem with dividend stocks, but we warn subscribers not to get caught up in the thrill of high yields. You’re better off seeking total returns. If the yield on your investments does not meet your income needs, consider selling some of your stocks periodically to create your own portfolio ‘dividend’.”

In short, you’re better off selling high-performance stocks for income than depending on high dividend yields to do the job for you.

If you want the best of both worlds — superior returns and dividends — you can have it, says the advisory. It has compiled a list of 20 stocks that have high overall Quadrix scores (70 out of 100 or better) and dividends that yield over 1 per cent.

It features three of those stocks, including a Canadian firm that it likes very much.

Solid operating momentum

“Manulife Financial (TSX;NYSE-MFC) has dodged the troubles of many North American insurers by avoiding subprime mortgages and related investments,” says Dow Theory Forecasts.

“Despite the stock market’s poor performance and a slowing U.S. economy, Manulife’s per-share-profits jumped 23% excluding currency fluctuations in the December quarter. While many insurers and money managers had a tough time in the quarter, the Canadian insurer’s premiums and deposits rose 10%.”

Life insurance sales rose 15 per cent and wealth management sales jumped 24 per cent, adds the advisory. It also points out that most of Manulife’s income comes from outside Canada: 21 per cent from Asia and Japan, 49 per cent from the U.S. (John Hancock). Growth in Japan stalled in 2007 but should revive this year. And the rest of Asia shot up 37 per cent in 2007.

“Over the last three years,” concludes the advisory, “Manulife raised its dividend at an annualized rate of 31% and reduced its share count by 7%. With solid operating momentum and more than $3 billion in excess capital, Manulife is positioned to continue repurchasing shares and boosting the dividend.” It is both a Focus List Buy and a Long-Term Buy, which means the advisory believes it is among the best buys over the next 12 months and the next 24 months.

Appeal during tough economic times

One ongoing problem has plagued oil giant Chevron (NYSE-CVX) over the past three years: reserve replacement. The advisory believes that will turn around in 2008. In every other respect, the company has been a strong performer.

Chevron outpaced the S&P 500 over the last three, five and 10 years. It is adding natural gas properties in Angola and China and boosting production in Kazakhstan, and has more projects on the board for 2009 that should pump up the replacement ratio.

The company has raised its dividend in each of the past 20 years, with the payout rising at an annualized rate of 7 per cent since 1997. It doesn’t get quite as high a rating as Manulife, but it is a Buy and Long-Term Buy.

Next we turn to another strong stock that also has problems to deal with. “Owning a well-known, well-run and diversified company like Johnson & Johnson (NYSE-JNJ) has appeal during tough economic times, especially when a 45-year history of dividend increases illustrates a commitment to sharing the wealth with stockholders.”

But this famous firm does face headwinds, adds the advisory. The consumer division could suffer as the economy cuts into spending. Plus there’s a problem in the pharmaceutical division. There are safety concerns about an anemia treatment called Procrit (a study suggests it may be linked to a 10 per cent increase in death rates among cancer patients), and sales have fallen off. The drug is still on the market, but it is not exactly due to enjoy brisk sales.

But there is still room for optimism elsewhere: an over-the-counter version of allergy medicine Zyrtec and four other drugs will be launched this year and could boost sales by hundreds of millions of dollars over the next three years. “A little good news could go a long way with J&J,” concludes the advisory. It is a Buy and a Long-Term Buy.

Of course average investors who go looking for income can’t expect to be bailed out by Washington or Ottawa. They’ll just have to be smarter and more prudent than Bear Stearns. According to a lot of market insiders, that shouldn’t be too difficult.