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Value Series III: Value Investing and Dividends for Target Employees and Retirees

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Given the current elevated market volatility, we think now is a good time to revisit important value metrics with Target employees and retirees in our four-part series. In the third part of this four-part value series, we will look at the Dividend Yield ratio.

We believe the Dividend Yield ratio can be a valuable tool in planning for Target employees' retirements. Investors are often looking for ways for their clients to beat the market. If you're one of those investors, you may want to consider the following strategy that has been implemented by the investment greats. Some value investors have historically beat the average annualized returns of the S&P 500, and many have successful track records spanning several decades to prove it. The most famous value investor, of course, is Warren Buffett, but there are many others, including Benjamin Graham, David Dodd, Charlie Munger, Christopher Browne, and Seth Klarman.

This investment style focuses on four metrics that characterize a value investment. These four metrics include the Price-to-Earnings Ratio, the Price-to-Cash Flow Ratio, High Dividend Yield, and the Price-to-Book Ratio. These metrics, as you will see, are strong indicators of undervalued security. If undervalued security is brought back to fair value then we would see positive returns on that security. We will examine the effect of investing based on certain characteristics and how their investment returns are correlated.

The dividend yield is a popular value metric for investors for two reasons. First, it’s the obvious metric for investors favoring income over capital gains. Second, unlike earnings or cash flow, dividends are actually paid out to shareholders, and therefore independently verifiable. Where other metrics like price-to-book value, earnings or cash flow rely on management providing a true accounting of a company’s performance, the dividend is tangible proof of excess free cash flow. Thus, the argument goes, the dividend yield provides the most reliable picture of a company’s business performance, and prospects, which in turn may lead to better investment decisions and investment performance.

We understand the importance of research-driven solutions for Target employees and retirees. Set out to the right, are the results of two Fama and French backtests of the dividend yield data from 1926 to 2013. As of December 2013, there were 3,393 firms in the sample. The value decile contained the 198 stocks with the highest earnings yield, and the glamour decile contained the 137 stocks with the lowest earnings yield (the deciles are smaller than 1/10th of the stocks in the sample because 1,894 stocks pay no dividend at all) (Carlisle-Div, P2).

The average size of glamour stocks is $8.60 billion and the average size of value stocks is $3.06 billion. Portfolios are formed on June 30 and rebalanced annually. In this backtest, the two portfolios are weighted by market capitalization, which means that bigger firms contribute more to the performance of the portfolio, and smaller firms contribute less. Here we can see that the value decile has outperformed the glamour decile, returning 10.3 percent compounded (13.4 percent in the average year) over the full period versus 8.3 percent for the glamour decile (11.3 percent in the average year) (Carlisle-Div, P3)

These returns are considerably lower than the returns found for the price-to-earnings and cash-flow ratios discussed previously. The reason is that the earnings and cash flow back tests ran back to only 1951, and the dividend yield data, like the book value return data, begins in 1926. The difference is partly due to the 1929 crash, which had an oversized impact on returns. The crash is visible on the chart and striking; it took almost twenty years for the value decile to fully recover.

To make a comparison possible of dividend yield’s performance to the performance of book, earnings, and cash flow over the same period, it's important that we also show Target employees and retirees the measured returns beginning in 1951. Since 1951 the high dividend yield value decile has generated a compound annual growth rate (CAGR) of 11.4 percent and an average annual return (AAR) of 13.6 percent (Carlisle-Div, P5). Over the same period, the glamour decile returned a CAGR of 9.6 percent and an AAR of 12.9 percent. These returns are still considerably lower than the returns generated by the low PB, PCF, and PE studies over the same period.

The value premium is the outperformance of the value decile over the glamour decile. This chart provided for Target employees and retirees shows the yearly returns of each of the value and glamour deciles, the value premium (value-glamour) in each year, and the rolling average from the start of the data in 1926.

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The rolling average tells a sad story for value relative to glamour: The value premium has gradually disappeared over time. Over the 73 years of data to 2000 it was actually zero, but it has slightly recovered since then to be 1.8 percent compounded over the full period (Carlisle-Div, P7). (The rolling average is the annualized average return for over the 5 yrs. following each year-long period (sometimes called a 5-year rolling return)

The following chart provided for Target employees and retirees shows the returns to each of the deciles sorted by dividend yield (1 is glamour, and 10 is value). This chart shows that the dividend yield is a fair, but not great, metric for sorting stocks into value and glamour portfolios. This is due to the fact that less than half of all stocks pay dividends (only 44 percent pay dividends). A better comparison might be the dividend payers to the 1,894 stocks in the non-dividend paying cohort. The non-dividend payers underperformed all the dividend payers, generating a compound annual growth rate (CAGR) of 9.0 percent and an average annual return (AAR) of 13.5 percent over the full period (and, since 1951, a CAGR of 8.4 percent and an AAR of 13.2 percent) (Carlisle-Div, P8).

As we’ve discussed previously, value’s out. performance over glamour is not a historical anomaly. If we examine just the period since 1999, we find that value has been the better bet. Though value started out almost 40 percent behind in 1999, it outperformed glamour over the period since 1999, beating it by 5.2 percent compounded, and 6.5 percent in the average year–about the same differential for the low PB study (Carlisle-Div, P10). Market capitalization-weighted returns are useful for demonstrating that the outperformance of value over glamour is not due to the value portfolio containing small-cap stocks. Unless you’re running an index (or hugging an index), they’re not really meaningful.

The easiest portfolio weighting scheme is to simply equally weight each position. (If we’re prepared to put up with a little extra volatility for a little extra return, we can also Kelly weight our best ideas). Kelly Weighting is determined by the Kelly Criterion which is a formula used to determine what percentage of their capital should be used in each trade to maximize long-term growth. There are two key components to the formula (Kelly % = W- [(1 - W) / R]): the winning probability factor (W) and the win/loss ratio (R). The winning probability is the probability trade will have a positive return.

The win/loss ratio is equal to the total positive trade amounts divided by the total negative trading amounts. The result of the formula will tell investors what percentage of their total capital that they should apply to each investment. Here are the equal weight return statistics for dividend yield.

In the equal weight backtest, value generated 12.7 percent compounded return (16.1 percent on average), beating out glamour’s 11.6 percent compounded return (15.5 percent on average) (Carlisle-Div, P11).

Since 1951, the equally weighted high dividend yield value decile has generated a compound annual growth rate (CAGR) of 13.5 percent and an average annual return (AAR) of 15.7 percent. Over the same period the glamour decile returned a CAGR of 12.5 percent and an AAR of 15.5 percent. These returns are still slightly lower than the returns generated by PB, PCF and PE over the same period (Carlisle-Div, P12).

Again, the value premium was never very large for the equal weight portfolios and has gradually diminished to 1.1 percent compounded over the full period. We see again that the dividend yield doesn’t do a great job sorting glamour and value portfolios. The dividend payers do, however, comprehensively outperform the non-dividend paying cohort, which returned a CAGR of 13.4 percent and an AAR of 21.2 percent over the full period (and, since 1951, a CAGR of 12.4 percent and an AAR or 18.3 percent) (Carlisle-Div, P14). For this reason, we believe- dividend yields can be a valuable tool for Target employees.

Michael Keppler, who wrote “The Importance of Dividend Yields in Country Selection”, focused on the effect of stock returns based on dividend yield. He examined Australia, Austria, Belgium, Canada, Denmark, France, Germany, Hong Kong, Italy, Japan, The Netherlands, Norway, Singapore/Malaysia, Spain, Sweden, Switzerland, the United Kingdom and the United States. The study assumes each quarter an equal weighted portfolio is composed by dividing each of the 18 Morgan Stanley international equity indexes into quartiles based on their dividend yield. As seen in the following graph, the highest dividend yielding quartile significantly outperforms its low dividend paying counterparts.

The highest paying dividend quartile returned 18.49% compounded and 19.08% compounded when adjust to US dollars. The lowest paying quartile only returned 5.74% and 10.31% compounded when converted to US dollars. The MSCI World Index returned 12.14% compounded annually and 13.26% when converted to US dollars (Tweedy Browne, p.32). We can see from this evidence that high paying dividend companies significantly outperform non-dividend paying companies.

While there is a slight correlation that high dividend companies outperform low dividend companies, we must agree that ultimately it is the fact that dividend paying companies historically outperform non-dividend paying companies.

In a more recent study by Manning & Napier Advisors, LLC, they find that high dividend yield stocks still outperform the low to no dividend-paying stocks. They look at the performance, for a 25-year period (1990-2015), of high cash flow yield and high dividend yield stocks independently as well as how they can be used together.

As can be seen in Figure 2, screening for high dividend yield stocks can protect the downside. This is due to the fact that the companies that pay higher dividends are returning capital to their investors which eliminates the uncertainty that comes with companies carrying cash. In fact, Figure 3 shows that a significant (over 40%) part of total return from 1926 to 2015 has come from dividends as opposed to capital appreciation.

In addition, we'd like to point out to Target employees that higher dividend yields have generated better capital stability for investors. Figure 5 shows that higher dividend yields have demonstrated lower downside capture since 1990. This limited downside can be important for Target retirees looking for both current income and low volatility.

As can be seen in these three studies we've provided for Target employees, it is apparent that by simply screening for high-dividend stocks with no fundamental analysis it is possible to outperform non-dividend paying stocks. Unlike the P/E, P/CF ratios, and ultimately the P/B ratio, which are all very useful metrics for sorting cheap stocks from expensive stocks, the dividend yield is less useful. This is likely because only around 44 percent of all stocks pay dividends. The message seems to be clear, that expensive stocks and undervalued stocks that pay dividends outperform all non-dividend paying stocks. Reinforcing this metric are the value-oriented track records of notable names such as Warren Buffet, Bruce Berkowitz, and Seth Klarmen who all use the dividend yield as a supplemental indicator for their investment universe.

The Retirement Group is a nation-wide group of financial advisors who work together as a team.

We focus entirely on retirement planning and the design of retirement portfolios for transitioning corporate employees. Each representative of the group has been hand selected by The Retirement Group in select cities of the United States. Each advisor was selected based on their pension expertise, experience in financial planning, and portfolio construction knowledge.

TRG takes a teamwork approach in providing the best possible solutions for our clients’ concerns. The Team has a conservative investment philosophy and diversifies client portfolios with laddered bonds, CDs, mutual funds, ETFs, Annuities, Stocks and other investments to help achieve their goals. The team addresses Retirement, Pension, Tax, Asset Allocation, Estate, and Elder Care issues. This document utilizes various research tools and techniques. A variety of assumptions and judgmental elements are inevitably inherent in any attempt to estimate future results and, consequently, such results should be viewed as tentative estimations. Changes in the law, investment climate, interest rates, and personal circumstances will have profound effects on both the accuracy of our estimations and the suitability of our recommendations. The need for ongoing sensitivity to change and for constant re-examination and alteration of the plan is thus apparent.

Therefore, we encourage you to have your plan updated a few months before your potential retirement date as well as an annual review. It should be emphasized that neither The Retirement Group, LLC nor any of its employees can engage in the practice of law or accounting and that nothing in this document should be taken as an effort to do so. We look forward to working with tax and/or legal professionals you may select to discuss the relevant ramifications of our recommendations.

Throughout your retirement years we will continue to update you on issues affecting your retirement through our complimentary and proprietary newsletters, workshops and regular updates. You may always reach us at (800) 900-5867.

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Carlisle, Tobias. “Investing Using the Price-to-Earnings Ratio and Earnings Yield (Backtests 1951 to 2013)”. May 26, 2014. <http://greenbackd.com/2014/05/26/price-to-earnings-ratio-backtest-1951-to-2013/>.
Hobson, Ben. “Don't get your head turned by glamour shares: How David Dreman perfected the art of contrarian stock-picking”. April 2013 <http://www.thisismoney.co.uk/money/diyinvesting/article-2308111/David-Dreman-art-contrarian-stock-picking.html>.
Tweedy Browne Company LLC. “What Has Worked in Investing: Studies of Investment Approaches and Characteristics Associated with Exceptional Returns.” 1992.<http://www.tweedy.com/resources/library_docs/papers/WhatHasWorkedFundVersionWeb.pdf>.
Manning & Napier Advisors. “Free Cash Flow and Dividends: How A Focus On Yield Can Help Investors Provide for Today and Prepare for Tomorrow” April 2016.

What are the key benefits provided by Target Corporation's Personal Pension Account and Traditional Plan for employees approaching retirement, and how do these plans ensure financial security during retirement years? Understanding the synergy between these two plans is essential for retirees, as they work together alongside Social Security and personal savings to replace a portion of an employee's paycheck after retirement.

Key Benefits of the Personal Pension Account and Traditional Plan: Target Corporation's pension plan includes two components: the Personal Pension Account and the Traditional Plan. These plans work in tandem to replace a portion of an employee's paycheck during retirement. The Personal Pension Account provides pay credits and interest that accumulate over time, while the Traditional Plan uses a final average pay formula. Together with Social Security and personal savings, these plans help ensure financial security in retirement(Target Corporation_Dece…).

How can employees elect different payment options, such as the Single Life Annuity or the Joint and Survivor Annuities, within Target Corporation's pension plans? It is crucial for employees to grasp not only the financial implications of these choices but also the necessary spousal consent required when designating a joint annuitant, particularly if the chosen joint annuitant is not the employee's spouse.

Payment Options and Spousal Consent: Employees can elect different payment options, including the Single Life Annuity, which provides the highest monthly benefit and ceases at the retiree’s death, or the Joint and Survivor Annuity, which continues payments to a surviving spouse. To elect a non-spouse as a joint annuitant, spousal consent is required, and this must be notarized to ensure compliance with plan rules(Target Corporation_Dece…).

In what circumstances might benefits not be paid under the Traditional Plan, and what steps can employees take to ensure they remain eligible for their pension benefits upon termination of employment? Target Corporation's policy outlines several scenarios where benefits could be denied, making it necessary for employees to be proactive in understanding their rights and responsibilities concerning plan participation.

Circumstances for Denial of Benefits under the Traditional Plan: Benefits under the Traditional Plan may not be paid if an employee leaves before becoming vested (less than three years of service). Employees should ensure they meet the vesting requirements and maintain eligibility by avoiding termination before they reach the minimum service period(Target Corporation_Dece…).

What procedures should employees follow to report changes in marital status, address, or beneficiaries to ensure compliance with the requirements of Target Corporation's pension plan? Employees must understand the importance of timely reporting these changes to avoid potential issues with their retirement benefits and ensure that their pension plan information remains up-to-date.

Reporting Changes in Marital Status or Beneficiaries: Employees must promptly report changes in marital status, address, or beneficiaries to Target's Benefits Center to ensure their pension records remain up-to-date. Failing to do so can lead to delays or issues in processing pension benefits(Target Corporation_Dece…).

How does Target Corporation determine the final average pay used to calculate retirement benefits under its pension plans, and what factors may affect this calculation? Employees nearing retirement should be fully informed about how their compensation is considered in determining their pension benefits, including aspects such as bonuses and overtime that may influence their final average pay calculation.

Final Average Pay Calculation: Target Corporation calculates final average pay based on the five highest years of earnings out of the last 10 years of service. This includes regular pay, overtime, bonuses, and commissions but excludes items like workers' compensation or long-term disability payments(Target Corporation_Dece…).

How can employees begin the process of rolling over their Target 401(k) accounts into the Pension Plan, and what advantages does this Pension Purchase Program offer? Understanding this rollover option is vital for maximizing retirement benefits, as it can provide employees with a stable income stream while avoiding unnecessary fees typically associated with purchasing annuities outside the plan.

Rolling Over 401(k) into the Pension Plan: Employees can roll over their 401(k) accounts into the Pension Plan using the Pension Purchase Program. This option offers several advantages, including avoiding fees associated with purchasing annuities outside the plan and receiving a stable income stream during retirement(Target Corporation_Dece…).

What are the implications of a participant's age and joint annuitant's age on the payment amounts under the various Joint and Survivor Annuity options at Target Corporation? Employees should be aware of how age differences can impact their pension payouts, as the specific percentages payable under these options may vary based on the ages of both the participant and their designated joint annuitant.

Effect of Participant and Joint Annuitant’s Age on Payments: The Joint and Survivor Annuity options are influenced by the ages of both the participant and the joint annuitant. The younger the joint annuitant, the lower the monthly payout due to actuarial adjustments. Employees should consider these factors when selecting an annuity option(Target Corporation_Dece…).

How are retirement benefits managed during potential plan terminations or amendments at Target Corporation, and what protections are in place for employees in these scenarios? Employees should be well-informed regarding their rights in the event of changes to the pension plan, including how benefits would be distributed and under what circumstances they may remain fully vested.

Plan Terminations or Amendments: In case of plan terminations or amendments, vested benefits are protected, and employees will receive their earned pension. If the plan is amended or terminated, Target ensures that vested benefits are distributed according to the plan's terms(Target Corporation_Dece…).

For employees retiring or leaving Target Corporation, what options are available with respect to unused vacation time and how might this be factored into pension calculations? Understanding how accrued time off translates into benefits could have a significant impact on an employee's financial positioning upon retirement.

Unused Vacation Time and Pension Calculations: Unused vacation time does not directly affect pension benefits but can be included in eligible earnings calculations that determine final average pay. Employees nearing retirement should consult with Target’s Benefits Center to understand how unused time may impact their overall benefits(Target Corporation_Dece…).

How can employees contact Target Corporation for assistance with their retirement benefits to address any questions or concerns they may have about their pension plans? Accessing the right resources and support is essential for employees to navigate their retirement benefits effectively. They can reach out to the Target Benefits Center at 800-828-5850 for more specific inquiries related to their personal circumstances. These questions aim to enhance employees' understanding of their retirement benefits, ensuring they are well-prepared for their transition into retirement.

Contacting Target for Pension Assistance: Employees can contact the Target Benefits Center at 800-828-5850 for assistance with their retirement and pension plans. This center provides support with any questions related to pension options, payments, and administrative requirements(Target Corporation_Dece…).

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For more information you can reach the plan administrator for Target at 10 South Dearborn Street 48th Floor Chicago, IL 60603; or by calling them at 1-800-440-0680.