Thriving on the dividend and buyback dietFebruary 14, 2013: 5:00 AM ET
Why it's more important than ever to focus on the dividends and buybacks that companies return to shareholders.
FORTUNE -- Dividend-paying stocks have generated intense debate in recent years. Has the rising market made their prices too high and their yields too low -- or is a dividend-heavy portfolio still the best way to garner superior returns? For Chris Brightman, that discussion misses the point. Brightman is the head of investment management at Research Affiliates, an investing think tank that devises and licenses indexes that are used to manage $70 billion in ETFs and mutual funds, including funds sold by Schwab (SCHW) and PowerShares.
Brightman sees dividends as a key metric -- but not the sole one. His latest brainstorm is a value-oriented methodology that screens not only for dividends but also for the impact of stock buybacks. In theory, when a company reduces its number of shares by, say, 2% while keeping profits and the price/earnings ratio steady, it should translate to a 2% increase in stock price. So Brightman adds the percentage of shares repurchased to the dividend yield percentage to calculate what he calls "total yield." He argues that stocks with the highest total yields are far and away the best buys on the market.
The strategy is premised on Brightman's view that the overall market will reap puny rewards for the foreseeable future. He computes the expected return by adding up the average dividend yield, the "real" growth in earnings per share (EPS), and inflation. As Brightman points out, the S&P 500 (SPX) yield is just 2%, less than half the historical average. The real shocker is future EPS. It typically grows at an inflation-adjusted rate of just 1.5% a year. Why so low? "Companies are constantly issuing more shares to make acquisitions, build plants, or otherwise expand," he explains. "All the dilution means that earnings per share grow at two points less than total earnings, getting us to the 1.5% figure." It's folly to expect more, Brightman contends, since "profits are already at incredibly high levels by any measures -- including margins and share of national income."
By Brightman's math, the 2% yield and 1.5% growth in earnings, combined with a projected 2.5% inflation rate, mean an expected return for the overall market of just 6%, compared to the historical average of around 9%. Brightman believes his approach can boost returns by several points without venturing into highly volatile, risky territory. The formula consists of purchasing shares in big, stable companies that generally offer dividend yields well above average, coupled with annual repurchases that exceed 2% of the outstanding shares.
Brightman targets stocks with a total yield of 5% or more. He takes a conservative view of earnings growth for these companies, since they pay out rather than reinvest such a high proportion of their earnings. He reckons profits should rise by at least 0.5% in real terms, or 3% including inflation. That amounts to a total return of 8%.
Brightman's screen produces an array of marquee stocks. Since these companies each offer total yields of 5% or more, their P/Es tend to be low. (If their prices soar, by definition, their dividend yields drop, and any cash spent on buybacks will then purchase a smaller proportion of the shares outstanding.) Brightman adds another test. The companies must have sufficient free cash flow (cash from operations minus capital expenditures) to maintain the 5% payouts for dividends and buybacks.
Here are some of Brightman's top choices using this formula. He's a fan of Exxon Mobil (XOM), which offers a 2.5% yield and which repurchased $20 billion worth of shares in 2012, or 4.8% of the "float." That's a 7.3% total yield. One caveat: Exxon's free-cash-flow yield is lower than its total yield, which means that Exxon is likely to trim its buybacks over the next few years. That said, its cash flow rate suggests its total yield will settle closer to 5.5%, which would still be terrific.
Wal-Mart (WMT) is another Brightman favorite. Its yield is just 2.3%, but it offers buybacks of approximately 2.7%, for a total of 5%. By contrast, AT&T's (T) long-term buyback plans are unclear (it has scooped up 2% of outstanding shares in the past 12 months), but its dividend, a rich 5.3%, makes it a prime choice even without more buybacks.
Fortune applied Brightman's methodology and turned up two health care stocks. Pfizer (PFE) has a 3.6% dividend, plus another 4% from buybacks, for a total of 7.6%. For its part, medical-equipment maker Medtronic (MDT) pays a 2.3% dividend and adds 3.7% from repurchases, bringing its overall yield to 6.0%. If you add projected earnings growth and inflation, each of these stocks meets or surpasses the 8% target.
Research Affiliates is still developing a low-cost, quasi-passive product that incorporates Brightman's ideas. For now, he suggests using his screening criteria to assemble a portfolio of eight to 20 stocks. When following this strategy, Brightman adds, it's essential to rebalance portfolios by selling shares that jump in price. If the total yield drops substantially, he says, it's time to replace those names with a new crop of out-of-favor picks. He recommends rebalancing once a year on your birthday (a date he chooses because it's easy to remember). If his strategy pays off, it'll give you a new reason to look forward to that date.
This story is from the February 25, 2013 issue of Fortune.