“The market for ‘Lemons”
The market for used cars:
some used cars are “cherries”
and others are “lemons.” The rub, however,
is that the buyer cannot distinguish between
them. Only the seller knows if the used car
is a cherry or a lemon. Afraid of buying a
lemon, the buyer demands a discount from
a would-be cherry’s price, and the seller—if
knowingly selling a cherry—will refuse to deal
at the discounted price. Without a meeting of
the minds, the seller will not receive a fair
price and is discouraged, as are other owners
of cherries, from even offering them for sale.
As a result, the market for used cars contains
a disproportionate amount of lemons.
Akerlof’s observation about used cars can
help us understand why more information
improves purchasing decisions, and not just
for used cars.
So how will we pick higher-yielding dividend stocks? One interesting approach is to screen large-cap stocks for high dividend yields, and then screen them again for quality. Research Associates recently published a research report called “The Market for Lemons: A Lesson for Dividend Investors,” which I urge you to read.
The report, written by Chris Brightman, Vitali Kalesnik and Engin Kose, is based on a study of large-cap U.S. stocks using 50 years of data.
The idea of the study is to begin with the largest 1,000 publicly traded U.S. companies, by market value, and compare this group’s performance over very long periods with two other groups: the 200 with the highest dividend yields, and smaller groups of 100 high-yield, high-profitability companies and 100 high-yield, low-profitability companies, by average return on assets (ROA).
The data were adjusted by industry, since measures of profitability can differ greatly, and because new companies were formed and others merged out of existence or were delisted, etc.
Digging deeper for quality
Brightman, Kalesnik and Kose then discussed the importance of screening further for quality, by looking at “distress risk,” which was most easily identified by reviewing debt-coverage ratios. A company’s DCR is its annual earnings divided by the sum of its interest payments for the year and debt principal coming due that year.
The researchers then searched for “accounting red flags” by focusing on increases in net operating assets. NOA is difference between net income and free cash flow. The idea is that if a company’s earnings are growing more slowly than free cash flow, it may have problems with collections, it may be using aggressive accounting to prop up earnings results or it may be forced to slow the rate of dividend increases.