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JONATHAN BURTON'S LIFE SAVINGS 

June 13, 2013, 6:15 a.m. EDT

Income hunters: Bank on this dividend stock play

Commentary: Share buybacks add kick to a yield-driven portfolio

Reuters

Buying stock in companies that increase dividends and repurchase shares, such as Chevron, can be a rewarding investment strategy.

SAN FRANCISCO (MarketWatch) — Corporate America is flush with cash, but to some investors, businesses are flushing money away by paying dividends. They’d rather see companies buy back stock. Of course, others want the dividend income — in regular and greater amounts.

It’s a big shareholder divide, one made even wider now that rising bond yields have slammed utilities stocks and other dividend darlings. Read more: Where to put your money when bond yields rise.

Weighing dividends vs. buybacks is a good problem to have — like deciding whether to wear diamonds or pearls. Yes, these are two completely different uses of capital — dividends assume you’ll use the money better, while repurchases signal potential buyers that the company’s shares are attractively priced.

But companies with the option to spend money on either of these fashions are fundamentally sound.

“Companies that pay high dividends or are returning cash to shareholders through buybacks are inherently healthy companies,” says Chris Brightman, head of investment management at Research Affiliates LLC, which creates indexes for exchange-traded funds and mutual funds.

Even better: Paying dividends andrepurchasing shares.

Many companies actively increase dividend payouts and implement buyback programs. Dividend growers offer investors a steady stream of cash, while buybacks tend to boost a company’s stock’s price. It’s a marriage of opposites, but it works.

Healthy and wealthy

So, how do you find these stocks?

Brightman says the first order is to eliminate low-quality companies from your dividend and buyback screen. These stocks seem attractively priced but in fact are a set-up for what’s known as a “value trap.”

Instead, he points out, look for companies with below-average volatility and debt relative to their industry, plus above-average debt coverage — meaning there’s more than adequate cash to handle obligations.

“That’s a pretty strong indication that the company is not distressed,” Brightman notes.

From that group, pick the highest-yielding stocks and then check to see which have share-repurchase programs.

At MarketWatch’s request, Brightman compiled a list of 10 stocks he called “healthy companies priced at relatively high yields.”

As of May 31, these included Exxon Mobil XOM -0.82% , AT&T T -1.07% , Verizon Communications, VZ +0.85%  Procter & Gamble PG -0.51% ,  Wal-Mart StoresWMT -0.17%  , Altria Group MO -0.50% , Lockheed Martin LMT -0.25% , Dominion Resources D -0.64% , ConAgra Foods CAG -0.29%   and Campbell Soup CPB +0.56%  .

Indeed, this year has seen a buyback frenzy, on pace to finish second only to 2007’s record, according to research firm Birinyi Associates.

The 10-largest buyback authorizations so far through May came from companies that also pay dividends, including Apple AAPL -1.36% , Home Depot HD +0.08% , Merck & Co.MRK +0.10% , AT&T, Goldman Sachs Group GS -1.75% , General Electric GE -0.68% , PepsiCo PEP +0.18%  , United Parcel Service UPS -0.47%  , American Express AXP -2.98%  and 3M MMM -0.15% .

A one-two ETF punch

If individual stock picking isn’t your skill, a solid dividend-growth and buyback strategy can be crafted using exchange-traded funds.

For example, PowerShares Dividend Achievers PFM -0.54%  owns shares of companies that have increased their annual dividend for 10 or more consecutive fiscal years — no easy feat.

Sibling PowerShares Buyback Achievers PKW -0.44% invests in companies that have repurchased at least 5% of their shares over the past 12 months — not just an announcement to buy back shares, as many companies try to get away with, but actually forking over the cash.

Each of the two portfolios is full of cash-rich, well-known companies. As can be expected, Dividend Achievers currently yields about 2.2%, while the buyback fund yields around 0.9%.

Performance-wise, both ETFs have topped the Standard & Poor’s 500-stock indexSPX -0.59% over the past three- and five years, though Dividend Achievers has lagged the benchmark over the trailing 12 months. Buyback Achievers also has trounced the dividend fund, but it’s riskier — although both funds have been less volatile than the market itself.

Combining the two ETFs offers the best of these worlds, which in fact are more interconnected than would appear. Dividend Achiever’s top holdings include Johnson & Johnson JNJ 0.00% Chevron CVX -1.13% , Wal-Mart, Procter & Gamble and Exxon — all of which have instituted buyback programs.

The buyback fund’s biggest stakes, meanwhile, include Oracle ORCL -1.40% , Conoco-Phillips COP -1.01%   , Amgen AMGN -1.11% , American International Group AIG -1.22%and Time-Warner TWX -0.76% — of which all but AIG are dividend payers.

The dividend ETF’s high bar keeps overlap with Buyback Achievers to a minimum. Just four names surfaced in both funds, based on a Morningstar screen: Conoco Phillips; Lowe’s Cos. LOW -0.05% ; Norfolk Southern NSC -1.08%  and Chubb CB -0.93% .

As for results, a 50-50 split between the dividend and buyback funds would have handily beaten the S&P 500 over one-, three- and five years, as well as through May of this year — with less-than-market risk. The combination’s 7.7% annualized return over five years outshines the S&P 500’s 5.1% comparable total return, according to Morningstar, and its 17% gain for the year as of May 31 was 1.5 percentage points better than the U.S. market benchmark.

Other dividend-growth focused ETFs to consider include SPDR S&P Dividend ETFSDY -0.22% , which reflects the S&P High Yield Dividend Aristocrats Index, Vanguard Dividend Appreciation VIG -0.41% , and the new WisdomTree U.S. Dividend Growth Fund DGRW -0.53% . 

Keep in mind that dividend-growth focused ETFs and mutual funds tend to be heavily invested in consumer staples, telecom, utilities and other traditionally defensive sectors.

For example, the most widely traded dividend-stock ETF, iShares Dow Jones Select Dividend Index Fund DVY -0.32% , commits almost 30% of its portfolio to utilities, which has been the hardest-hit market sector in the wake of rising interest rates; consumer staples and telecom also have lagged.

In contrast, WisdomTree U.S. Dividend Growth acknowledges the stronger U.S. economy by splitting 60% of the fund about equally among technology, industrial and consumer cyclical stocks.

PowerShares Dividend Achievers, meanwhile, allocates about one-third of its portfolio to defensive stocks and 25% to cyclical stocks, but adding Buyback Achievers flips that around, trimming defensive exposure to about 25% and upping cyclical stocks to 36%.

Remember, timing is everything; be careful of the price you pay, or you’ll pay the price. Right now cyclical shares with a yield are relatively cheaper than utilities and other bond-like stocks — and you can be sure that’s not lost on company directors contemplating share repurchases.

“Buy good quality companies and buy them when they’re cheap,” Brightman advises. “This is not much different from what you would be instructed to do by Warren Buffett or Ben Graham.” 

Jonathan Burton is a MarketWatch editor and columnist based in San Francisco. Follow him on Twitter @MKTWBurton.