Alan Brochstein identifies five stocks that conservative investors may be overlooking
Investors are increasingly turning to equities in order to find alternatives to bonds, whose yields have dropped to levels so low that the income may be insufficient and the price risk, should interest rates rise, too great. For investors willing to invest out to ten years but not willing to take credit risk, U.S. Treasury notes offer yield-to-maturity of about 1.6%. One can purchase corporate bonds or mortgages to boost the yields a bit, but the returns are still rather low. The Barclays Aggregate Bond index, which is broadly diversified by maturity and credit, has a yield of just 2%.
Those seeking equity alternatives have tended to focus on several areas, including Utilities, Master Limited Partnerships (MLPs), Real Estate Investment Trusts (REITs) and high-yielding stocks. Just looking at the S&P 500, there are 17 stocks with dividend yields in excess of 5%, including a REIT and 3 Utilities.
If a borrower doesn’t pay the interest on its debt (a bond), it is in default and can lose its entire investment, a powerful incentive to fulfill its obligations. For instance, if a company misses its payments, the lenders (bond owners) can seize the assets of the business. A company paying a dividend, on the other hand, can reduce or eliminate that payment without suffering such consequences. So, investors typically look at dividends as being less secure than interest on bonds.
Rather than trying to just maximize dividend yield, I recommend considering the risks as well. Not only can one minimize the risk of a short-fall in dividends, but it’s actually possible to identify companies that can be expected to increase their dividends over time. This works to the buyer’s advantage because the income will increase over time and the principal (the investment) may become more valuable in the future due to this higher level of income. A bond, on the other hand, pays a fixed amount and pays off only the “par” value.
The idea of investing in high quality companies that typically boost their dividends is known as “dividend growth investing”. Standard & Poors tracks companies that have boosted their dividends for each of the past 25 years or more, anointing them as “Aristocrats”. Currently, there are 51 companies in the S&P 500 that meet this stringent criterion.
I suggest that investors interested in this style of investing expand their horizon to smaller companies, as I have found many interesting companies that offer attractive valuations and strong investment characteristics. Most everyone knows about Exxon (XOM), for instance, but there are smaller companies that escape the scrutiny of big institutional investors but that might prove to be a better investment because they are less mature and capable of generating higher dividend growth.
Using Baseline, I wanted to run a screen for you focused on finding promising candidates to review more closely. Here is what I did (and why):
- Stocks from the Russell 3000 index, with market cap > $500mm
- Dividend Yield > 2.5% (S&P 500 = 2.1%)
- Payout Ratio < 50% (conservative because earnings reduction won’t lead to dividend shortfall)
- 5-year Dividend Growth > 6% (Looking for growing dividends – S&P 500 is down over past 5 years)
- Dividend Increases Last 5 Years = 5 (Looking for increase each year)
- 5-year EPS Growth > 0% (Good test of ability to “weather the storm”
- 2012 Projected EPS Growth > 0% (No near-term risk to dividend growth)
- Net Debt to Capital < 20% (Strong balance sheet)
The screen resulted in a dozen companies fitting the criteria, but here are the 5 with market caps less than $4 billion:
Please keep in mind that these are not recommendations. Past performance is no promise of future performance, so one must dig a little deeper to assess the likelihood of continued growth in dividends. American Greetings (AM), for instance, which is the stock with the lowest valuation as measured by its PE of 6X, is in an industry that is in decline. While its sales and earnings grew last year, they haven’t increased much in five years.
Among the other four stocks that met the requirements, I like that we have several sectors represented, as BOK Financial (BOKF) is a Financial, Crane Company (CR) is an Industrial, Owens & Minor (OMI) is in the Healthcare sector and Williams-Sonoma (WSM) is in the Consumer Discretionary sector. The latter two have more cash than debt.
Screening is a tool to identify stocks to study more closely for potential investment. In this case, we have identified 5 stocks that might be attractive alternatives to bonds, offering dividends that could potentially continue to grow. Despite favorable characteristics, 4 of the 5 have lagged the S&P 500 over the past year, and the valuations appear to be reasonable.
Founder, Invest By Model and AB Analytical Services
TradeKing All-Star Commentator
Disclosure: OMI and WSM are held in one or more model portfolios at InvestByModel.com, a service operated by the author
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