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.

Regards,
Alan Brochstein
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

At the time of publication and in the preceding month, TradeKing and the third-party content provider did not have ownership greater than 1% in any stocks mentioned here and do not have any other actual, material conflict of interest known at the time of publication. Neither TradeKing nor the third-party content provider, received compensation from a public offering or from investment banking services related to any companies mentioned here within the past 12 months, or expects to receive any in the next 3 months. Neither TradeKing nor the third party content provider engaged in market making in the securities mentioned here. TradeKing selects and defines as All-Stars certain independent market commentators who are recognized industry personalities and experienced traders. TradeKing All-Stars provide timely market commentary via the TradeKing All-Star blog at http://community.tradeking.com/members/tk-all-star/blogs. Each All-Star commentator's bio, related qualifications and disclosure as to their relationship with TradeKing can be found on the All-Star blog roster, available at http://community.tradeking.com/members/tk-all-star/details. The selection of All-Stars commentators is solely based on the quality and style of the content provided. TradeKing does not measure, endorse, or monitor the performance or correctness of any statement or recommendation made by independent All-Stars commentators on TradeKing.com. Supporting documentation for any claims made in this post will be supplied upon request by the author of the post, who is solely responsible for the views expressed here. Send a private message to All-Stars using the link below the profile image.

Alan Brochstein maintains a business relationship with TradeKing.

All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. You alone are responsible for evaluating the merits and risks associated with the use of TradeKing's systems, services or products.

© 2012 TradeKing Group, Inc. Securities offered through TradeKing, LLC. All rights reserved.