These may be the times that try men’s souls, but this is also the sort of time when long-term investors can snatch up great bargains. What do I mean by a great bargain? A good solid company selling at a low valuation.
The reason you buy stocks is that they represent partial interest in a company. You want to own companies, because over time they make a lot of money, and they can then pay that money out to you in the form of dividends. Even with stocks that currently don’t pay a dividend, the idea is that they will be able to redeploy the cash they earn better than you could, so that they continue to grow their earnings and thus sometime down the road can pay out even bigger dividends.
Dividends a Good Source of Income
With interest rates at rock-bottom levels, income is very hard to find. Dividend-paying stocks are a great place to look for it. The sell-off has pushed up dividend yields, and strong companies have a tendency to increase those dividends over time. This will raise your yield on cost.
For example, if a company has been increasing its dividend at 15% per year (and should be able to continue to do so) and it was initially yielding 2%, it means that after five years you are actually holding a security that is paying you 4% based on your original cost. If you don’t need the income now, those dividends can be reinvested, and the power of compound interest results in even higher eventual income down the road when you do need the income.
If you buy a T-note yielding 2%, after five years, it is still going to be yielding 2% on your original cost. Now suppose that the market sell-off has pushed that yield up to 3% today. Well, if the company continues to raise its dividend at 15%, then five years from now you are getting 6% on your original cost. If you reinvest the dividends, the compounding effect is even greater.
It is unlikely that the stock will actually be yielding 6% five years from today. Instead, the price of the stock will rise, but that will not change your yield on cost.
Screening for Long-Term Bargains
The Zacks Rank
To help identify some potential great long-term bargains I ran a screen. First I eliminated all the firms that have either a Zacks #5 Rank (Strong Sell) or Zacks #4 Rank (Sell). The Zacks Rank is an unparalleled short term tool for traders.
Even if a stock looks like a bargain today, you would be better advised to wait a month or two to buy it if it has a bad Zacks Rank. If you are a short-term trader, a good Zacks Rank (ideally a Zacks #1 Rank, but a #2 is OK) should be absolutely the first thing you look for. However, if you are planning to hold on to the stock for 5 or 10 years, it is best just to avoid potential land mines. It is no fun buying a stock based on getting 3.5% a year in dividends if over the next week it falls by 10%.
Large Market Cap
The next thing I did was only look at companies over $2 billion in market cap. In turbulent times, small caps are often much more volatile than large caps. There are small caps out there that would fit the bill, but I wanted a more manageable list, and I want stable companies that will be around for a long time. Large caps tend to be less dependent on a few customers or a specific geographical area.
Yielding More than the 10-Year
I then looked for all the companies that are yielding more than 3.0% today. That is well above the yield on the 10-year Treasury today, and not all that far below what even the 30-year is yielding.
Since the last thing you want to see if you are buying a stock for its yield is to have the dividend cut, I looked for two lines of defense. The first is the payout ratio. A company cannot pay out everything it earns and still be able to grow for very long.
If it pays out more than it earns, then it has to borrow to do so, and eventually that will catch up to it. If it is paying out significantly less than it earns, the board of directors will generally feel much more confident about raising the dividend.
Dividends Upped During Latest Crisis
Also, the first cut is the hardest for a company to make. I thus required that the company have grown its dividend by at least 5% a year over the last five years -- and that period has included the worst economic downturn since the Great Depression.
If companies didn’t cut during the 2008-'09 downturn, they are not likely to do so now. Another way of looking at it is that if a company has a 3% yield today, and raises its dividend at 5% per year for five years, and the stock still yields 3% five years from now, then your total return will be 8%. In the current environment, that would be a very acceptable rate of return.
Cheap on Price-to-Earnings
Finally, since dividends are paid out of earnings, I wanted the companies to be cheap on that basis as well, so only the companies that are trading for single digit P/E’s based on 2012 earnings are included. While the Payout Ratio is calculated on trailing earnings, the effect of putting a low P/E requirement in based on 2012 earnings was to further eliminate the stocks that were at the high end of the payout ratio range.
The highest actual payout range for the 30 stocks shown is 55%. To the extent that earnings are higher in 2012 than they have been over the last 12 months, the payout ratios will be even lower than they are now...unless of course the companies raise their dividends.
Don't Fear Foreign Stocks
The screen shows that you should not be afraid to look outside the borders of the U.S. if you are looking for bargains, especially if you define bargain by high and rising dividend yields. Almost half the companies on the screen are based outside the U.S. That includes all five of the highest yielders, and eight of the top ten.
The list is dominated by oil companies and financial firms based outside of the U.S. While oil prices have recently retreated in response to the economic slowdown, they are still at high levels on a historical basis, and those levels are very profitable for the oil companies.
Given how difficult it is to find and develop the amount of oil that is required by the rapidly growing middle class of places like China and India, I suspect that oil prices will continue to remain high over the next five years or so (and probably permanently).
In any case, it is very hard for me to envision any of the major oil companies shown on this list going out of business anytime soon. With the payout ratios generally below 40% and very low P/E’s based on 2012 earnings, it looks like the sort of dividend growth rates they have posted over the last five years can easily be sustained.
Yes there is always the chance that a Royal Dutch Shell (RDS.B) or Conoco Phillips (NYSE:COP - News) could be involved in a BP (:BP)-type disaster, but hey, even BP is still in business. Buying a basket of firms is probably your best defense against that sort of thing happening to you.
The Canadian Banks also show up the screen. They came through the 2008 meltdown with flying colors, in large part because the Canadian Bank Regulators were far more competent than were ours or the Europeans. While Bank of America (:BAC) and Citigroup (:C) and even JPMorgan (:JPM) were forced to slash there dividends during the crisis -- and given the state of their balance sheets even today, regulators would be nuts to allow them to raise their dividends anytime soon (with JPM the possible exception) -- Toronto Dominion (NYSE:TD - News) and Royal Bank of Canada (NYSE:RY - News) have been able to consistently raise their dividends.
Canadian Banks are well, Canadian: nice safe and stable, but a little boring. But heck, these days boring can be a great virtue!
One group that shows up well on the screen that I would be a bit cautious with, even though they are cheap, are the defense contractors. The austerity madness that is sweeping Washington is likely to hit defense spending (half of the “backup $1.2 Trillion in cuts that happen if the Super Committee can’t come to an agreement or Congress does not approve it, will come from Defense). In that case, while a Lockheed Martin (NYSE:LMT - News) might not have to cut its dividend, it is not likely to continue to raise it at 21.5% a year either, even if its trailing payout ratio is only 40%.
Turmoil Likely to Continue
Is the current downturn in the market over? Honestly I don’t know. There are some very good reasons for it. While corporations are in great shape, the economy is not. The government is not in a good position to help get it going again, especially after the recent debt-ceiling agreement essentially took away the possibility of using fiscal stimulus to get unemployment down and economic growth up.
It is very brittle to any external shock, and the shocks coming out of Europe -- with the potential breakdown of the single currency itself -- are big ones. Still, the U.S. has been through worse, and has always come out the other side.
These are the sorts of times that are the best friend to the long-term investor. Don’t try to be a hero in here and shoot for the most aggressive names. But don’t hide in a hole and curl up in the fetal position. Start buying good, solid companies paying attractive, safe and preferably growing dividends. Five years from now you will be very glad that you did.
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