Don't Give Up on Higher-Dividend Stocks

 | Jun 07, 2013 | 10:30 AM EDT  | Comments
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The overall market has generated strong returns, up nearly 37% since the beginning of 2011, as measured by the S&P 500. Stocks that have a focus on paying good dividends have been outperformers over that time, up 39.5% on the basis of the SPDR S&P Dividend ETF (SDY).

Prior to the recent correction in the dividend group, the gap of outperformance was even wider, and if you include 2010 returns, dividend stocks had outpaced the S&P 500 by more than 650 basis points at their peak. Further, these stocks have achieved these very favorable gains with far less than market volatility.

The reasons for the stocks' recent appeal are well known -- low interest rates driven by Federal Reserve bond purchases, a recovering economy supporting corporate profit growth, few good alternatives for investors who have an income requirement, etc. Now that the Fed seems likely to "taper" its bond buying over the next few months, interest rates have backed up, creating modest competition for dividend stocks and a mindset that the dividend trade was over, leading to a lightning-fast rotation out of the names.

We feel that the pace of outperformance will not continue in upcoming periods. But in light of these stocks' recent pullback, we do believe that investors can buy a basket of them into this weakness, as part of an overall diversified portfolio. Don't expect them to shoot the lights out, but they can produce a healthy dividend stream approaching a 4% yield plus modest capital appreciation over the next 12 to 18 months.

When screening for dividend stocks, we generally look for companies that have strong balance sheets, high and sustainable yields with a consistent track record, a payout ratio below 50% of earnings and solid business prospects. We advocate buying a portfolio of such stocks, spread among industries and sectors. In the current environment, we would include select utilities, telecom, pharmaceuticals, industrials and energy. Five stocks that we like that fall into these groups are Duke Energy (DUK), AT&T (T), Pfizer (PFE), General Electric (GE) and Royal Dutch Shell (RDS.B).

Duke is the largest regulated electric utility in the U.S., and it has the potential for meaningful cost synergies after its merger with Progress Energy. Earnings will be flattish this year but up around 5% next, and the stock trades at 15.3x current earnings per share. Duke pays a 4.6% dividend yield, and the per-share payout will grow with earnings.

AT&T is the well-known phone company. Management has been strongly focused on shareholder returns, and it has a massive share-repurchase program and commitment to a strong dividend. Valuation is fair at 14.2x this year's estimated EPS, as the entire telecom industry has become more competitive. The dividend is very safe and attractive at a 5.1% yield.

The major pharmaceutical company Pfizer, after losing patent protection on Lipitor, has managed well, and the stock has rebounded from its lows. Its drug portfolio is now better diversified, and its research-and-development costs have been reined in from its free-spending days. Earnings growth should resume next year, fed by new drug approvals, and thus the stock trades at under 12x 2014 estimated EPS. The dividend generates a healthy 3.4% yield, and it will grow at least in line with earnings.

General Electric went through the wringer during the global financial crisis, and GE Capital is just now returning to a more stable operating profile. GE Capital will continue to downsize, but it is increasing its dividend to the parent corporation. In the meantime, GE's industrial businesses have good prospects in energy, aviation and healthcare. EPS growth has resumed, and the stock is valued at 14.2x this year's earnings. Its free cash flow is growing, supporting the current 3.2% yield and future increases.

Royal Dutch Shell is one of a handful of energy super-majors, and it has global operations in all facets of the oil and gas industry. Management's key financial goal is cash-flow generation at strong rates of return, so a significant dividend is an important objective. Its 5.3% yield is best in class, while its operating performance is at or above the group average. Importantly, the "B" class shares do not have foreign dividend withholding for U.S. taxpayers.

Higher interest rates will eventually offer a competitive return to dividend-paying stocks. But good quality companies that grow value over time and additionally generate a nice annual payout through dividends should produce a steady and attractive absolute rate of return. As one part of an investor's overall asset allocation, yield-oriented equities can provide a conservative yet compensatory foundation.

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