A smart dividend strategy

1/12/2009


The S&P 500 Index is sending mixed signals to income investors.

The index’s yield rose to 13-year highs in the second half of 2008. The current yield of 3.0% is well above the average of 1.7% over the past 10 years. Unfortunately, the rising yield reflects lower stock prices — not higher dividends

In fact, 40 S&P 500 companies cut dividends and 22 suspended payments in 2008, both numbers up at least four-fold from 2007 levels. In the December quarter, the index’s per-share dividend fell for the first time since the June quarter of 2003. Unless economic conditions improve quickly, 2009 is not looking good for dividends.

A strategy of buying stocks based solely on big dividends or even dividend growth won’t cut it in the current environment. High-yield stocks have performed poorly over the last year, and even longtime dividend growers have become more willing to cut payouts. Investors seeking income from their stock holdings should take the following steps in the year ahead.

Stop chasing yield: The events of the last year — most notably the collapse of the financial sector and the push for companies of all types to cut back on their cash usage — give credence to our oft-repeated warning against focusing on stocks with high yields. Chasing yield in the current environment is risky.

Remember to diversify: Historically, buying stocks from a variety of sectors has limited portfolio volatility. All sectors got clobbered this year, but even in the rough 2008 market, defensive sectors tended to outperform more aggressive portions of the market. Going forward, investors should make sure they own stocks from a variety of sectors.

Don’t live in the past: The rise and fall of Citigroup ($7; C) illustrates the risks of buying based on reputation. From 1999 through 2007, Citigroup’s per-share dividend rose at an annualized rate of 23%. Citigroup cut the per-share payout twice in 2008 and must cut it to no more than $0.01 per quarter this year. Last year, a number of companies with 25 years of higher payouts cut or suspended dividends, including Bank of America ($14; BAC) and Fifth Third Bancorp ($8; FITB).

With the above points in mind, the Forecasts created a diversified portfolio of dividend-paying stocks. None has the unsustainable 9% yields over which investors salivate, as such high yields often signal that a dividend may be cut. But all 20 of the stocks in the table on page 5 not only have a history of growing dividends, but also have the financial wherewithal to continue boosting those payouts.

The diversified dividend portfolio, which contains only Forecasts recommendations, yields a solid 2.3%. Our recommended portfolios — the Focus, Buy, and Long-Term Buy Lists — all generate lower yields on a fully invested basis because they contain stocks that do not pay dividends. Our recommended cash position boosts portfolio yields. The Vanguard Short-Term Investment-Grade ($9.68; VFSTX) fund, which represents 32.5% of the Focus List and Buy List and 34% of the Long-Term Buy List, yields about 5.7%.

In the following paragraphs, we profile three interesting dividend-paying stocks suitable for purchase.

Aflac ($46; AFL) saw steep investment losses in the September quarter and said it expects to write down an additional $110 million for exposure to Icelandic banks in the December quarter. But the insurer represents an attractive option in a sector littered with landmines. Less than 2% of Aflac’s investment portfolio falls below investment grade.

The insurer has $759 million in securities backed by residential mortgages and $40 million backed by commercial mortgages, combining to make up just 1.3% of fixed-income securities. Consensus estimates have held steady over the last month and project per-share-profit growth of 15% in 2009. Yet the shares trade at just 10 times expected year-ahead earnings.

Operating cash flow increased 9% in the first nine months of 2008, while free cash flow climbed 8%. That solid cash flow is key to continuing dividend growth. Aflac, yielding 2.5%, has increased the payout in each of the past 26 years. Aflac is a Long-Term Buy.


Things are looking up for PepsiCo ($56; PEP) after a disappointing September quarter. The food and beverage giant’s per-share profits missed consensus estimates by 2% while beverage volume declined 4% in North America. For 2009, management forecasted declines in consumer spending and rising commodity costs. Preparing for the storm, PepsiCo announced job cuts expected to save $1.2 billion over the next three years.

PepsiCo’s long-term potential remains intact. And at 14 times expected year-ahead earnings, the shares linger near a five-year low valuation. In the near term, approval of a new natural zero-calorie sweetener could drive beverage sales to increasingly health-conscious consumers.

In November, PepsiCo reaffirmed 2008 earnings guidance of at least $3.67 per share, implying growth of at least 9%. Wall Street expects profits to continue their ascent in 2009, with per-share earnings up 7%. PepsiCo, yielding 3.1%, is a Buy and a Long-Term Buy.


Hurt by a slowdown in spending on oilfield services, Schlumberger ($48; SLB) warned in early December that 2008 profits would fall below $4.76 per share, the consensus at the time. Wall Street now expects profits of $4.59 per share, up 10% from year-earlier numbers, followed by a 15% decline to $3.89 per share in 2009. At 12 times the 2009 estimate, Schlumberger trades well below its five-year average forward P/E ratio of 19.

Schlumberger’s long-term outlook remains solid. The company has a proven growth record, with operating per-share profits rising at double-digit rates in 21 of the last 22 quarters. While 2009 looks rough, the company should resume its growth path when oil prices rise and economic conditions improve. A sustained rise in per-barrel oil prices to $50 or $60 should help stabilize demand for drilling projects — a manageable target considering the recent rally to $45 in the wake of violence in the Middle East. Schlumberger, yielding 1.8%, is a Long-Term Buy.


United Technologies’ ($55; UTX) cash position jumped 29% in the 12 months ended September, rising during each quarter. Free cash flow surged 37% in the first nine months of 2008, while operating cash flow increased 26%. In December, United Technologies distributed some of that cash, raising the quarterly dividend 20%. The stock yields 2.8%.

Order rates stalled in the December quarter, and United Technologies faces challenging markets in 2009. Consensus estimates project a 4% decline in sales and a 1% drop in per-share profits. To fatten the bottom line, management looks to improve operating profit margins in all six divisions.

The aerospace divisions, benefiting from solid military spending, could prove to be a bright spot. United Technologies can also work down its massive backlog, last reported at $59 billion in October. United Technologies is a Buy and a Long-Term Buy.

DIVERSIFIED DIVIDEND PORTFOLIO
Equal-dollar positions in the 20 stocks listed below make up a diversified portfolio that yields 2.3% — below the yield of the S&P 500 Index, but with excellent fundamentals and higher growth potential. Only the technology sector accounts for more than 15% of the portfolio.
Company
(Price; Ticker)
Div.
($)
Yield
(%)

Payout
Ratio
(%)

5-Yr.
Div.
Growth
(%)
Quadrix
Overall
Score
Sector
Advice
Accenture
($33; ACN)
0.50
1.5
18
NM
90
Technology
Focus Buy †
Aflac
($46; AFL)
1.12
2.5
30
30
75
Financials
LT Buy 
Airgas
($40; ARG)
0.64
1.6
21
32
80
Materials
Focus Buy
AstraZeneca
($42; AZN)
1.90
4.6
38
20
91
Health Care
Buy †
Chevron
($77; CVX)
2.60
3.4
23
13
94
Energy
Buy †
Energen
($33; EGN)
0.48
1.4
11
6
82
Utilities
LT Buy 
Exxon Mobil
($80; XOM)
1.60
2.0
18
10
90
Energy
LT Buy 
General Dynamics
($61; GD)
1.40
2.3
23
17
92
Industrials
Buy †
Harris
($41; HRS)
0.80
2.0
23
32
96
Technology
Focus Buy †
IBM
($89; IBM)
2.00
2.2
24
26
86
Technology
Focus Buy †
Johnson & John.
($60; JNJ)
1.84
3.1
41
15
77
Health Care
Focus Buy †
Lockheed Martin
($84; LMT)
2.28
2.7
30
31
89
Industrials
LT Buy 
Microsoft
($21; MSFT)
0.52
2.5
27
27
84
Technology
Buy †
PepsiCo
($56; PEP)
1.70
3.1
47
22
71
Cons. Staples
Buy †
Qualcomm
($37; QCOM)
0.64
1.7
29
27
75
Technology
Focus Buy †
Questar
($37; STR)
0.50
1.4
13
5
92
Utilities
LT Buy 
Schlumberger
($48; SLB)
0.84
1.8
18
18
81
Energy
LT Buy 
Sigma-Aldrich
($41; SIAL)
0.52
1.3
20
12
67
Materials
LT Buy 
United Tech.
($55; UTX)
1.54
2.8
32
22
77
Industrials
Buy †
Wal-Mart Stores
($56; WMT)
0.95
1.7
28
21
68
Cons. Staples
LT Buy 
Portfolio Average
2.3
26
20
83
Notes: Quadrix scores are percentile ranks, with 100 the best.      † Also qualifies as a Long-Term Buy.      The payout ratio represents the indicated dividend divided by trailing 12-month earnings.      NM Not meaningful because the company did not pay a dividend five years ago.

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