Look Carefully For Income Plays
Income-oriented stock investors have participated in the market’s resurgence, but dividend cuts and fears of future cuts have weighed on relative performance.
Of the 367 stocks in the S&P 500 Index that paid dividends at the end of 2008, 85 have since reduced their payout, with 11 eliminating the dividend altogether. On average, the dividend-payers have returned 15.5% so far this year, versus 32.4% for the nonpayers.
This performance gap also reflects investors’ recent preference for low-quality names, and now seems a good time to look for values among dividend-paying blue chips. Listed in the table below are 12 stocks with solid dividend yields, backed by strong fundamentals. You won’t find any 6% yields on the list because very few stocks with such high yields are fundamentally strong enough to satisfy us. Chasing high yields has historically resulted in subpar returns, a trend that has continued this year.
We separated the S&P 500 Index’s dividend stocks into five equal-numbered baskets based on yield at the end of 2008. Stocks in the highest-yielding quintile (8.0% average) averaged a year-to-date total return of 8% and a 40% decline in the dividend over the last year. In contrast, stocks in the two lowest-yielding quintiles averaged total returns of nearly 21% so far this year and 12-month dividend growth of 7%.
Many investors see a high dividend yield and assume a stock is undervalued. But such yields may instead presage financial pressures and dividend cuts.
Investing for yield
Investors considering high-yield stocks should consider the Quadrix® Financial Strength score as well as the Overall score. The Financial Strength score reflects profit margins, interest coverage, and debt levels — all of which bear on a company’s ability to meet its financial obligations, including the dividend. On its own, the Financial Strength score isn’t particularly effective at selecting stocks that outperform, but it can help steer investors away from the riskiest companies. Two of our top selections for yield are profiled in the following paragraphs.
AstraZeneca’s ($47; AZN) operating cash flow jumped 24% in the first half of 2009, allowing the company to retire $3 billion in debt since the end of 2008. That extra cash also eased the way for AstraZeneca’s board to boost the September dividend 7% to $0.59 per share. AstraZeneca pays two dividends each year, with a larger payout in March.
June-quarter per-share profits rose 31% to $1.64, cruising past the consensus estimate of $1.38. Sales were roughly flat at $7.96 billion but rose 9% at constant currency. Sales of cholesterol drug Crestor jumped 23% to $1.13 billion, while the Seroquel antipsychotic saw revenue rise 12% to $1.25 billion. These gains were offset by lower sales in the gastrointestinal, repiratory, and oncology segments.
In July, U.S. regulators approved Onglyza, a potential blockbuster diabetes drug. Analysts predict that Onglyza’s peak annual sales could range from $300 million to more than $1 billion.
Strong operating momentum prompted AstraZeneca to raise its full-year profit target. The company now anticipates per-share earnings of $5.70 to $6.00, $0.55 above earlier guidance and implying at least 18% growth. AstraZeneca, yielding 4.4%, is a Buy and a Long-Term Buy.
General Dynamics ($57; GD) yields 2.7%, yet the payout represents less than one-fourth of annual earnings. The dividend has grown at an annualized rate of 17% over the last five years, and the defense contractor appears to have both the will and the financial strength to continue boosting the payout.
In the first half of 2009, total revenue rose 14% to $16.36 billion, paced by almost 20% sales growth in combat (29% of first-half sales) and marine systems (20%). In the June quarter, the backlog grew 22% to $67.6 billion, of which $47.7 billion is funded. The company’s outlook is improving, though 2009 profits will probably lag results from last year. The business-jet market has regained some of its lost altitude. Customer defaults have declined since the March quarter, and orders are picking up.
As the government nears its deadline for preparing the defense budget for fiscal 2010 starting October, visibility regarding General Dynamics’ military projects should improve. While other large contractors face possible cuts in many of their largest programs, the budget as proposed in April called for General Dynamics to build three new destroyers for roughly $2.5 billion apiece. Past defense allocations had only guaranteed the company one boat. General Dynamics, our top selection in the defense group, is a Buy and a Long-Term Buy.
Investing for growth
Income-oriented investors should also consider dividend growth. Companies that consistently raise their dividends in good times and bad make a strong statement about their financial and operational condition. The table below lists 15 Forecasts stocks that have raised their dividend for at least 15 consecutive years. Two of our most impressive dividend growers are reviewed below.
Stryker’s ($41; SYK) 15 years of annual dividend hikes have been made possible by its firm financial footing. Over the last 15 years, the dividend has risen at an annualized rate of 29%, including a 22% increase this year. Free cash flow has also climbed 15% over the past 12 months, and the company’s Quadrix Financial Strength score ranks in the top 2% of our research universe.
Stryker estimates that it controls 32% of the $3.3 billion global market for operating-room equipment. In 2008, Stryker extended its lead, growing revenue 16% versus the market’s 10% gain. This year, growth will not match last year’s pace. Hospital budget constraints have hampered equipment sales, and Stryker’s sales of surgical equipment fell 8% in the six months ended June. However, hospitals can only put off buying surgery tools and other equipment for so long. In July, the company said this market is showing signs of stabilization.
Meanwhile, Stryker’s orthopedic business has managed flat sales so far this year, and management has adroitly cut expenses. Wall Street expects per-share profits to climb 4% this year, and the company seems capable of double-digit profit growth in 2010 and annually over the next five years. Stryker is a Buy and a Long-Term Buy.
Wal-Mart Stores ($50; WMT) has increased its dividend every year since its first payout in 1974. The shares yield 2.2%, and the payout ratio is just 32%, allowing substantial room for further increases. Supporting the dividend is strong operating cash flow, which usually exceeds net income. The company also deploys its cash resources to buy back stock, spending $21 billion and reducing the share count by 9% over the last five years. In June, Wal-Mart announced a $15 billion repurchase program.
Wal-Mart’s low cost structure helps it entice customers with bargains. In July, Wal-Mart took aim at the back-to-school market, offering a broader selection of laptop computers. Lower-priced notebooks have been one of the few bright spots in the computer market during the recession.
Consensus estimates project per-share-profit growth of 3% this year and 9% next year, targets the company may be able to exceed. Wal-Mart Stores, slated to release July-quarter profits Aug. 13, is a Long-Term Buy.