NEW YORK (MONEY Magazine) -
Where do you put cash at a time like this? Bond yields are at record lows, money-market accounts pay next to nothing, and the stock market looks highly uncertain.
One answer: dividend-paying stocks. The dividends offer a steady stream of income while the market treads water, yet you don't have to give up on the possibility of growth once equities rebound.
Better yet, because income investing has been out of style for so long, you can find compelling values among dividend-paying stocks.
Over the past 12 months (through March 24), the dividend stocks in the S&P 500 have risen 36 percent, while their non-dividend-paying counterparts have soared 57 percent, according to Thomson/Baseline. Partly as a result, dividend-paying stocks in the S&P 500 trade at less than half the average price/earnings ratio of their nonpaying counterparts.
The gap "is staggering," says Larry Keblusek, chief investment officer of Mellon's private wealth management group.
Over the past few weeks, the market, recognizing the value in yield stocks, has been shifting from the low-quality, speculative names that dominated last year.
While it's too early to know if this rotation is for real, it may mean that dividend stocks will finally have their day. Certainly, smart investors can gain by looking at them now.
| Notes: As of March 24. P/E ratios are for 2004. Growth rates are projected average earnings gains for next five years.|
| Source: Thomson/Baseline.|
What's the appeal of dividends? Stability, lower volatility, protection against inflation and bondlike income streams.
Last year's tax cut offered an added bonus for income-seeking investors by slashing the tax investors owe on qualified dividends to 15 percent from marginal income tax rates that had been as high as 38.6 percent -- putting an extra $14 billion in investors' pockets. (Dividends on most common stocks qualify for the tax break; dividends on most real estate investment trusts and preferred stocks do not.)
Companies have begun to respond to the tax break. Since the beginning of 2003, 23 companies in the S&P 500 have started offering dividends for the first time, bringing the total number of dividend payers in the index to 372. And 223 companies in the index have upped their dividends once or more -- for a total of 332 increases.
More are expected to follow. Goldman Sachs accounting analyst Michael Clement and strategist Abby Joseph Cohen argue in a recent report that this will be "a year of notable dividend activity, with much of it concentrated in the first half of the year."
The mere fact that a stock pays a dividend, of course, doesn't make it a buy. There are several factors to consider when evaluating yield stocks, including the company's dividend history and its ability to maintain or raise its payout in the future.
Below, we'll detail strategies for finding outstanding dividend stocks and profile nine attractive choices.
1. Look for financial strength.
Yield itself tells you very little about the quality of a company. Remember, when a company decides to pay a dividend, it sets a fixed amount per share; the yield is the total annual dividend divided by the stock price. So when the stock price sinks, the yield rises. That means you have to proceed with care.
"Usually when people think of dividends, they think in terms of yield," says Don Taylor, manager of Franklin Rising Dividends fund. "But a lot of times when you screen for yield, you screen for problems."
Of course, the market may be overreacting to those problems, creating a buying opportunity in a solid stock that is in a temporary slump.
For his part, Taylor prefers a conservative approach: He searches for companies that have increased their dividends in at least eight of the past 10 years and have the financial strength to continue to do so in the future.
To gauge a company's financial strength, look to two key numbers: the debt-to-capital ratio (a figure of 50 percent or less is good) and the payout ratio -- that is, the percentage of earnings that the firm pays out in dividends. Dividend payout levels vary widely by industry, but here again look for a ratio of 50 percent or less.
For comparison, among dividend-paying stocks in the S&P 500, the average payout ratio is 37 percent and the average debt-to-capital ratio is 40 percent.
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But these are just rough guidelines, and there are many exceptions. For example, banks tend to have higher debt-to-capital ratios. And if you're playing a turnaround or an industry coming out of a cyclical downturn, the payout ratio is likely to be well above 50 percent.
Another gauge of financial strength is a long history of paying -- and even better,increasing -- dividends. Standard & Poor's quantitative services division tracks a list of what it calls "dividend aristocrats," companies that have raised their dividends for 25 consecutive years.
One of the highest-yielding names on that S&P list is Altria Group (MO: Research, Estimates), the old Philip Morris, which now yields 5.1 percent. Altria is a favorite of value investors such as David Dreman and Vanguard Windsor II's Jim Barrow.
The world's largest tobacco company is a modest grower that throws off a lot of cash and, at a price of 11 times forecast 2004 earnings, "it's a good place to get excess returns as long as you don't trip on the litigation land mine," says Jonathan Golub, equity strategist at J.P. Morgan Fleming Asset Management.
The consumer-staples sector offers plenty of other consistent dividend plays, Golub says.
"These companies have a steady stream of earnings and a very stable way of generating dividends," he says.
Consider Kimberly-Clark (KMB: Research, Estimates), the diaper and paper goods giant, which most recently raised its dividend in January and now yields 2.7 percent. It's got a strong balance sheet (with debt to capital at 29 percent and a payout ratio of 40 percent) as well as sizable market share with products like Huggies and Kleenex. The stock trades at 17 times this year's estimated earnings, while far larger Procter & Gamble sports a 23 P/E.
2. Think total return.
In boom times, when the market is notching double-digit gains every year, dividends can seem trivial. But over time they make an important contribution to your gains.
Since 1926, dividends have accounted for more than 40 percent of stocks' total return. A company that offers modest earnings growth and a reliable dividend may be a better bet than a high flier posting profit increases that it probably can't sustain.
Two sectors where you can find slow and steady stocks: energy and financial services.
In energy, for example, Goldman Sachs figures that both ChevronTexaco (CVX: Research, Estimates), which yields 3.4 percent, and ExxonMobil (XOM: Research, Estimates), which yields 2.5 percent, will be among those to increase their dividends significantly this year. After all, the sector has the wind at its back from rising oil and gas prices, and both companies have rock-solid balance sheets.
ExxonMobil is the industry leader, but ChevronTexaco stock trades at a discount -- 13 times forecast 2004 earnings vs. 16 times for ExxonMobil.
As Tom Sassi, lead manager of Scudder Large Cap Value fund, which owns ExxonMobil, ChevronTexaco and a slew of other dividend payers, puts it, "Yield is important, but more important is that dividends are growing over time."
In financials, meanwhile, we've regularly recommended Citigroup (C: Research, Estimates) and Washington Mutual (WM: Research, Estimates). Both sport yields above 3 percent, modest payout ratios and below-market valuations.
Citigroup has an unparalleled array of global financial businesses, while Washington Mutual, which does big business in mortgages and commercial real estate loans, has been a big gainer from the housing boom.
Looking beyond those familiar names, there is a less popular bank worth considering. U.S. Bancorp (USB: Research, Estimates), the nation's eighth-largest bank, has steered clear of the mega-acquisitions now sweeping the banking industry. But it generates a return on capital of 7.6 percent, well above average and in line with Citigroup's; its return on equity, at 19.7 percent, puts it near the top of the pack as well.
"It is still cheap relative to competitors," says Anna Dopkin, manager of T. Rowe Price Growth & Income fund, which counts U.S. Bancorp among its largest positions. Dopkin figures the stock will be higher next year -- plus investors get a 3.5 percent dividend while they wait.
3. Take a chance on a turnaround.
As we mentioned above, a high yield can be a sign of trouble, but it can also point to worthy stocks that are temporarily out of favor.
If you're looking for a turnaround play, consider Bristol-Myers Squibb (BMY: Research, Estimates), a beaten-down company that has recently attracted a lot of attention from value investors.
The stock has suffered from a spate of problems: litigation, accounting restatements and competition from generics. Bristol's biggest seller, Pravachol (a cardiovascular drug), for example, is scheduled to come off patent in 2006.
But it's a nice value: The stock is 67 percent off its high of the past five years and now trades at just 16 times this year's expected earnings, far below the average for big pharmaceutical companies. The dividend yield, at 4.7 percent, is the highest among the drugmakers, which gives investors a cushion while they wait for the real payoff: new drugs in the pipeline.
"The thing that is most underappreciated about Bristol is the quality of its mid-stage pipeline," says Judson Brooks, an analyst at the Oakmark Funds, which has been accumulating shares. "At $25, you're not paying more than a dollar or two for everything that is not disclosed yet, so that creates what we think is a margin of safety."
Our final turnaround prospect comes, oddly enough, from the utility industry, once loved by dividend investors for its stability.
Duke Energy (DUK: Research, Estimates) is not your grandma's utility play; in fact, it's outside our conservative parameters for both debt-to-capital and payout ratios. But a new management team, led by turnaround specialist Paul Anderson, is making strides in paying down debt, cutting costs and selling underperforming assets. And the stock currently yields 5 percent.
"It's in the middle of a financial turnaround," says T. Rowe's Dopkin, who often buys when sentiment is at its worst. "We think fears of a dividend cut are unfounded, and the valuation is attractive."