In spite of an incredible market recovery during the last three months, the overall outlook remains a bit murky. The recent rise in coronavirus cases in many of the southern states as well as states like California has raised the specter of a second wave of the pandemic. However, we are in the uncharted waters here, and no one, including the so-called experts, really knows how this thing is going to play out. Will a vaccine be ready before a serious second wave during the winter, or would we just have to learn to live with this virus for some time, or will the virus simply fade away? These are some of the questions that everyone is looking for answers. To top it, we are in the election year and partisan politics is at its worst. That said, so far, the market has taken all these uncertainties in stride and just ended the second quarter on a high note. However, the big question is where it goes from here.
Needless to say, there are many challenges and uncertainties that remain, and it’s very difficult to know the future with any degree of certainty, especially in the current environment. However, we should look at investing as a long-term game plan and not on the basis of day-to-day or week-to-week gyrations.
S&P 500 ETF (SPY) six-month chart, courtesy YCharts.
As long-term dividend investors, we need to pay less attention to the short-term movements of the market and pay more attention to the quality of companies that we buy and buy them when they are being offered relatively cheap. The goal of this series of articles is to find companies that are fundamentally strong, carry low debt, support reasonable, sustainable and growing dividend yields, and also trading at relatively low or reasonable prices.
The market is not easy to navigate in the best of times. However, it remains extremely uncertain right now in these difficult times. Nonetheless, we remain on the lookout for companies that offer sustainable and growing dividends and are trading cheap on a relative basis to the broader market as well as to their respective 52-week highs. We believe in keeping a buy list handy and dry powder ready so that we can use the opportunity when the time is right. Besides, we think, every month, this analysis is able to highlight some companies that otherwise would not be on our radar.
This article is part of our monthly series, where we scan the entire universe of roughly 7,500 stocks that are listed and traded on US exchanges, including over-the-counter (OTC) networks. However, our focus is limited to dividend-paying stocks only. We usually highlight five stocks that may have temporary difficulties and/or lost favor with the market and offering deep discounts on a relative basis. However, that’s not the only criteria that we apply. While seeking cheaper valuations, we also demand that the companies have an established business model, solid dividend history, manageable debt, and investment-grade credit rating. Please note that these are not recommendations to buy, but should be considered as a starting point for further research.
This month, we highlight two groups of five stocks each that have an average dividend yield (as a group) of 2.70% and 6.39%, respectively. The first list is for conservative investors, while the second one is for investors who seek higher yield but are still reasonably safe.
We start with a fairly simple goal. We want to shortlist five companies that are large-cap, relatively safe, dividend paying, and trading at relatively cheaper valuations in comparison to the broader market. The objective here is to highlight and bring to the notice of value-oriented readers some of the dividend-paying and dividend-growing companies that may be offering juicy dividends due to a temporary decline in their share prices. The excess decline may be due to an industry-wide decline or some kind of one-time setbacks like some negative news coverage or missing quarterly earnings expectations. We adopt a methodical approach to filter down the 7,500-plus companies into a small subset.
Note: Please note that when we use the term “safe” regarding stocks, it should be interpreted as “relatively safe” because nothing is absolutely safe in investing. Also, in our opinion, for a well-diversified portfolio, one should have 15-20 stocks at a minimum.
Goals For The Selection Process
Our primary goal is income that should increase over time at a rate which at least beats inflation. Our secondary goal is to grow the capital and provide a cumulative growth rate of 9%-10% at a minimum. These goals are by and large in alignment with most retirees and income investors as well as DGI investors. A balanced DGI portfolio should keep a mix of high-yield, low-growth stocks along with some high-growth but low-yield stocks. That said, how you mix the two will depend upon your personal situation, including income needs, time horizon, and risk tolerance.
A well-diversified portfolio would normally consist of more than just five stocks and preferably a few stocks from each sector of the economy. However, in this periodic series, we try to shortlist and highlight just five stocks that may fit most income and DGI investors, but at the same time, are trading at attractive valuations. However, as always, we recommend you do your due diligence before making any decision on them.
The S&P 500 currently yields roughly 2%. Since our goal is to find companies for our dividend income portfolio, we should logically look for companies that pay yields that are at least better than the S&P 500. Of course, the higher, the better, but at the same time, we should not try to chase high yield. If we try to filter for dividend stocks paying at least 2% or above, there are nearly 2,200 such companies trading on US exchanges, including OTC networks. If we further limit our choices to companies that have a market cap of at least $10 billion and daily trading volume over 100,000 shares, the number comes down to roughly 380 companies.
We also want stocks that are trading at relatively cheaper valuations, but P/E will not be a valuable measurement in the current environment. Since the broader market is roughly 8%-10% down from the top, we will add a criterion that the close price is at least 7.5% below the 52-week high. At this stage, we want to keep our criteria broad enough to keep all the good candidates on the list. After applying these additional criteria, we got a smaller set of about 342 companies.
Criteria to Shortlist
- Market cap >=$10 Billion
- Daily average volume > 100,000
- Dividend yield >= 1.90%
- Dividend growth past five years >= 0%
- Distance from 52-week high < -7.5%.
By applying the above criteria, we got roughly 342 companies.
Narrowing Down the List
As a first step, we would like to eliminate stocks that have less than five years of dividend growth history. We cross-check our list of 342 stocks against the CCC list (list of Dividend Champions, Contenders, and Challengers created by David Fish and now maintained by Justin Law). The CCC list currently has 774 stocks in all the above three categories. The CCC list currently includes 137 Champions with more than 25 years of dividend increases, 272 Contenders with more than ten but less than 25 years of dividend increases, and 365 Challengers with more than five but less than ten years of dividend increases. After we apply this filter, we are left with 158 companies on our list. However, the CCC-list is quite strict in terms of how it defines dividend growth. If a company had a stable record of dividend payments but did not increase the dividends from one year to another, it would not make it to the CCC list. We also wanted to look at companies that had a stable dividend history of more than five years, but maybe they did not increase the dividend every year for one reason or another. At times, some of them are foreign-based companies, and due to currency fluctuations, their dividends may appear to have been cut in US dollars, but in reality, that may not be true at all when looked in the actual currency of reporting. So, by relaxing this condition, a total of 47 additional companies made to our list, which otherwise met our criteria. After including them, we had a total of 229 (158+71) companies that made to our first list.
We then imported the various data elements from various sources, including CCC-list, GuruFocus, Fidelity, Morningstar, and Seeking Alpha, among others, and assigned weights based on different criteria as listed below:
- Current yield: Indicates the yield based on the current price.
- Dividend growth history (number of years of dividend growth): This indicates the dividend growth rate during the last five years.
- Payout ratio: This indicates how comfortably the company can pay the dividend from its earnings. This ratio is calculated by dividing the dividend amount per share by the EPS (earnings per share).
- Past 5-year and 10-year dividend growth: Even though it’s the dividend growth rate from the past, this does tell how fast the company has been able to grow its earnings and dividends in the recent past. The recent past is the best indicator that we have to know what to expect in the next few years.
- EPS growth (mean of previous five years of growth and expected next five years growth): As the earnings of a company grow, more than likely, dividends will grow accordingly. We will take into account the previous five years’ actual EPS growth and the estimated EPS growth for the next five years. We will add the two numbers and assign weights.
- Chowder number: This is a data point that’s available on the CCC list. So, what’s the Chowder number? This number has been named after well-known SA author Chowder, who first coined and popularized this factor. This number is derived by adding the current-yield and the past five years’ dividend growth rate. A Chowder number of “12” or more (“8” for utilities) is considered good.
- Debt/equity ratio: This ratio will tell us about the debt load of the company in relation to its equity. We all know that too much debt can lead to major problems, even for well-known companies. Lower this ratio, better it is. Sometimes, we find this ratio to be negative or unavailable, even for well-known companies. This can happen for a myriad of reasons and not always a reason for concern. This is why we use this ratio in combination with the debt/asset ratio (covered next).
- Debt/asset ratio: This data is not available in the CCC list, but we add it to the table. The reason we will add this is that, for some companies, the debt/equity ratio is not a reliable indicator.
- S&P’s credit rating: Again, this data is not available in the CCC list, and we will add manually. We get it from the S&P website.
- PEG ratio: This also is called the price/earnings-to-growth ratio. The PEG ratio is considered to be an indicator if the stock is overvalued, undervalued, or fairly priced. A lower PEG may indicate that a stock is undervalued. However, PEG for a company may differ significantly from one reported source to another, depending on which growth estimate is used in the calculation. Some use past growth, while others may use future expected growth. We are taking the PEG from the CCC list, wherever available. The CCC list defines it as the price/earnings ratio divided by the five-year estimated growth rate.
- Distance from 52-week high: We want to select companies that are good, solid companies but also are trading at cheaper valuations currently. They may be cheaper due to some temporary down cycle or some combination of bad news or simply had a bad quarter. This criterion will help bring such companies (with a cheaper valuation) near the top, as long as they excel in other criteria as well. This factor is calculated as (current price – 52-week high) / 52-week high.
- Adjustment for Financial Companies: During the last few months, we have observed that due to several factors, there is somewhat of overcrowding by banks and financial companies in our top 50 list. This is partly because the financial sector has generally been trading much below their 52-week highs and also they all tend to have much higher credit rating due to the nature of business. Also, there are simply many more companies in this sector. So, to provide an equitable chance to other sectors and stay diversified, we will be adjusting the total weightage for banks, financial services, and insurance companies by four, three and two points respectively, prior to making our list of 50.
Below is the table with weights assigned to each of the ten criteria. The table shows the raw data for each criterion for each stock and the weights for each criterion and the total weight. Please note that the table is sorted on the “Total Weight” or the “Quality Score.” The list contains 229 names and is attached as a file for readers to download if they so desire.
A sample of the table with the top 20 rows (in order of quality score) is displayed here as well:
[Source: Author/ Financially Free Investor]
Selection of the Final 20
To select our final 20 companies, we will follow a multi-step process:
- Step 1: We will first take the top 20 names in the above table (based on total weight or quality score).
- Step 2: Now, we will sort the list based on dividend yield (highest at the top). We will take the top 10 after the sort to the final list.
- Step 3: We will sort the list based on five-year dividend growth (highest at the top). We will take the top 10 after the sort to the final list.
- Step 4: We will then sort the list based on the credit rating (numerical weight) and select the top 10 stocks with the best credit rating.
From the above steps, we have a total of 50 names in our final consideration. The following stocks appeared more than once:
Appeared two times: ADP, BAC, and TSN
After removing four duplicates, we are left with 47 names.
Since there are multiple names in each industry segment, we will just keep a maximum of three names from the top from any one segment. We keep the following:
- Financial Services, Banking, and Insurance:
• Business Services:
• Consumer/ Retail:
• Communications/ Media
TABLE-2: List of Final 23
[Source: Author/ Financially Free Investor]
Final Step: Narrowing Down to Just Five Companies
This step is mostly a subjective one and based solely on our perception. The readers could select any of the above 15 names according to their own choosing or as many as they like.
The readers could certainly differ from our selections, and they may come up with their own set of five companies. We make two lists for two different goals, one for safe and conservative income and the second one for higher yield. Nonetheless, here’s are our final lists for this month:
Final List-1 (Conservative Safe Income):
Final List-2 (High Yield, Moderately Safe):
It goes without saying that each company comes with certain risks and concerns. Sometimes these risks are real, but other times, they may be a bit overblown and temporary. Obviously, the current situation adds further uncertainty and the risk of a prolonged downturn. So, it’s always recommended to do further research and due diligence.
Nonetheless, we think these five companies (first list) would form a solid group of dividend companies that would be appealing to income-seeking conservative investors, including retirees and near-retirees. Our final list of five has, on average, 29 years of dividend history (including two dividend-aristocrat), 21% and 17% annualized dividend growth during the last five and 10 years, excellent average credit rating, and trading on an average of 25.7% discount from their 52-week highs. Their average dividend/income (as a group) is decent at 2.90%. We could have gone for higher dividends with some other stocks, but for A-list, we just wanted to stick with quality and conservative names with excellent credit ratings.
The second list (B-list) includes a few names that are a bit riskier, with less than stellar credit ratings but offer much higher yields. There’s an element of risk with some of these companies on the second list, like EPD and VIAC. Though unlikely at this time, there’s certainly an element of risk that they may cut their dividends in the future due to lower margins and adverse market conditions. Folks who do not like to have EPD (an MLP partnership) due to the K-1 tax issues could look at Exxon Mobil (XOM) as a replacement. XOM is offering nearly an 8% dividend at current prices. This list offers an average yield of 6.35%, an average of 18 years of dividend history, reasonable dividend growth, and a nearly 41% discount from their 52-week highs. Readers also should look at our extended list of 23 stocks and pick according to their needs, preference, and suitability.
Below is a snapshot of five companies from two groups:
Table-3A: List-1 (Conservative Income)
[Source: Author/ Financially Free Investor]
Table-3B: List-2 (High Yield)
[Source: Author/ Financially Free Investor]
We have used our filtering process to narrow down our large list of stocks to a very small subset. We presented two groups of stocks (five each), with different audience and goals in mind. The first group of five stocks is for conservative investors who prioritize the safety of the dividend over higher yield. The second group reaches for higher yield but with little less safety. It’s evident in the credit rating of each set. The first set has all stocks with A- or better ratings except one which has a BBB rating. The second group consists of three stocks that have BBB or BBB+ ratings. The first group yields 2.90%, whereas the second group yields 6.35%. We believe these two groups of five stocks each make an excellent watch list for further research and buying at an opportune time.
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Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, UNH, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, PRU, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LMT, LYB, ARCC, AWF, CHI, DNP, EVT, FFC, GOF, HCP, HQH, HTA, IIF, JPC, JPS, JRI, KYN, MAIN, NBB, NLY, NNN, O, OHI, PCI, PDI, PFF, RFI, RNP, STAG, STK, UTF, VTR, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. The author is not a financial advisor. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. The stock portfolios presented here are model portfolios for demonstration purposes.
Originally published on Seeking Alpha