Five great yield stocks
These dividend payers promise steady income and boast strong growth potential, says Fortune's David Stires.
(Fortune Magazine) -- This has been a nerve-racking year for investors, with oil prices up, growth slowing and worries that the meltdown in the subprime-mortgage market could spill over into other parts of the economy. After a rocky March, all the major stock indexes had erased their early-year gains.
Given the uncertain state of the markets, many top Wall Street pros are recommending a tried-and-true strategy that will be familiar even to investing novices: Seek shelter in dividend-paying stocks. But it's not just the usual argument that the steady income from dividend stocks can give investors a way to get ahead of the pack. After years of delivering subpar returns, dividend payers are finally posting better results. Through Feb. 28, the dividend stocks in the S&P 500 posted a 12-month total return, from price change and dividends, of 14.8 percent - beating the 8.3 percent return of the nondividend stocks.
With that in mind, Fortune enlisted the services of Charles Schwab, the San Francisco-based brokerage house. In a recent report, senior equity researcher John Zbesko screened Schwab's universe of 3,200 stocks and found that those with dividend yields above 2 percent that also met a series of additional criteria returned an impressive 18 percent per year, on average, from 1990 through 2006. That beats the 12 percent annualized gain of the S&P 500 and the 11 percent return of the Wilshire 5000 during the same period. In addition, Zbesko's picks were 20 percent less volatile than the typical stock Schwab covers.
Zbesko's dividend recipe cooks up a healthy plate of comfort food with a dash of spice. In early March he screened 1,400 stocks with dividend yields above 2 percent, the market's historical average. He zeroed in on stocks with return on equity - a key measure of profitability - of at least 5 percent, providing a quick check to see that the firm is earning its dividend and is therefore unlikely to cut it.
Finally, he screened for companies that had recently reported a positive earnings surprise - Schwab's research found that such firms are more likely to do so again in the next quarter - and he eliminated any stocks that had lagged the market over the past six months. He gave us 12 stocks that survived all this tire kicking and, according to Schwab's quantitative ranking system, are expected to beat the market over the next 12 months. We picked the five we like best.
Carnival (Charts) (CCL, $47, 2.3 percent yield) Fears over hurricanes, terrorism, and the slowing economy torpedoed shares of the nation's largest cruise operator last year. Although the stock has begun to recover, it still appears undervalued at 15 times estimated earnings for the next four quarters.
"It's the best-managed cruise line in the business," says Ken Kuhrt, an analyst at Ariel Funds, which owns 4.5 million Carnival shares. He points out that longtime CEO Micky Arison, son of the company's founder, plans to increase Carnival's fleet some 25 percent over the next four years to more than 100 ships, expanding into far-reaching places from Costa Rica to China.
By bulking up, Carnival will gain bargaining power with suppliers, allowing it to spread costs across more ships and boost profit margins. In a business with huge barriers to entry - a new ship costs hundreds of millions to build - those profits should be well protected.
CBS (Charts) (CBS, $31, 2.8 percent) Does the Digital Age mean the end of the Tiffany network? You'd think so, considering that the market is valuing the stock at no more than book value (assets minus liabilities). True, the bulk of CBS's revenue comes from ads at more than 200 TV stations and 144 radio outlets. But since CBS split from Viacom last year, CEO Les Moonves has been aggressively reshaping the company - selling theme parks, upgrading radio stations to digital from analog and launching a new film unit.
In addition to being the most watched television network, CBS also has the rights to some extremely valuable content - "CSI," "Survivor," "60 Minutes" - that can be repackaged for viewers to watch over the Internet or on mobile phones and other devices. (It put March Madness on YouTube in a deal sponsored by Pontiac.) Meanwhile, Moonves has twice raised the dividend, and more hikes are likely. Using the premiums paid in recent media takeovers as a yardstick, Mark Boyar, who owns CBS shares in his top-performing Boyar Value fund, figures the stock is worth at least $42 a share.
Dow Chemical (Charts) (DOW, $46, 3.3 percent) Buyout rumors have stoked the shares of the nation's largest chemical company, which have risen from the mid-30s in recent months. But at 12 times expected earnings for the next four quarters, the stock is still significantly undervalued compared with competitors such as DuPont.
The disparity stems in part from the fact that nearly half of Dow's $49 billion in annual sales comes from highly cyclical commodity chemicals such as polyethylene. But CEO Andrew Liveris is shifting into high-margin products such as latex, which are selling particularly well in foreign markets that now account for two-thirds of Dow's revenue. He is also cleaning up Dow's balance sheet, having slashed its debt-to-capital ratio nearly in half since 2002, to 0.33.
Federated Investors (Charts) (FII, $37, 2 percent) We recently recommended Federated - one of the nation's largest investment managers with $237 billion in assets - after the stock passed a rigorous series of screens designed to ferret out firms selling well below their estimated takeover values. So we were pleasantly surprised to see the Pittsburgh-based firm make our strict dividend screen as well. It is one of the most profitable money managers in the business, with return on equity approaching 40 percent, and it has a long history of rewarding shareholders, having boosted its dividend eightfold since 1998.
What's more, CEO Christopher Donahue's plan to improve the performance of its funds is beginning to pay off. Aided by last year's strong equity market and better returns at some of its stock portfolios, Federated's net income jumped 23 percent last year, beating Wall Street's fourth-quarter earnings estimates by 13 percent. Assuming continued high-single-digit sales growth, Morningstar analyst Rachel Barnard estimates shares are worth $46.
Yum Brands (Charts) (YUM, $59, 2 percent) With more than 34,000 restaurants, Yum Brands is the largest fast-food company in the world. Four of its units - KFC, Pizza Hut, Taco Bell and Long John Silver's - dominate their respective categories (chicken, pizza, Tex-Mex, and quick-service seafood). The business is brutally competitive, with price wars breaking out on a regular basis.
And the company's brands will always be vulnerable to bizarre, unforeseen setbacks - bird flu and E. coli scares, and who knows what else. But what investors like about Yum is its enormous potential to grow overseas, where Yum has 12,000 stores in about 100 countries.
"The exciting part here is definitely the international story," says Colin Hudson, an analyst at Harris Associates, which holds a 7 percent stake in the company. "The international operations are well diversified throughout the world, and they're in a lot of the faster-growing emerging markets. They're adding 700 new stores internationally each year, and we think they can do that for the foreseeable future." Sounds tasty to us.
From the April 16, 2007 issue