For most of the year, I've spent my time focusing my investment energies on two supermajor oil companies: BP (NYSE:BP) and Royal Dutch Shell (RDS.B). That was the best place to find undervalued stocks offering high income. For the most part, I was content to leave the yield-chasing allure of most REITs, upstream energy MLPs, tobacco stocks, and telecommunications companies to the other investors.
From 1926 to 2006, the S&P 500 and Dow Jones both offered total returns (price appreciation + dividends) of that magical 10% figure you often hear about. Considering that Shell and BP both had over $100 billion worth of total reserves, and considering that the starting dividend yield for both of those stocks was 5%, I was already earning half of the stock market's historical return just by passively sitting on my rear and collecting my share of the profits -- I only needed to get that other 5% out of a rising share price from those companies, either due to (1) growing profits, or (2) an increase in the valuation that other investors are willing to pay for each dollar that those companies generate.
As much fun as that has been, I've heard the clarion call to return back to the low starting yield/high dividend growth rate waters. In particular, I'm talking about IBM (NYSE:IBM).
It's been heading in the direction of reaching the point where it becomes a stupidly obvious buy.
Because the company generates about $15 in profits while only mailing $3.80 per share to owners in the form of a dividend each year, IBM gets to dedicate $11 or so in shareholders' profits to capital expenditures aimed at growing the company and buybacks aimed at removing some of the other IBM shareholders so that your share of the company will entitle you to a larger slice of the overall profit pie.
The tech giant has retired about half of its shares since 1996. Back then, there were 2 billion shares of IBM outstanding. Today, there's a little over one billion. Considering that the company has issued stock to make acquisitions along the way, the effect of the buyback program is even more impressive than it sounds at the superficial level because you have to adjust for that absorption (since IBM regularly issues stock as part of its acquisitive strategy, it would be very tedious to tally up the 1,000+ stock transactions over that time period, and I'm guessing that's why no one on the internet has performed that calculation. And plus, you'd have to adjust for management's compensation as well. But I better digress and throw this tangent in the ditch before it takes over the whole post).
From a valuation perspective, it's wild to see IBM, which is slated to make about $15.50 this year, trading at $181 as of August 28, 2013. It's hard to see how you don't do well fifteen years from now if you pay 11-12x for one of the world's top three diversified service providers.
The current dividend yield just crossed the 2.0% mark, which is normally nothing to get excited about, until you realize that 2009 was the only time in the past twenty years in which the company offered prospective investors a starting dividend yield over the 2.0% threshold). From 1997 until 2006, the company never even crossed the 1.0% dividend yield basis for more than twenty consecutive trading days.
Over the past decade, profits have gone up 12.0% on average while dividends have gone up 18.0% on average.
There aren't all that many opportunities in life where you get a chance to buy 11-12x earnings for a company that has a relatively high likelihood of growing earnings and dividends by 9-10% annually over the coming 5-10 years. I don't think the analysts are crazy for predicting $21 per share in profits by 2018. That would generally require IBM to keep doing what it's been doing the past 5-7 years. And if it trades at my estimation of intrinsic value (around 14x earnings or so), we're talking a ballpark range of $300 before this decade comes to close. And even if IBM falls short of that, the current price of $181 allows investors a good chance to achieve satisfactory returns anyway. When high quality companies give you prices that offer a margin of safety, you know what you have to do.
Disclosure: I am long IBM, RDS.B, BP. 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.