High Dividend Stocks: An Alternative to Fixed-Income Investing

by: Stephen Yu, CFA

In a too-big-to-fail-world, governments run the printing press 24/7 to rescue everyone in sight. It really should not be called “too big to fail”, for no matter the size, if you are in trouble, the government will save you. Whether you are big like GM or small like a home “owner” with an underwater mortgage, the government is here to print enough money to keep you afloat. And under normal circumstances, one would think that after more rescue programs than I can count, and after so many months, the world economy should begin to stabilize.

But these are no normal circumstances we live in. Over the last couple months, the size of the entities that require bailouts has only grown. We are now not even talking about home owners or big corporations any more. We are talking about countries, PIIGS. Sure, these are relatively small countries, but judging by the trend, who is to say that large countries such as the UK or the U.S. are not next. And if even the richest countries in the world need help, who can help them? No one, at least no one from the present.

One solution - invent a time machine that allows us to go to the future and get the help from our future and from future generations. And that is precisely what the Bernankes of the world are doing, except that they call it a printing press. But their printing press may as well be called a time machine, for it only pushes today’s problems into the future in the form of inflation.

I know, in the short run, we are more likely to have deflation rather than inflation. But no economies in history ever escaped inflation when too much money was issued to solve a debt crisis.

Given that never in history has more money been printed than in the past 2 years, odds are that inflation will come sooner or later. In an inflationary world, bonds are obviously unattractive, especially when 30-year Treasuries yield slightly north of 4% only. Some people, myself included, favors holding gold to preserve one’s purchasing power. However, gold pays no interests; and as Warren Buffett puts it,

Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. Anyone watching from Mars would be scratching their head.

Therefore, it is understandable that some are skeptical about gold. So if bonds are no good, and gold does not do it for you, what can you do? My suggestion is to forget about inflation. Just go for high return. The better your investments perform the less inflation matters. So how does one get high return today? My suggestion is to buy stocks that meet these criteria:

  1. Blue chip U.S. stocks – Many blue chip, large U.S. stocks lagged smaller and riskier stocks during the 2009’s market rally. The valuation of mega cap U.S. stocks as a group remains attractive relative to smaller cap groups. Based on Jeremy Grantham’s latest asset class return forecasts, among several asset classes including U.S. and international stocks and bonds, U.S. high-quality equities offer the best performance over the next 7 years.
  2. Undervalued - History has shown that buying undervalued securities is the safest way to assure high future return. If you pay $60 for a stock that is worth $100, you are likely to make more money than if you pay $100. As long as you are right about the fair value of the stock and you have the patience and resource to hold it until it reaches fair value, your investment is safe despite market fluctuation. Furthermore, if the stock pays dividends, you are paid to wait for it to reach fair value; and this brings me to the next point.
  3. Pay high dividends – Fixed income investors buy bonds for yield. But bond yields are unlikely to offset inflation going forward. So an investor should buy stocks that pay dividends as a substitute for bond coupons. More specifically, investors should buy stocks of companies that have the power to raise dividends over time. Rising dividends help offset inflation. So what companies can raise dividends over time? Please see the next point.
  4. Pricing power – Some companies are in commodity business in which their products are indistinguishable from their competitors’. Their customers make purchase decisions simply based on prices. In an inflationary environment, these companies face rising costs, yet they have a hard time passing higher costs onto their customers for fear of losing customers. These companies have little to no pricing power. Other companies, on the other hand, have unique competitive advantages that allow them to pass higher costs onto customers. As a result, these companies will experience relatively stable profit margins regardless of inflation; and they are likely to be able to raise dividends.

Using the above criteria, I came up with a list of stocks that may help inflation-proof a portfolio:

  1. Pharmaceutical companies – Pharmaceutical companies will benefit from an aging population and from growing wealth (and demand for better healthcare) in developing countries. Healthcare reform in the U.S. could force the drug companies to accept lower drug prices, but it also helps more patients afford medicines. Overall, I believe the positives outweigh the negatives and the sector as a whole will be able to maintain pricing power and raise dividends. There are potentially a number of good stocks in this sector, but I focus on Pfizer (NYSE:PFE), Merck (NYSE:MRK) and Johnson & Johnson (NYSE:JNJ). All these stocks lagged the general market in 2009. PFE is selling at under 7x PE and MRK under 9x. Both PFE and MRK pay over 4% annual dividends. One reason that these stocks are cheap is that their drugs are facing patent expiration, but the current valuation gives them no credit for the drugs in their pipeline. Finally, JNJ is probably one of the best run companies in the world. It has a diversified portfolio of healthcare products. In addition to pharmaceuticals, it makes medical devices, and many stable consumer products. JNJ is selling near 11x PE, hardly a demanding multiple for such a world class company, and it pays 3.7% in dividends.
  2. Verizon (NYSE:VZ) – Some may say that telcos are a dying breed as consumers cut their traditional phone lines and switch to wireless phones exclusively. While this is true for consumers, business customers are unlikely to cut their phone lines. Business customers need land lines for their phones, fax machines, and internet access, and business customers are higher margin than consumers. So I think an obituary for telcos is premature. Besides, Verizon also owns nearly 50% of Verizon Wireless. While the wireless business is also competitive, and consumers are increasingly switching to lower margin pre-paid plans, business customers are likely to hang on to their Blackberries and high margin data plans. Verizon trades near 11x PE, not an unreasonable price, and pays nearly 7% in dividends. (AT&T is also a good candidate. Valuation and dividend yield are similar to Verizon’s. However, on a technical basis, Verizon is more oversold than AT&T is in the near term.)
  3. Qwest (NYSE:Q) and CenturyLink (CTL, formerly CenturyTel) - Both are traditional telephone companies. As in the case of Verizon, I do not think telcos are going away. Q pays 6.4% and CTL pays over 8% in dividends. And here is an interesting twist to the story - CTL is buying Q. For each share of Q, holder receives 0.1664 share of CTL. CTL is selling for around $33. So if you buy Q, you will receive $5.5 worth of CTL for each share of Q when the deal closes. Q is trading at $5.25 now, a 5% discount, and it pays 6.4% dividend while you wait for the deal to close! The risk is that the deal does not close. The risk is small, but if it rattles you, then buy CTL. CTL looks undervalued. Barron’s had a nice article on CTL on May 22 and believes the stock could rise 20% in 2011; Morningstar has a fair value of $38.
  4. Allegheny Energy (AYE) AYE is in a utility business and so it is as stable as it gets. It is being acquired by First Energy (NYSE:FE). For each share of AYE, holder will receive 0.667 share of FE. Therefore, at current FE market price of $35, AYE is worth $23.3. Yet, AYE is trading around 20.5, over 10% discount. AYE and FE expect to receive government approvals for the merger in 12 - 14 months, a rather long time, but AYE pays an annual dividend of around 2.9% while you wait. Furthermore, there is likely more upside to the merger arbitrage spread. As mentioned, FE is trading at $35. Most analysts, however, value FE at $44. In fact, Morningstar values FE at $55. So FE is undervalued, and if it reaches just the lower value of $44, AYE could be worth $29, 43% above current price! Lastly, if the deal goes through, AYE shares are converted to FE shares, and depending on FE price at that time, you may want to continue to hold FE because FE pays a nice dividend. At current market price, FE pays over 6% in dividends. As with Qwest and CenturyLink, if you do not want to depend on the merger to go through, you can buy FE straight.
  5. Philip Morris (NYSE:PM) – PM sells tobacco products outside of the U.S. It has a number of dominant brands including Marlboro. It has great growth potential in emerging markets such as China, trades at a modest 13x forward PE and yields 5%.
  6. Diamond Offshore (NYSE:DO) – It is an offshore driller that has been hurting of late due to the oil spill in the Gulf. DO does not own the exploded rig and so it has no liability tied to the spill. The whole industry will be under a cloud near term and may face tighter regulation in the future. However, we are short of oil and we need the industry. I don’t see the industry going away. DO is run conservatively and has little debt. It has the financial power to purchase rigs on the cheap in an industry downturn. Due to the taint from the oil spill, it is trading just above the March, 2009 low and sells near 7x PE. Importantly, it pays regular and special dividends. This year, total dividends should amount to $6-$7. So dividend yield is close to 10%! Once the spotlight on the oil spill passes, DO should move up again.
  7. Penn Virginia (NYSE:PVR) - PVR is a publicly-traded coal and natural gas limited partnership. Like a REIT, it is not taxed at the company level. The company leases its natural resources to mining companies and collects royalties. The royalty agreements are designed to provide stable and predictable income during period of low coal prices and to allow the company to benefit in periods of high prices. PVR’s dividend yield is nearly 9%.

So here you have it. These stocks may not outperform gold in a runaway inflationary scenario. However, if central banks miraculously restore the economy without causing inflation, gold will dive, but these stocks should hold up well, inflation or not.

Disclosure: Author holds long positions in PFE, JNJ, VZ, CTL, AYE, PM, DO, RIG, NE. No positions in MRK, T, Q, FE, PVR, ESV.