Balancing Risk and Growth When Looking for Basic Materials Dividend Stocks

by: Bennington Investment Ideas

Basic materials are hot right now. With oil prices rising past $110 a barrel, copper setting all time highs, and steel close to its 2008 peaks, many investors are scouring the markets for good investment opportunities. Some investors look at basic materials as good dividend stocks - strong consistent dividends; however, it can often result in simply chasing the highest yield.

One can always ask the questions, 'is this a high dividend yield because it has strong earnings and good prospects or is it a high yield because the price is in decline due to fundamental questions about the company'. Finding a 5% dividend yield only to have the stock drop 10% in price is not very useful. When looking at investment opportunities it is important to dig a little deeper to understand the company's growth prospects and risk profile. However, for those interested in simply chasing yields here are the current top dividend yielding stocks in basic materials with at least $250 million in market capitalization.

Top Yielding Stocks
Ticker Name Yield (%) Market Cap ($ Millions) Industry
SCCO Southern Peru Copper Corporation 6.3* 31,459 Copper mining
SDRL Seadrill Limited 5.4 15,516 Oil & Gas Drilling
RDS.B Royal Dutch Shell 4.3 245,007 Integrated Oil & Gas Firm
SSL Sasol Ltd. 4.0 34,055 Integrated Oil & Gas Firm
TRP Transcananda Pipelines, Ltd. 4.0 29,693 Production and Pipelines
BTE Baytex Energy Corp 3.9 7,048 Oil Exploration and Production
TOT TotalFinaElf, S.A. 3.9 149,907 Integrated Oil & Gas Firm
SID National Steel Corporation 3.7 22,963 Steel Production
NL NL Industries, Inc. 3.6 669 Specialty chemicals
SE Spectra Energy Corp 3.6 18,697 Oil and Gas Pipelines
Click to enlarge

Data is provided by services downloaded on April 29, 2011 and is current as of April 28, 2011. *SCCO yield is 6.3% by both Zacks and Yahoo!Finance which represents an annual yield based on the most recent dividend of $0.58. Using the trailing twelve months dividends would give around 4.9% yield which would place it in 2nd place. This distortion will appear for any stock with irregular dividends.

As noted by the presence of oil companies above, I've included oil and gas companies as well as the traditional coal, steel, and paper companies. This list does exclude partnerships and trusts. The second list below reflects the highest yields in this category:

Partnership and Trust - Top Yields
Ticker Name Yield (%) Market Cap ($ Millions) Industry
CQP Cheniere Energy Partners, LP 9.3 485 Production and Pipelines
BPT BP Prudhoe Bay Royalty Trust 8.2 2,487 Oil & Gas Royalty Trust
CLMT Calumet Specialty Products Partners, L.P. 8.2 808 Refining and Marketing
ENP Encore Energy Partners LP 8.1 1,123 E&P MLP
MVO MV Oil Trust 7.9 476 Oil & Gas Royalty Trust
FGP Ferrellgas Partners, L.P. 7.6 1,974 Refining and Marketing
BBEP BreitBurn Energy Partners, L.P. 7.6 1,284 Exploration and Production
SBR Sabine Royalty Trust 7.6 1,007 Oil & Gas Royalty Trust
GLP Global Partners L.P. 7.2 602 Refining and Marketing
NRT North European Oil Royality Trust 7.0 288 Oil & Gas Royalty Trust
NRGY Inergy, L.P. 6.9 4,468 Refining and Marketing
OXF Oxford Resource Partners, LP 6.9 262 Coal
Click to enlarge

Data is provided by services downloaded on April 29, 2011 and is current as of April 28, 2011.

The above two lists provide good starting points for looking for the highest yields, but the focus will be to find stocks with strong yields when also adjusted for risk and growth.

Balancing Dividends with Growth and Risk
Simply chasing yields fails to consider growth and risk with respect to the selection. The key growth is in dividend growth, but sales and EPS growth may also provide some indication of potential dividend growth. While the ability to convert sales into cash flow and dividends may vary, the large range of differences clearly impacts potential dividend yields going forward. One way to balance growth and risk with dividend yield is to look at the dividend formula:
Current Price = Forward Dividend / (Required Equity Return – LT Growth)

So looking at this equation to maximize the Price, one wants to maximize the Forward Dividend, minimize the Required Equity Return and maximize the LT Growth or some combination of these levers. Some rearranging shows that the goal is to maximize the following:
DRG Index = Forward Dividend Yield + LT Growth – Required Equity Return

The Required Equity Return can be calculated using the Capital Asset Pricing Model. The Risk Free Rate is most typically associated with the U.S. Treasury bond with the most appropriate time frame to match that of stocks. I would use the 10-year bond, which is currently yielding 3.296% and 6% for the equity risk premium. The Forward Dividend Yield which can be calculated based upon the Current Dividend Yield and some estimate of 1 year of Dividend growth.

This method does face a couple of challenges since growth estimates can seem to be unrealistic at times for forward projects and historical rates can be misleading. For example, a company that has just started paying dividends might show significant growth that would be expected to slow. I created a couple of arbitrary steps and capped dividend growth at 20% for computing the one year forward dividend yield. I then capped the long term growth rate using the minimum of the historical dividend growth, the long term consensus EPS growth and 15%.
While these caps are somewhat arbitrary, the goal of any screening type of analysis is to create a useful list. The previous two lists already show the top yielding stocks. The second aspect was that I decided to exclude the partnerships and trusts from consideration since they do not operate under the same going concern considerations that the other companies due. Also, the quick review of the top performing partnerships and trusts mirrored the list of highest yielding partnerships and trusts.

The analysis focuses on the following companies that showed the greatest excess growth and dividend yield relative to calculated hurdle rate (a.k.a. required equity return). The first recognition is that the basic materials group included several agricultural and other types of companies (Monsanto) that might not typically be thought of as basic materials.
Hurdle Rates
Ticker Name Risk Free Rate Beta Equity Risk Premium Hurdle Rate
MON Monsanto Company 3.3% 0.8 6.0% 8.3%
SU Suncor Energy Inc. 3.3% 1.6 6.0% 12.8%
NUE Nucor Corporation 3.3% 1.0 6.0% 9.5%
CLB Core Laboratories N.V. 3.3% 0.8 6.0% 8.2%
ENB Enbridge Inc 3.3% 0.7 6.0% 7.4%
ESV ENSCO plc 3.3% 1.2 6.0% 10.3%
UGP Ultrapar Participacoes S.A. 3.3% 1.0 6.0% 9.4%
CRR Carbo Ceramics, Inc. 3.3% 0.6 6.0% 6.7%
MUR Murphy Oil Corporation 3.3% 1.0 6.0% 9.2%
ADM Archer-Daniels-Midland Company 3.3% 0.2 6.0% 4.7%
Click to enlarge

Data is provided by services downloaded on April 29, 2011 and is current as of April 28, 2011.

The next key component is the forward dividend yield which is based on the current dividend yield projected with the historical dividend growth rate. I capped this figure at 20% as well. It should be noted that this had limited impact on the results. Projected growth rates are the largest driver of the results with the adjustment from current dividend yield to forward dividend yield having the smallest impact.

Forward Dividend Yields
Ticker Dividend Yield Historical Dividend Growth Forward Dividend Yield
MON 1.7% 28.1% 2.0%
SU 0.9% 28.2% 1.1%
NUE 3.1% 37.8% 3.7%
CLB 1.1% 43.2% 1.3%
ENB 3.0% 12.8% 3.4%
ESV 2.4% 52.2% 2.9%
UGP 2.6% 14.8% 3.0%
CRR 0.5% 14.4% 0.6%
MUR 1.4% 18.2% 1.7%
ADM 1.8% 10.1% 1.9%
Click to enlarge

Data is provided by services downloaded on April 29, 2011 and is current as of April 28, 2011.

Putting it together shows the top 10 stocks as well as their "outperformance" measure.

Top 10 Stocks adjusted for Yield, Risk and Growth
Ticker Name Forward Dividend Yield Growth Used Hurdle Rate DRG Index Industry
MON Monsanto Company 2.0% 24.1% 8.3% 17.7% Agricultural products
SU Suncor Energy Inc. 1.1% 23.0% 12.8% 11.2% Canadian Integrated Oil
NUE Nucor Corporation 3.7% 15.0% 9.5% 9.2% Steel Production
CLB Core Laboratories N.V. 1.3% 16.0% 8.2% 9.1% Oil Field Services
ENB Enbridge Inc 3.4% 12.8% 7.4% 8.9% Production and Pipelines
ESV ENSCO plc 2.9% 16.0% 10.3% 8.6% Oil & Gas Drilling
UGP Ultrapar Participacoes S.A. 3.0% 14.8% 9.4% 8.4% Production and Pipelines
CRR Carbo Ceramics, Inc. 0.6% 14.4% 6.7% 8.3% Oil Field Services
MUR Murphy Oil Corporation 1.7% 15.0% 9.2% 7.5% Integrated Oil & Gas Firm
ADM Archer-Daniels-Midland Company 1.9% 10.0% 4.7% 7.2% Agricultural products
Click to enlarge
Data is provided by services downloaded on April 29, 2011 and is current as of April 28, 2011.

The stocks ranked 11 - 20 are listed below and include their industry groupings:

Stocks Ranked 11-20 for Yield, Risk and Growth
Ticker Name Yield Market Cap Industry
NE Noble Corporation 0.4% 10,606 Oil & Gas Drilling
SQM Sociedad Quimica y Minera S.A. 0.9% 15,234 Mining/Chemicals
XEC Cimarex Energy Co 0.3% 9,392 Exploration and Production
EOG EOG Resources, Inc. 0.6% 29,798 Exploration and Production
RRC Range Resources Corporation 0.3% 8,814 Exploration and Production
PX Praxair, Inc. 1.9% 32,540 Diversified Chemicals
ARG Airgas, Inc. 1.7% 5,810 Diversified Chemicals
CCJ Cameco Corporation 1.4% 11,615 Other Mining
NBL Noble Energy Inc. 0.8% 16,942 Exploration and Production
POT Potash Corporation of Saskatchewan Inc. 0.5% 47,352 Agricultural Chemicals
Click to enlarge

Data is provided by services downloaded on April 29, 2011 and is current as of April 28, 2011.

This analysis attempts to dig deeper than just looking at yield. However, it is still just a screening tool since it does not look at the fundamental valuations of any company. Nor does this analysis address any strategic questions or other qualitative assessments of the companies listed. Additional fundamental analysis would be critical prior to making any sort of investment decision; however, this offers a great starting point with a focus on the basic materials industries. The high level conclusions:

  1. The partnership and trust companies typically provided the highest overall yields. For an investor seeking current income, these are potentially the best opportunities. They also performed well on the adjustment for risk and growth. However since that list was close to the initial top 10 list, I excluded it from consideration but those stocks and tickers are: Legacy Reserves (NASDAQ:LGCY), Encore Energy Partners (NYSE:ENP), Cheniere Energy Partners (NYSEMKT:CQP), Targa Resources (NYSE:NGLS), Alliance Holdings (NASDAQ:AHGP), LInn Energy (LINE), Terra Nitrogen (NYSE:TNH), Spectra Energy Partners (NYSE:SEP), El Paso Pipeline Partners (NYSE:EPB), Western Gas Partners (NYSE:WES). The exclusion was largely over questions of the sustainability of their historical dividend growth and overall long term growth prospects.
  2. The top yielding basic materials stocks were driven by Oil and Gas companies from various sectors. While this analysis is naturally focused on U.S. and some Canadian companies due to stock listings, SCCO, a Peruvian company, had one of the two highest yields. Increasing demand for copper and rising copper prices may make this a very attractive investment.
  3. The top yielding basic materials stocks when adjusting for risk and growth had no overlap with the highest yielding stocks. The closest was NUE which had a yield of 3.1% and an estimated forward yield of 3.7%. Some of these stocks had yields less than 1%, but scored well since they had very strong growth prospects. Furthermore, these companies appeared to represent a more diverse group of industry segments further suggesting that they might represent growth champions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.