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by Dirk van Dijk

With the 10-year T-note yielding only 2.50%, those investors interested in getting income from their investments are in sort of a tough place. Dividend paying stocks are a very good place to look for a replacement. One thing you know for sure is that the coupon payment on a 10-year note is not going to rise. A yield of 2.50% does not offer much of a cushion against inflation.

What is inflation likely to average over the next 10 years? I have no idea, but based on the spread between the regular 10-year note, and the 10-year TIPS, the market is implicitly expecting a rate of about 2.20%, which while somewhat below the historical experience (Headline CPI) over the last 20 years of 2.57%, is still not nothing.

While core inflation is the thing to keep an eye on when judging if monetary policy is too tight or too easy, it is headline inflation that investors -- particularly fixed-income investors -- have to be concerned about.

After all, the whole point of buying a bond is to defer consumption of a basket of goods and services from today, in order to be able to consume a bigger basket of goods and services in the future. Both of those baskets are going to contain food and energy. An expected real return of 0.30% is not a very big payoff for that long a period of delayed gratification.

Inflation Over the Long Term?

I do not think that inflation is currently a huge threat. I agree with Ben Bernanke that the recent commodity price spike that fueled increases in headline CPI is likely to be short-lived. With the economy weakening, oil prices are pulling back. On the other hand, it seems quite plausible to me that we could see much higher inflation a few years from now, particularly if the economy manages to get back on track and unemployment falls to more normal levels.

Over the long term, the likely course of oil prices in particular is likely to be higher as the lower cost reserves have been exploited and a rising population of relatively richer people in places like China and India continue to consume more and more.

I’m not talking about a trip to Zimbabwe, or even a return to the 1970’s, but inflation rising to around 4% would not shock me. Given the huge indebtedness of the consumer sector, and increasingly the government sector, it would not be the worst thing in the world either. It could actually be a good thing (although here is a case where one can easily have too much of a good thing).

If that proves to be the case, then your real return on the T-note will be negative. The yield will rise, and the price of the bond will fall. You are simply not being paid very much for taking that risk.

For now, though, with the economy weakening, there is little demand from the private sector for loans. People are desperately trying to deleverage and improve their balance sheets, but with asset values shrinking (especially for housing) the balance sheets continue to get worse. Even with the threat of a downgrade, there will still be a flight to quality, and that means demand for T-notes.

S&P and Moody’s grades are, in the end, just opinions -- and they have been wrong before. Their downgrade of Japan’s debt did nothing to stop Japanese bond yields from going to a “one handle” and on occasion a “zero handle.” As long as the Federal debt is denominated in dollars, and the government owns a printing press, the only way that the Government can default is a political decision to do so.

Don't Fear an S&P Downgrade

The threat of a S&P downgrade is wildly overblown. Sure it would cause some disruptions, but institutions would probably just change their policies and prospectuses to allow them to hold T-notes even if they are not AAA.

However, I digress. The point still remains that income is very hard to find, and dividend paying stocks are the best available replacement. I set the bar at a dividend yield of over 2.8%, comfortably more than the 10-year today. The dividend yields, incidentally, are from last night (early morning 8/4/11), before today’s big sell off, so they are probably higher than shown.

It is, however, a mistake to only look at the dividend. Buying a stock because it yields 4.0% and seeing the stock fall by 5.0% right after you buy it is not going to make you either happy or wealthy. You want to find both a good steady income, and some potential for near-term appreciation. Therefore, I looked for stocks that are currently rated either #1 (Strong Buy) or #2 (Buy) based on the Zacks Rank.

Dividend investing is a long-term strategy, and the Zacks Rank is mostly for shorter-term traders, but even long-term investors should not ignore it entirely. It is still a good timing tool for them.

If you are buying a stock for income, the last thing you want to see is a cut in the dividend. The best defense against that is a low payout ratio. Managements generally will try to avoid dividend cuts, but paying out more than you earn each year is not sustainable.

A company needs to retain at least some of its earnings to grow -- not just earnings, but the dividend as well. I therefore require that the company pay out no more than 60% of its earnings so there is a very strong cushion against dividend cuts.

One of the nice things about dividends is that they tend to grow, particularly if the company has a history of raising dividends. It is that dividend growth that can protect you from inflation. That is something that a T-note simply will not do for you.

In the screen I required that dividends increase by an average rate of 5% per year over the last five years. In other words, the dividends have increased by more than twice the rate of inflation over that period.

More significantly, the first cut is the hardest. The five percent growth requirement has the added advantage of eliminating any firm that has cut its dividend in recent years. With a dividend plus dividend growth strategy, it is imperative to avoid dividend cuts. I would not expect some of the historic growth rates to be continued.

It is highly unlikely that ABB Ltd (ABB) is going to generate the sort of earnings growth needed to grow its dividend at over 59.7% per year over the next five years. Most, however, have dividend growth rates in the mid-teens or lower, and those sorts of growth rates are probably sustainable, at least for a few more years.

Look Outside the U.S.

Don’t be afraid to look outside the U.S. for income stocks. The dollar has been declining, and I think it will probably continue to do so. That would mean that a dividend paid in euros or yen would be translated into even more dollars. I think that the decline of the dollar is a good thing, in that it should help promote growth and reign in our massive and unsustainable trade deficit.

Also, while dividend paying firms are generally larger market cap firms, that is not always the case, as this screen shows. Yes, there are huge firms on the list like Phillip Morris (PM) and McDonald’s (MCD), but there are also five sub-$500 million micro caps as well.

Historically, dividend paying companies have far outperformed non-dividend paying stocks, and dividends account for about 40% of the total return from owning S&P 500 stocks over the long term. The combination of high dividends plus short-term estimate momentum just could lead to long-term success in the market. This is not a flashy strategy, but a solidly profitable one. It focuses on both sides of total return, income plus capital appreciation.

Yes it has been a scary couple of weeks in the market, but the time to sell is when all others are greedily buying, and the time to buy is when others are despondently selling. Earnings have been doing very well lately, and at the end of the day, that is still the most important thing for stocks.

Stocks with Zacks Ranks of #1 or #2 are ones that have better recent earnings pictures than the vast majority of stocks out there. I am well aware of the macro-economic problems on both sides of the Atlantic, and recent developments on both sides have not been promising. Still, good solid profitable companies will endure and prosper.

Some of the firms on the list have tended to do better in bad times than in good. For example, Genuine Parts (GPC). If the economy stays bad, people are going to try and fix up the old clunker rather than getting a new car. That means more auto repairs and hence replacement parts. In bad times, going out to eat at Red Lobster might seem extravagant, but people will still buy a McDouble or McChicken off the $1 menu.

As always, keep in mind that a screen like this one should be the starting point for your investigation of what stocks to buy, not the endpoint. But in times like these, this is a good place to start your search.

Company Ticker Dividend Yield Div Yld 5 Yr Avg Payout Ratio Zacks Rank Div 5 Yr Growth Market Cap ($ mil)
Rwe Ag -Sp Adr RWEOY 7.15% 4.03% 0.37 2 12.26% $27,337
Edp Sa-Spon Adr EDPFY 5.49% 3.40% 0.38 2 7.92% $12,652
Textainer Group TGH 4.78% 5.74% 0.43 2 9.71% $1,269
Exelon Corp EXC 4.77% 3.68% 0.49 2 5.88% $29,191
Cdn Impl Bk CM 4.56% 4.77% 0.5 2 5.96% $30,276
Avista Corp AVA 4.36% 3.75% 0.59 2 16.73% $1,453
Shaw Comms-Cl B SJR 4.08% 3.58% 0.59 2 21.80% $9,295
Alliance Finl ALNC 3.73% 3.83% 0.45 1 8.05% $153
Bankinter Sa BKNIY 3.72% 2.55% 0.55 2 52.12% $3,044
Natl Bnkshrs Va NKSH 3.72% 3.62% 0.41 2 5.96% $179
Philip Morris PM 3.60% 4.32% 0.59 2 9.58% $126,569
Telenorte L Adr TNE 3.43% 4.10% 0 2 21.40% $5,349
Genuine Parts GPC 3.39% 3.68% 0.54 2 5.04% $8,363
Tompkins Fin Cp TMP 3.37% 3.13% 0.43 2 5.55% $440
First Long Is FLIC 3.31% 2.98% 0.42 2 14.51% $233
Toronto Dom Bnk TD 3.31% 3.58% 0.43 2 8.11% $70,773
Banco De Chile BCH 3.26% 4.84% 0.49 2 14.21% $12,058
Intel Corp INTC 3.25% 2.75% 0.32 2 12.18% $118,394
Ntt Docomo -Adr DCM 3.14% 2.73% 0.46 1 15.90% $76,882
Somerset Hills SOMH 2.91% 2.05% 0.47 2 17.94% $45
China Petro&Chm SNP 2.85% 2.36% 0.19 1 8.86% $88,836
Eaton Corp ETN 2.84% 2.83% 0.39 2 9.91% $16,361
Mcdonalds Corp MCD 2.82% 2.82% 0.49 2 27.38% $89,730
Abb Ltd-Adr ABB 2.81% 0.76% 0.49 2 59.70% $
Source: 24 High Yield (And Rising) Dividend Stocks