It may sound counterintuitive but investors looking for high-dividend yielding stocks may be better off choosing stocks that pay more modest dividends. Point in fact, the two sectors of the S&P 500 that pay the highest yields - utilities and telecoms - were the only groups to lose money last year and are amongst those losing the most so far this year; consumer goods is the other group down the most year to date.
This trend is encouraging many investors to ditch these more defensive stocks in favor of more cyclical ones. In other words, the popularity of these so-called defensive stocks ruined their appeal. Their share-price valuations were high enough that it raised the price of stock, forcing the dividend yield down. These higher valuations may limit the available upside, but that doesn't mean that defensive stocks are necessarily bad picks.
Higher yielding stocks still have room to go. None of them were technically overvalued last year. Besides, bond prices are likely to remain low at least through 2014 thanks to the Fed so dividend-yielding stocks will be the virtually only investment vehicle that can produce predictable income (relatively - obviously dividends can be cut or cancelled at anytime). Of course, that fondness toward dividend-yielding stocks will be tempered somewhat on fears of the U.S. government raising taxes on dividend income.
In the end, stocks that pay modest dividends but offer strong upside will likely be the best bets for investors. We found three that we think fit this bill nicely. Each was a strong performer in 2011, has a moderate dividend and still has some upside to spare.
Electric utility company Southern Co (SO) is one of the most popular stocks in the U.S., especially after having gained 26% last year. It is down 0.43% this year. The company recently traded for $44.37 a share and pays a $1.89 dividend (4.30% yield). Analysts say that Southern could go as high as $50 a share in the next year. If they are correct, investors buying in today would enjoy 12.69% in upside, plus the 4.30% yield, for a total return of roughly 17%. For all that, Southern is priced fairly low relative to its future earnings, with a forward P/E of 15.73.
Healthcare giant Johnson & Johnson (JNJ) gained almost 10% last year but it is down 0.72% so far this year. It pays a $2.28 dividend (3.50% yield) and recently traded at $64.83 a share. Some analysts say that Johnson & Johnson's share price could reach as high as $90 in the next year. If they are correct, that would give the company an upside of 38.82%. Including its dividend yield, investors buying in today would enjoy a total upside of 42.32%. Johnson & Johnson's earnings are expected to grow by 5.70% per annum on average over the next five years, compared to expectations of 6.96% for its industry.
Cigarette company Philip Morris (PM), which rose 35% in 2011, is up 6.27% so far this year. It recently traded at $84.23 a share. Analysts say Philip Morris stock could go as high as $93 a share in the next year, making for 10.41% upside. This combined with its $3.08 dividend (3.70% yield) would make for a total return of roughly 14%. Philip Morris is priced low at 14.30 times its forward earnings. According to Yahoo Finance, analysts estimate that Philip Morris' earnings will grow by an average of 12.46% a year for the next five years, versus expectations of 10.48% for its industry.