Tuesday’s plunge in Freddie Mac (FRE) on write-downs and suggestions of a cut to the dividend served as a powerful reminder that all dividends are not the same. I have written twice about a prudent way to think about dividend stocks, first in early May (32 stocks) and then in late July (23 stocks), when I had become known as “Armageddon Alan”. Make no mistake, I am as bearish as I have been in my professional life (21 years) and suggest to all to move to the lowest equity allocations consistent with their long-term goals. With that said, though, I highly recommend that anyone investing for retirement or in retirement to keep in mind a couple of points:
- Unless you want to retire later or go back to work after retirement, guard your principal.
- Think about “yield” in a longer time-frame than just one year.
Integrating those two points and going back to FRE, I find that many investors who rely on their portfolio returns to sustain them want more than a 2% or 3% yield. Before yesterday, FRE must have been looking quite good from that simple perspective. After all, it was paying a juicy $2 dividend. At the $66 price at the beginning of the year, it had a decent yield of 3.3%. At the $40 closing price on 11/19, the yield was an eye-popping 5%. Well, after yesterday’s plunge, that $2, if paid, would yield 8%. Too good to be true? Yup. The company suggested that it is considering halving the dividend. So, if you owned FRE at the beginning of the year and were banking on that $2 per share per year and decide to sell now, you got $1.50 so far this year, but you have lost $40 per share. So far. And next year, you will get only $1. You may never live to see your investment “whole”again.
If you find yourself in this boat on FRE or any stock, you have my sympathy. While I can’t guarantee that my approach will prevent these types of disasters in all cases, I can assure you that FRE never would have made the cut. Conceptually, I am looking for companies that pay an above-market dividend but that have the potential to grow that dividend over time. I include several safeguards as well, such as quality of the balance sheet and the size of the pay-out ratio. In very simple terms, a dividend yield substantially above the market implies that the investor is taking some risk. If you get anything at all from this article, I hope that you will strive to always understand why the yield is so high. Allow me to share an example that will illustrate how a lower but safe yield can beat a high yield (even if the high yield is sustained).
In this example, an investor has a choice of two stocks, PIG and OWL. PIG pays out 70% of its earnings in dividends, while OWL pays out less than half. PIG trades at a PE of 10, while OWL commands a higher PE (16) due to its higher growth potential. If one looks out 10 years, a couple of things stand out:
- The dividend of OWL will eventually surpass that of PIG
- Even assuming that they are both priced at a terminal PE of 10 (PIG the same, OWL down a lot), the stock appreciation of OWL overwhelms the cumulative dividends of PIG
While this example is obviously contrived, it illustrates that a company with higher growth potential and a lower dividend yield initially can ultimately give the investors more dividends and a huge capital gain to boot. Some might argue that OWL is a riskier prospect due to the assumption of higher expected growth that could disappoint, but I don’t believe that is necessarily the case. PIG could be like FRE! Not every “OWL-like” stock will pan out as fabulously as this example, but some will. From my own personal experience, Pepsi (NYSE:PEP) sure did the trick (though when I got my one share back in 1977 as a Bar Mitzvah gift, I wasn’t thinking retirement!). Note that the chart below doesn’t even include the fact that YUM! Brands (NYSE:YUM) was spun out as well 10 years ago. Ironically, PEP remains on the list even today. Note that the yield has never been that “high” – typically about 2% yield though higher when rates were much higher in the early 80s.
Here is my approach to solving the problem of providing for wealth preservation and potential growth for retirement or near-retirement investors. As I have described before, I screen the entire domestic stock universe (using StockVal) in order to find companies with relatively high and sustainable dividend yields. Here are the key parameters that I use to create a list from which one can do further analysis to determine the suitability for inclusion into a portfolio:
- 2% minimum dividend yield (valuation)
- 150% maximum of five-year median forward PE (valuation)
- 5% minimum annualized revenue-per-share growth for the past three years (growth)
- 5% minimum annualized earnings-per-share growth for the past three years (growth)
- 5% minimum annualized dividend-per-share growth for the past three years (growth)
- 10% minimum return on capital (safety)
- 10% maximum decline in next year’s projected earnings over past twelve weeks (safety)
- 35% maximum total debt to capital ratio (safety)
- 10-year minimum history of dividend payments (safety)
- 67% maximum payout of earnings (safety)
As you can see, the screen incorporates parameters that address valuation, growth and safety. Perhaps the parameters are too restrictive – obviously, one can loosen them and find more stocks that are still most likely to merit further investigation. The stocks meeting these criteria today are in the table below. While the number of stocks meeting these criteria has decreased from 32 six months ago to just 21, those that do cut it represent 7 of the 10 economic sectors and range from Micro-Cap to Ultra-Large-Cap. While there may be some comfort in the large and familiar names, don’t be afraid to investigate tomorrow’s large and familiar name that isn’t so large and familiar today!
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Disclosure: No positions in any of these stocks