Income Criteria For Fear And Loathing Stocks

by: nstollon

It seems that many income articles these days suggest we all need to be in a dividend growth or aristocrat portfolio. For those in the summer of their investing life, with many years of compounding ahead of them, this makes sense. However, the reality of investing in income for tomorrow is often rather different from investing in income for today.

For others who are approaching the "golden" years, the lure of a 2-3% dividend payout, which may increase by 10-15% every year, is not much better than that of a 2-3% CD. There is cold comfort in knowing that you have long-term income stock winners, if today you are only getting enough income to buy cat food for lunch.

Thankfully, I am not ready to retire and I don't plan on any lunches that come from tin cans, but, given a market that does provide stocks with much higher dividend, my interest is whether you can get a "standard of living" dividend on a decent quality, long-term portfolio. I am going to make the argument that there are ways that you can.

One way is via dividend income from what I call the "Fear and Loathing" Stock Sector. Neither a scary film company or Las Vegas casino portfolio, this essentially refers to investing in stocks that the market has discarded. The market always is deciding certain stocks or industries are not worth owning, and pricing them accordingly. Once tagged with is "Fear and Loathing factor," these stocks tend to be unduly punished, even in face of profitability, improving fundamentals or positive news. In most cases, such companies are not worth our time or money - but for some feared and loathed companies that pay dividends, being beaten down, as a byproduct, provides compelling yield opportunities.

These are not the coolest stocks; but then again neither is eating cat food. On my list that follows are companies in mature industries; printing, mail, landlines, etc. which while not high growth industries, seem equally unlikely to disappear any time soon. Indeed most, having weathered years against competition, have found defensible niches that do generate sustainable profits. This is an important measure of safety, since most profitable companies are historically loath to cut their dividend, even on significant stock price declines. So, to start, some criteria for a Fear and Loathing portfolio:

First is to identify high dividend income, for this article I put it at a lower limit of 6.5%. Obviously, this threshold differs for everyone, but I find 6.5% useful, as a dividend return higher than most competing U.S. income classes, including most bond funds, traditional dividend stocks, (most utilities, energy, and REIT), and even most annuities. MLPs, having a competing yield and other virtues and risks in their own rights, I am keeping outside this article, as their financial and tax features deserve a separate discussion.

As a second criteria, I define stocks of interest as ones that have declined by at least 40% over the 1-1.5 years. Looking at stocks that have taken such major losses clearly establishes these stocks as "fear and loathing" candidates. Expectations are lower, to the point that, in many cases, valuations are below book value. (More on this later). While never assured, logic says that a stock beaten to a single digit price has a limited downside.

The third criteria looks at free cash flow (FCF) and future earnings estimates as measures of earnings to cover the dividend. Since quarterly accounting games play with earnings, FCF seems a better way to measure company profit and ability to pay a dividend. Noting that FCF may also get distorted over a near term by (positive) company decisions (investment in growth or infrastructure, reorganizing to reduce costs, paying down debt or obligations, etc.) I also consider next year earnings (NYE) when these exceed current free cash flow. Personally, I typically will not consider any company with negative cash flow and future earnings as an investment. I look for margins of at least 1.5X between FCF or NYE and dividend. The larger this ratio, the more secure the dividend.

A fourth criteria is book value, and in particular, discounts to book value. Since "Fear and Loathing" implies continued stock price pressures, a discount to book value combined with high yield sets a dual price floor, which is an inherent buffer to limit risk. Profitable stocks selling below book value may well be on some acquisition list.

As a fifth criteria, dividend paying companies under stress need liquidity. I look for a company to maintain a cash position that supports at least two years of dividends, as a indicator of liquid financial strength. In most cases, this cash is going to stay in reserve, if FCF and earning numbers are large enough to cover the dividends, but profitable companies with free cash on hand to cover dividends, do not tend to cut dividends.

A last and more informal criteria of a Feared and Loathed stock is either recent dividend increases or major insider purchases of stock. A company that increases its dividend while under stress shows an underlying confidence, Likewise, executives buying shares points to a positive opinion where it seems to really count. Disposing of shares is not as strong a converse indicator, since this is typically an automated selling process.

Having set these criteria, what are the candidates? - Some of mine follow in the table below. I openly invite any reader to suggest other stock candidates that meet the above criteria. I will try (no promises) to track those that interest me as a portfolio and report back at some future date(s).

The chart lists six stocks that meet at least 4 of 5 of my criteria. While France Telecom (FTE), Nokia (NYSE:NOK), and Telefonica (NYSE:TEF) are telecom centric, others are in more non-traditional high dividend areas such as Semiconductor- ST Micro (NYSE:STM), printing - RR Donnelley (NASDAQ:RRD), and business services - Pitney Bowes (NYSE:PBI). NOK meets all 5 criteria, with FTE just a hair away from hitting 5 out of 5. Others fall short in P/B >1 (RRD, and TEF and most extremely PBI) or FCF coverage . I use a go/no go test for discussing criteria, however it is the art of investing to recognize and adjust for a continuum of differences in financial strength vs. varying yield of the candidate stocks in putting together a portfolio. It is interesting to note, half these stocks (FTE, STM, NOK, TEF) are European, which is, for now and probably the near future, ground zero for Fear and Loathing in the stock market.

I also list for comparison some stocks, Frontier (NYSE:FTR), Safe Bulkers (NYSE:SB), CenturyLink (NYSE:CTL) that do not meet most of my criteria, but that are high yield and have strong enough fundamentals based on metrics to be worth more investigation or at least monitoring.

Windstream (NASDAQ:WIN) I include as a counterpoint example that I would not consider for this portfolio based on its financials

Of course, metrics and criteria are only a starting point and never substitute for common sense. Understanding the company, its business, and industry is essential in investment. As in any investing, you need to make some assumptions - To invest in RRD and PBI, you need to believe to some level that companies and people will continue to print things and mail things for a foreseeable future. Investing in NOK requires faith that the company has a means to presume to compete against iPhones and Androids. Investing in FTE and TEF assumes that Europeans and South Americans will continue to use their phones, even if the euro goes to heck. Personally, I will not invest in a stock for income if I cannot make a value argument for why I am doing it. Right or wrong, even the best analysis will not guarantee the future, but it can educate on whether a stock is a reasonable bet, given the risks and the payoffs.

My list is not intended to be inclusive, it is based on stocks that I am familiar with or have followed for some time (as an engineer, I tend to weigh toward technical companies). I am sure readers will let me know other candidates that I am not considering.

As a parting comment, I want to note that my discussion of these stocks is to provide examples, and secondary to the more important message of the criteria and methodology that I used to select them, which I hope will be the worthwhile takeaway for the reader.

As a final comment and caution, caveat emptor- obviously this is an extreme investment strategy. It has risks and is not for everyone; some of these stocks discussed remain in free fall, well past their book value, even in the face of what I consider as positive events, indicating that Fear and Loathing in the market remains alive and well. My analysis is one attempt to discuss an unfortunately rather timely need of many people entering retirement - who have assets, but difficulties in generating adequate income from them, and who may be willing to take some investment risk to maintain a needed income level.

Disclosure: I am long FTE, RRD, PBI, STM, NOK, TEF, FTR, SB, CTL.