This article is Part 3 of a series of articles focusing on finding value in the S&P 500 today. In Part 1, we laid out several classifications of equities that comprise the S&P 500. In our follow-ups we are focusing on each of these classifications one at a time, in order to focus on finding fair valuation within each category. There's a lot of discussion, much of it suggesting that stocks are overvalued today. We disagree, because we conducted a thorough examination of each of the S&P 500 constituents, we did indeed find a lot of value in this market. Here is a link to Part 1, where we laid out our thesis of a market of stocks rather than the stock market, and identified the categories that we are writing about in these subsequent articles.
In Part 2 we focus exclusively on high-growth stocks that are constituents of the S&P 500 and we believed were fairly valued today.
In Part 3, we turn our attention to the highest yielding stocks that are constituents on the S&P 500. However, we submit that there are essentially two primary reasons that explain why these stocks offer such high yields. The most prominent is that these are low growth entities that need to offer high dividend yields in order to attract investors. The next most prominent reason is that some of these entities have seen their stock prices collapse because of fundamental issues and challenges within their respective business models. Consequently, their high yields could be either a temporary illusion that will soon change, or perhaps indicative of high risk.
Therefore, we submit that the moral of this story is that everything is not all that it often appears to be. High yield is nice, but if it also implies high risk, the investor has to be prepared to factor that into their decision-making process. In other words, the prospective investor has to decide whether or not the reward is worth the risk taken to achieve it.
We have identified 17 companies in the S&P 500 that offer a yield of 5% or greater. We then broke this down into two sets, one that we felt had higher risk, and one that we felt represents good opportunities for the investor either seeking high yield, or high yield plus growth. It is very important to state that this is a prescreened list based solely on organizing the S&P 500 by order of highest dividend yield to the lowest utilizing the F.A.S.T. Graphs fundamental analyzer software tool. Then we ran individual earnings and price correlated graphs on each of our 17 selections in order to sort them by risk.
More importantly, the reader should understand that we are not recommending any of these selections. Nor are we suggesting that any of these selections should be avoided. Instead, we are offering both lists for the sole purpose of providing the reader with a selection of S&P 500 high yielding constituents that may be worthy of further due diligence and research. On the other hand, we hope that the reader finds it useful to have both lists sorted by apparent risk, based on fundamentals.
High Risk-High Yield S&P 500 Constituents
We do not believe it is a coincidence that our high-risk list contains most of the highest yielding S&P 500 constituents. In today's interest rate environment, the prudent investor needs to proceed with caution when they see yields that are significantly higher than the current environment generally is offering. On the other hand, given that the market can often improperly appraise the price of a stock, an aberrantly high-yielding security should not be immediately rejected either. There is always the possibility that a more comprehensive research effort may uncover a great long-term opportunity.
The following table lists nine high yielding S&P 500 constituents that we believe should be carefully evaluated and scrutinized. With many of the selections, further examination will show that there are current issues with the companies' profitability. In other words, some of the selections are experiencing deteriorating earnings for one various reason or another. Consequently, dividend cuts or even price erosion should be considered as real possibilities. In other cases, there are valuation issues, or more precisely, overvaluation issues that need to be evaluated. Later we will provide a more detailed example of both for illustration purposes.
Windstream Corp. (WIN)
Our first example reveals a telecommunications company that has experienced a lot of earnings pressure.
Windstream Corp. provides high-speed broadband Internet, phone service and Digital TV packages to residential customers as well as products and services for small, medium and large businesses, and government agencies. Windstream Corp. was formed from the spinoff of Alltel Corporation's landline business and merger with VALOR Communications Group, Inc.
As can be clearly seen from the following earnings and price correlated graphs, due to the challenges of its legacy wire line business, Windstream Corp. has experienced a steady erosion of its earnings. Consequently, we believe that the risk of a dividend cut is high, and therefore, investors should be cautioned not to be too enamored with its high yield.
As you review the performance of Windstream, there are two important concerns that need to be considered. First, note that as earnings have eroded, so has the principal value. Second, the current high payout ratio should serve as a red flag warning about the viability of its dividend long-term.
Health Care REIT Inc. (HCN)
Health Care REIT, Inc. is a real estate investment trust that has been at the forefront of senior living and health care real estate since the company was founded in 1970. Since REITs are primarily based on their ability to generate dividends, the reader should note that the following graphs represents a Funds From Operations (FFO) and price correlated graph instead of earnings and price.
Consequently, what we see here is a very stable REIT. However, history also shows that there hasn't been a lot of growth. But most importantly, the reader should notice that the company is currently trading at the highest valuation relative to Funds From Operations (FFO), its normal price to FFO, and its cash flow capability (the light purple line).
There is another good way to assess the current valuation of a REIT by evaluating its current dividend yield relative to historical norms. In other words, if Health Care REIT Inc. was trading at a more historically normal valuation, its current yield would be higher than the 5% it currently offers. All this suggests is that today's moderate overvaluation may limit both the total income and capital appreciation potential that the risk of owning this REIT would justify.
Moderate to Low Risk High Yield S&P 500 Constituents
Our second list of high yield S&P 500 constituents appear to offer their yields at lower levels of risk than our first list. However, the reader should be cautioned that it is only based on a prescreened review of the earnings and price correlation. Therefore, it is also possible that some of the companies on this list may also be of higher risk than many investors may be willing to accept. As always, a more comprehensive due diligence effort is suggested before any buy or sell decisions are made.
Lorillard Inc. (LO)
Lorillard is the third-largest cigarette manufacturer in the United States. And from the earnings and price correlated graphic below we discover that, like it or not, tobacco is a growth business. Consequently, it appears that Lorillard offers the conservative dividend growth investor the best of all possible worlds. Historically this company has generated above-average growth, an above-average yield and can be purchased at a sound valuation.
TECO Energy, Inc. (TE)
TECO Energy is a Tampa, Florida-based utility with a reasonably stable record of producing above-average yields and moderate growth for shareholders. Currently, the company appears to be trading at a historically sound valuation relative to its earnings power. However, the primary allure here is the above-average dividend yield.
Summary and Conclusions
Although the primary focus of this article was to review the highest yielding opportunities in the S&P 500, it provides a secondary illustration that it is a market of stocks and not a stock market. From the examples we reviewed, it should be clear that there are significant differences between the actual individual constituents of the S&P 500. Even though they all share membership in the same fraternity, each company is an individual in its own right. Moreover, even when they share similar attributes such as yields, etc., there can be great differences in the reliability and safety that these similar numbers represent.
The moral of the story, and the moral of this series, is simply to remind investors that it is more important to make the decisions based on the actual merits of the individual companies they own than it is on generalities. Not all common stocks are the same, and most importantly, not all stocks will generate the same returns, nor will their returns mirror the general stock market. We believe this builds a strong case against worrying about what the markets are going to do. Furthermore, predicting markets is difficult to impossible, while predicting the prospects of a given business is a much simpler and predictable task.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.