5 Defensive Dividend Stocks That Average An 8% Yield

Includes: CTL, LNGG, MO, MRK, WMC
by: CorvetteKid

The U.S. economy seems to be doing better - Friday's non-farm payroll slowdown not withstanding - and the global economy still has lots of potholes: Portugal, Cyprus, Spain, and Italy in the eurozone; a slowing South American dynamo in Brazil; and questions regarding the sustainability of Chinese growth. The U.S. stock market has been among the best performing stock markets year-to-date, and the S&P 500 is revisiting all-time highs whereas European, Asian, and South American markets are miles away from setting new records.

Focusing on domestic-oriented and defensive companies that pay dividends makes sense. While commentators and studies purport to show that defensive and dividend-focused stocks are relatively expensive based on historical metrics, these studies make two important mistakes. First, the relatively rich valuations are based on the last 20 years or so during which most other sectors (including the overall S&P 500) sold at much richer P/E ratios. This is true even if we go back only 5-7 years, according to a recent Merrill Lynch study. It is not that traditional defensive sectors like utilities, telecom, consumer staples, and energy got more expensive - it is that the rest of the market, and specifically 10 mega-cap stocks within the S&P 500, got substantially cheaper. As the S&P 500 has cheapened since peaking in 2000, defensive sectors have looked richer on historical metrics.

Second, most investors buying the defensive sectors are not necessarily looking to beat or even match the S&P 500 or some other benchmark. Most are retail investors looking to beat 0.10% money market funds, 1% CDs, and 2% treasuries. If they can earn 5-7% in dividends in relatively safe, conservative stocks plus whatever capital appreciation from the underlying stocks, they're happy even if no- or low-dividend stocks are the better buy and outperform defensive sectors the next few years. As my uncle once told me, he's happy making 8% in stocks or bonds or whatever- even if the S&P 500 or riskier fixed-income investments promise more.

I think most retail investors would be happy with 8% a year in an environment in which everyone from Bill Gross to Jeremy Grantham to John Bogle are urging investors to set their sights way, way, lower. With that in mind, here are 5 dividend-paying stocks from 5 different industries, which have an average yield of just under 8%. Even if you throw out the 1 outlier the remaining 4 average a very healthy 5.5% yield:

Altria Group (NYSE:MO): Altria Group is the U.S. domestic tobacco holdings of the former Philip Morris (Philips Morris International is now all tobacco sales ex-U.S.). Altria Group is the leading cigarette seller in the United States and leading brands including Marlboro, Parliament, L&M, and Virginia Slims. Marlboro is the best-selling cigarette in the U.S. (and the world) and accounts for about 80% (42% market share) of Altria's 50% market share. While recent trends among younger smokers have been a bit weak relative to the entire smokers market (probably because of an increased preference for discount brands as young people are still hurting economically), it's nothing to worry about.

A bet on MO is a bet on a return to MO's 12-year winning streak of outperforming the S&P 500, which was broken in 2012. Long term, if you look at the trend of cigarette sales in the U.S. since the 1980's, you would think that any stock in the sector would be one to avoid like the plague. Instead, Philip Morris/Altria was one of the best-performing stocks of the last 30 years, thanks in part to stock buybacks and a lush dividend that currently yields 5.1%:

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With the purchase of U.S. Tobacco in 2008, Altria also became the leading smokeless provider with names like Copenhagen, Skoal, Red Seal, Husky, and Marlboro Snus. Leveraging the Altria distribution network, Altria got into cigars around the same time as smokeless, principally under the Black & Mild brand, and also manufacturers pipe tobacco. The company also has tiny legacy positions in a small wine producing unit and a capital leasing division.

Altria, Lorillard, and Reynolds American have all seen their P/E ratios rise to just below previous peaks. Previous peaks were associated with troubles for a richly-valued stock market and good risk-adjusted total returns for tobacco stocks. As we noted above, we think the relative valuation argument has less merit when you take into account the cheapening of the S&P 500's mega-caps:

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As long as state and federal excise taxes are under control and the litigation environment remains manageable, Altria should be able to navigate the annual 3% decline in cigarette consumption through a combination of price hikes, trade-ups, and cost-cutting. The ability of Altria and other companies to grow the e-cigarette business and add Next Generation Tobacco (NGT) products that offer 'safer' alternatives could expand the revenue pool significantly. The new FDA commissioner is giving a speech on how the FDA will look at the introduction of new products in coming days and this bears watching.

Linn Energy LLC (LINE): Linn Energy is an MLP, an independent oil and natural gas company involved in the development and acquisition of oil and gas properties in the United States. Linn combines the best aspects of the MLP structure with the growth aspects of an E&P. It is the 9th largest MLP and 10th largest E&P.

Linn Energy has interests in various properties located in California, Kansas, Michigan, North Dakota, New Mexico, Oklahoma and Texas. The company began operations in March 2003 and was formed as MLP in April 2005. Including recent and pending acquisitions, the company has proved reserves in excess of 6.8Tcfe (proved developed and 52% liquids).

LINE's primary objective is to provide stability and growth in cash distributions to unit holders. The company has done this by:

  • acquiring properties that increase cash available for distributions
  • building regional scale to maximize value and operating cash flows
  • growing through low risk, low cost development drilling and other enhancements
  • mitigating commodity price risk through an aggressive hedging strategy.

It was the hedging strategy that garnered some recent negative publicity but even if one disregarded the entire hedging strategy LINE covered its distribution in excess of 100%.

LINE is the largest upstream MLP and 18th largest oil and gas producer by reserves and is excelling at its two-pronged value creation strategy: the arbitrage of its yield-driven MLP valuation (high) with private market values for domestic properties (lower). Many MLPs are garnering valuations of 10-12x EBITDA whereas the same assets in traditional E&Ps or large oil companies languish at 4-5x EBITDA. There are plenty of properties being divested by E&Ps, major integrateds, other MLPs, and private companies. Linn's key assets are in the Permian Basin (West Texas and South-East New Mexico), the Mid-Continent (Texas Panhandle, Oklahoma, and Kansas), California, Michigan, and the recently acquired Williston Basin.

Raymond James as well as other sell-side firms see small but predictable growth in the distribution (dividend) for Linn:

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LINE investors receive a K-1, not a 1099, and future guestimates are that investors will get an 80% tax deferred return of capital on distributions. Linn recently created a C-corp security (LNCO) utilizing the MLP units and some creative jumbling of the tax code. In effect, retail investors can own Linn Energy in a 1099-dividend format instead of the MLP K-1 structure with all the paperwork and unsuitability for retirement accounts. While there is some "tax leakage" - LINE yields 7.6%, LNCO yields 7.1% -- the difference is minimal and the added simplicity of LNCO and the ability to hold it in your tax-deferred retirement account (IRA, Roth IRA, etc.) are major plusses.

The recent acquisition of California-based Berry Petroleum (BRY) not only added long-lived oily assets to Linn's resource base, but the acquisition of another C-corp business will narrow the tax leakage and dividend yield gap going forward. The $4.3 billion deal for BRY is a perfect fit for an E&P-oriented MLP: lots of long-lived reserves with steady production not needing much in the way of CAPX.

Here's a Seeking Alpha Bonus: If you buy BRY, the deal closes in June with each share of BRY exchanged into 1.25 shares of LNCO. So if you are willing to accept the small risk of the deal falling apart, you can grab LNCO at a 7% discount to the current share price. That's nothing to sneeze at!

CenturyLink (NYSE:CTL): Excuse me? Wasn't this the same stock I knocked only 2 months ago when it cut its dividend for the first time in some 40 years? Yes, but CTL now is trading at metrics more in line with the rest of the telecom industry, even taking into account the future cash taxes that CTL will be paying as NOL's expire in 2015-16. This makes the dividend yield of 6% very attractive.

CTL is the 3rd largest telephone company in the United States behind Verizon (NYSE:VZ) and AT&T (NYSE:T). Concentrated in the Rocky Mountain States from the legacy Qwest (U.S. West) acquisition and in the Southeast, CTL combines less-competitive rural properties with faster-growing populations and economically-growing sectors of the U.S.

The big drop in the stock price in February was actually not so much tied to the dividend cut (though it didn't help, for sure) but because of confusion regarding the company's business model. Investors and analysts feared that there was "something else going on" and that the company might have been using the cash taxes excuse to cover weakening business fundamentals. But the company's Q4 numbers were in-line or better-than-expected and guidance released since on cash taxes in the out years confirms that in order for CTL to maintain a ~60% payout ratio for the dividend, a cut was necessary -- though I still think an early-warning about a change in 2014 or 2015 would have lessened the damage to the stock.

Line losses continue to be marginal relative to AT&T and Verizon:

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CTL looks to be paying about $1 billion in cash taxes in 2015 and 2016, which is a doubling of its previous run-rate. With forecasted growth in revenue and EBITDA, the reduced payout combines with the higher cash taxes in 2015-16 to produce a payout ratio that should not eclipse 60%, which is CTL's redline. Without the dividend cut, the payout ratio would have approached 80% of free cash flow, which is where other troubled telecoms have found themselves. Give CTL credit for being consistent on the payout ratio, if not on the timing.

In recent conversations to analysts and investors, CTL management has vociferously downplayed the likelihood of any major M&A, which would be at cross-purposes to the sizeable stock buyback they announced when they cut the dividend. Using a stock currency that is depressed would not please investors. Management seems focused on stabilizing the legacy U.S. West landline business, growing the Savvis cloud sector, and only has cursory interest in acquisitions that would be immediately accretive to growing revenue, cash flow, or EBITDA.

CTL should return about 90% of cash flow in the next 2 years before the higher tax rates bite. The current dividend payout ratio of 45% is a sector-low. CTL has the largest national fiber network among the major carriers, providing operating scale and access to major multinational customers. The cloud enterprise division - the old Savvis - is doing well on its own and in cross-selling other CenturyLink products.

Concerns going forward for CTL are that unlike VZ and T the company has no wireless product of its own (CTL is a VZ Wireless reseller) and its Prism fiber optic play is lagging the offerings of U-Verse and FiOS. The pension and OPEB funding deficits are sizeable but not threatening. With debt/EBITDA comfortably under 3x, total fixed obligations are not a problem. If revenue and EBITDA both start to grow in 2014, CTL will be able to reduce leverage, contribute to the pension plan, initiate regular buybacks and possibly start another 40-year run of dividend increases.

Western Asset Mortgage Capital Corp. (NYSE:WMC): Western Asset Mortgage is a mortgage REIT that came public in 2012. WMC is managed by veteran fixed-income powerhouse Western Asset Management (a division of Legg Mason) who have been managing mortgage-backed securities (MBS) since 1971. WAM has some of the best MBS traders in the business. With no legacy MBS positions prior to 2012 and with a relatively small portfolio compared to behemoths like Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC), WMC has been able to employ a nimble trading strategy not unlike that utilized by AGNC when it was younger and smaller. With the Federal Reserve initiating QE3 and buying up to $85 billion in mortgages monthly, this flexibility is essential to preserving net income and dividends for any MREIT.

WMC employs among the highest leverage in the sector, recently peaking at 9.4x in early-2013, though in recent weeks it was more in the mid-8's where management feels a bit more comfortable. The higher leverage allowed the total portfolio yield to increase 6 bp in Q4 2012 despite QE3, to 2.86%. Book value at year-end was $21.67, down 0.5%. Hedged NIM approached the Q2 2012 level pre-QE3:

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WMC paid a $0.95 Q4 2012 dividend and has been among the highest-leveraged, highest-NIM, highest-yielding of the agency MREITs. Normally, the most aggressive yield play in a sector is not how I prefer to play the sector. But Western Asset Management's trading prowess, history with mortgage-backed securities, and the difficult environment that MBS and MREIT investors will continue to face with the Fed buying $85 billion in MBS monthly - until the day they ease off the gas - means you want a portfolio management team with dexterity and maneuverability. An investment in WMC gives you those qualities. Not to mention a jaw-dropping dividend yield of 16% at the most recent quarterly-run rate.

An interesting penumbra surrounding WMC is whether it should be considered an agency or hybrid MREIT. The most recent portfolio holdings revealed a 95% agency, 5% non-agency split. Normally MREIT investors would consider any token agency amount over 1-2% to be indicative of a hybrid MREIT. However, WMC indicated that the non-agency MBS were not purchased purely for investment yield but for interest rate hedging purposes. By purchasing certain credit-sensitive products such as IOs and CMOs, an MREIT can sometimes hedge rate increases more effectively and cheaply than by purchasing swaps, swaptions, or other derivative securities. For now, I am still considering WMC an agency MREIT - with an asterisk next to it. Sell-side analysts I have spoken to say that any position over 10% would certainly move it into the hybrid category in their minds.

The good news is that if WMC is intent on following the AGNC business model, they will be looking to grow the capital base of the MREIT by doing secondary stock offerings to increase share liquidity, grow the portfolio, and increase the market cap (and WAM fees, too). Expect a few more offerings in 2013 as WMC looks to get over the critical $1 billion market cap threshold after which expenses are no longer a huge percentage of the cost structure and net income. You want to buy these secondary offerings when the stock should cheapen.

Mortgage REITs employ much higher leverage and are tied to developments in the financial markets (i.e., REPO markets) so if you decide to tie up a larger percentage of your portfolio in WMC, consider buying a basket of the MREITs as I have detailed before on this site.

Merck (NYSE:MRK): One of the largest of the global pharmaceutical companies, MRK's focus the next few years is going to be domestic. Buying Merck now is definitely a contrarian call, as other drug companies appear to have deeper pipelines and Merck continues to suffer missteps and potholes. Most recently, their longtime R&D director left after an uninspiring decade in that spot. The merger with Schering-Plough has been underwhelming, with the key drug in the acquisition - the TRA (thrombin receptor antagonist) Vorapaxar - suffering a major failure in 2011 studies; if ever approved it will be with a much narrower label for use and much smaller revenue opportunity. A few months ago the niacin-based Tredaptive (cholesterol/heart disease) failed in a major study and was yanked. Other drugs have suffered FDA or pipeline setbacks and no doubt that explained the change of R&D directors.

Merck is not without positive attributes. The company's flagship Vytorin was deemed not to have caused any negative effects in a large multi-year ongoing study which means the study continues until 2014 (it may still turn out to be a negative for Vytorin's effectiveness compared to generics but it can still turn out positive). Merck has a sterling balance sheet with cash and investments basically equal to debt; in addition, the company has a AA-credit rating. Merck's long-term bonds trade at about 3.75%, which is less than the stock is yielding at 3.80%. When an investment-grade company's stock yields more than the company's bonds, that's a sign of financial strength and dividend-boosting capacity. The dividend is at the historical payout ratio level since 1990 of about 50% of earnings/cash flow, and it could be boosted from further cost-cutting or any product upside.

The pipeline has promise, but plenty of pitfalls and obstacles to overcome. MK-3475 is in early stage testing for melanoma; Phase 1 results/tests should be released by June. Suvorexnat (insomnia) is up for FDA approval by mid-year, too. Odanacatib (osteoporosis) is awaiting a 2014 study on its effectiveness and safety profile. It's possible that Merck could engage in M&A to bolster the pipeline, but the stock as a currency would be expensive and dilutive to utilize. After getting singed on the flagship drug for Schering-Plough going belly-up, Merck senior management may not have an appetite for anything other than tuck-in acquisitions.

A real game-changer could be if the next-generation CETP inhibitor anacetrapib were to continue to make progress in the deliberate slow testing that it is currently undergoing. Right now visibility is limited: the next trial data release is not scheduled until late-2014. Recall that anacetrapib is supposed to lower "bad" LDL cholesterol and raise 'good' HDL cholesterol. There is still debate over whether or not raising HDL is important in preventing cardiovascular disease and events, but even Cleveland Clinic's Steve Nissin, a critic of early CETP compounds and a statin-naysayer, has said that a safe drug that lowered LDL and raised HDL would be of great benefit in treating heart and cardiovascular problems.

Both Pfizer's torcetrapib and Roche's dalcetrapib got KO'd in Phase III: the former on safety concerns, the latter on lack of efficacy. It could be late-2015 before the final Phase III tests are completed and could take until 2017 before Merck's compound gets final marketing and commercial approval. But if anacetrapib crosses the finish line where the other CETP drugs did not, it could be a $5 billion drug right out of the gate within a few years. Such a blockbuster would be worth $1 or more in EPS to Merck, and probably add $15-$20 a share to the stock price.

The drug sector has been exhibiting its defensive tendencies in recent quarters. Sentiment on Merck, however, has lagged the group. There aren't that many unexplored contrarian plays but Merck is definitely one, selling at a fraction of previous P/B and P/E multiples and still less than half its 2000 all-time high stock price.

If you noted a pattern in these 5 defensive domestic-oriented stocks, you're right. Each stock is also a representative of a group - Consumer Staples, Energy, Telecom, REITs, and Healthcare - that can also be part of a basket of stocks from that sector for larger allocations. If you want more exposure to each sector, then I believe it is prudent to have more than just the names above. However, for a properly diversified portfolio I believe there is sufficient diversification benefits from these 5 defensive stocks that only in strongly "risk-off" times would their correlations increase to where they all went down substantially without having their yields "brake" their declines.

In terms of acting today, I believe the purchase of LNCO via BRY is most compelling, followed by CTL (still building a base after the dividend cut). MO would be my 3rd cheapest, followed by MRK, and I would move last/smallest on WMC (unless it does a secondary). So while you can buy all 5 today, I would save some dry powder to buy the more expensive names a bit lower in price. Of course, you can say that about a lot of stocks in the market and the right move since last November has been to swallow hard and hit the BUY button.

The good thing is whether you buy it all at once or in stages, you have great defensive stocks with above-average market yields. As Otis from the Superman movies would say, "what more could anyone ask?"

Disclosure: I am long MO, LINE, CTL, WMC, MRK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. The author has existing positions in the above stocks in his managed online portfolios and may hold duplicate positions in personal or other accounts under his control.

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