While stocks might look risky in the short-term, they offer the highest yield in the long-run, says Prof. Jeremy Siegel, of the University of Pennsylvania, Wharton School of Business. In his book Stocks for the Long-Run, Siegel suggests that stocks offer more stable real returns than bonds in the long run, thanks to the mean reversion effect:
Remarkable stability of long-term real returns is a characteristic of mean reversion, a property of a variable to offset its short-term fluctuations so as to produce far more stable long-term returns.
His book also offers many different ways for choosing the best stocks for the cheapest price. One of the interesting methods suggested uses a combination of three metrics:
A rule of thumb for stock valuation that is found on Wall Street is to calculate the sum of the growth rate of a stock's earnings plus its dividend yield and divide by its P-E ratio. The higher the ratio the better, and the famed money manager Peter Lynch recommends investors go for stocks with a ratio of two or higher, avoiding stocks with a ratio of one or less.
- Dividend Yield: Higher is better.
- EPS Growth: Higher is better.
- P/E Ratio: Lower is better.
Here is the simple, yet powerful, formula, used by Wall Street investors:
O-Metrix = (Dividend Yield + EPS Growth) / (P/E Ratio)
As shown here, the back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as 5 years. Since 2006, companies with A+ O-Metrix scores such as Petrobrasil (NYSE:PBR) and Vale (NYSE:VALE) returned an average of 16.92% whereas those with Sub-F grades such as General Electric (NYSE:GE) had negative returns. Thus, higher O-Metrix scores resulted in significantly better returns. I regularly back-test this technique on different sectors, and so far the results are promisingly positive. I will perform sector-by-sector analysis to see the predictive power of O-Metrix in these specific sectors. Meanwhile, here is a list of 7 diversified dividend stocks that I expect to beat the market returns within the next 5 years: (data from finviz/morningstar, and is current as of Friday's close)
1) Intel (INTC), the glorious winner of the microchip battle, is among the best dividend picks for the next 5 years. Intel's primary business is semiconductor and microchip production, but the company also has a large investment portfolio in high-tech stocks, as well as a venture capital business. Intel's current yield of 3.87% is one of the best among blue chip companies. The stock is trading with a funky low P/E ratio of 10.11, and even lower forward P/E ratio of 9.05. Analysts estimate a 5-year EPS growth of 11.13%, which is pretty reasonable. Based on these parameters, Intel has an O-Metrix score of 8. I think, the recent pullback provides a good opportunity to buy more shares. There is an extremely strong support at the $20-$21 range, so I doubt it will fall below $20. You can find full analysis, here.
2) AT&T (T), has an interesting story of breakups and mergers. If approved, the latest acquisition of T-Mobile (OTCQX:DTEGY) will make AT&T the largest carrier in U.S. by leaps and bounds. That was a really bold move that will give AT&T almost monopoly status in many states. When we look at the results of merger between Cingular [SBC] and AT&T, the benefits are easy to see in the income statement, as well as the stock returns. Currently, the stocks trade with a P/E ratio of 9.07 and offer a yield of 5.61%. Analysts estimate an EPS growth of 6% for the next 5 years. However, given the exponentially increasing demand for data services, I expect at least 10% annualized EPS growth from AT&T. With an O-Metrix score of 7.8, AT&T is another dividend pick for the next 5 years.
3) Coca-Cola (KO), a long time Warren Buffett favorite, is the world's largest and most famous soft-drink company. Although Coca-Cola is an American symbol, the company has a significant number of operation centers all around the world. It is the firm's policy to enhance its global position through local alliances. Coca-Cola has more than 500 brands, globally. The company's annual dividend yield is 2.87%. Coca-Cola is a very profitable company. It has strong presence in emerging markets. Even if the company makes no profit, the existing current account surplus is enough to keep the current dividends for at least five years. Based on an EPS growth estimate of 8.93%, and trailing twelve month P/E ratio of 12.68, KO has an O-Metrix score of 5. Not as a high as others on the top list, but current P/E ratio is well-below historical 15-20 range. You can find a full analysis, here.
4) McDonald's (MCD) is the largest and most famous fast-food restaurant chain in the world. McDonald's' golden arches are synonymous with American style hamburgers and fries. Lately, with the awareness of health and weight issues, McDonald's started adding healthier products to their menu as well. The only serious competitor is Burger King [privately held], which is not as global as McDonald's. As of the last close, McDonald's is trading with a trailing P/E ratio of 17.03, and forward ratio of 14.46. Analysts estimate an EPS growth of 10% for the next 5 years. However, given the past 5 year EPS growth of 18%, in my opinion, an annualized EPS growth estimate of 14% is more reasonable for the next 5 years. Current dividend yield is 3.03%. Based on these parameters, McDonald's has an O-Metrix score of 5.5, which is above the S&P 500 (SPY) score of 4.5.
5) Chevron (CVX), the little brother of Exxon (NYSE:XOM), is one of the best dividend payers in the energy business. Chevron shareholders enjoyed the highest dividend payout so far of $2.88 per share in 2010, while the lowest dividend payment of $0.35 occurred in 2001. Thus, dividends increased 8-fold in the last 10 years. It is obvious that Chevron is a shareholder friendly company, and that dividends have not declined since 2001. Its gross margin of 32.77% and operating margin of 14.20% is higher than the industry average. The quarterly revenue growth of 25% also exceeded the industry average. The trailing P/E ratio of 9.81 falls to 7.81 for the next year. The stock is trading 15% below the average analyst estimate of $115. Analysts have very diversified opinions on Chevron. While the maximum estimate for next year's growth rate is 25%, the minimum is as low as -32%. In my opinion, given the above-industry profit margins, Chevron will experience an EPS growth of 7% to 8% in the next 5 years. Based on these parameters, Chevron has an O-Metrix score of 6.
6) Wal-Mart (WMT), is the largest retailer in the U.S. terms of revenues, profitability as well as number of customers. The company operates in three segments: Wal-Mart U.S., Wal-Mart International, and Sam's Club. The company made $15.48 billion of net profits in the last four quarters. While Wal-Mart's profit margin of 3.78% might seem like a very thin number, it is one of the highest in the retail industry. Wal-Mart's business model efficiently utilizes the returns to scale, offering significant cost reduction on input prices. The stock trades with a low P/E ratio of 12.48, and even lower forward P/E ratio of 10.93. With a current yield of 2.72%, and EPS growth estimate of 9.74%, Wal-Mart has an O-Metrix score of 5.5.
7) Microsoft (MSFT), the sin-stock of the techno bubble, is one of the most profitable companies in the world, yet the stock is among the cheapest in the high-tech industry. I was expecting that Microsoft would beat analyst estimates. EPS of 61 cents per share indeed beat the Zacks Consensus Estimate of 56 cents, and revenues of $16.43 billion beat the $16.19 billion estimates. What was not expected was the market's reaction. Since the earnings release, the stock is just going down. The share prices are back to their September levels. The ttm P/E ratio is 9.49, whereas the forward P/E falls to 8.63. I think at some point, sooner or later, the shares will reach double digit P/E ratios around mid-teens. In any case, with a current yield of 2.68%, and EPS growth estimate of 10.82%, Microsoft has an O-Metrix score of 7.5. Microsoft is a deeply undervalued company, but you need to be patient with the stock performance. Patience is the virtue when it comes to Microsoft.
Disclosure: I am long MSFT, INTC.