We might be heading back to a "risk on" trading market, depending on what the Federal Open Market Committee (FOMC) and the Bernanke "brain-trust" announces on September 21st.
This may lead to high-risk betting on "high-roller" stocks that have already benefited nicely from last week's rally.
If there is one lesson we have all repeatedly learned in the past 8 years and that's "buy low, buy quality and sell when everyone's extremely bullish". We've also learned that the stock market isn't always a rational valuation mechanism.
Right now I'm mainly interested in buying opportunities that appear to be overlooked and undervalued. I'm also interested in a decent dividend stream, because stocks with a consistently generous track record of paying dividends seems to less risky.
A couple of years ago, right after the March 2009 lows, the folks at Charles Schwab did a study on why investing in companies that pay dividends and also have an above average ROE (return-on-equity) was safer and less volatile (see here).
Their conclusions seem very congruous considering today's financial conditions:
We examined several factors, including payout ratio (the fraction of net income a firm pays in stock dividends), level and change in the debt-to-equity ratio (leverage), return on equity (ROE), and five-year historical sales growth.
We found that one of the more promising factors was ROE, which reveals how much profit a company has earned compared to shareholder equity found on the balance sheet.
A firm with high ROE is more likely to be able to generate income in excess of expenses and, thus, support its dividend.
To examine ROE’s ability to predict future dividend changes, we calculated each dividend-paying stock’s trailing 12-month ROE at the end of each month from 1990 to the present.
We also calculated each stock’s subsequent 12-month change in dividends at the end of each month, and used this change number to split our dividend-paying universe into three groups: those that cut dividends, those that raised them and stocks with no change.
Next, we examined the success of ROE in identifying safer dividend payers. We found that stocks in the lowest 20% of ROE were twice as likely, on average, to cut dividends as the other 80% over the subsequent 12 months, as you can see in the chart below.
We also discovered that stocks with higher ROEs experienced a greater number of dividend increases over time. Stocks in the top 20% of ROE increased dividends, on average, more than 60% of the time during the subsequent 12 months, as you can see in the chart below. So historically, investors could have minimized their risk of experiencing a dividend cut by focusing on dividend payers with higher ROE.
As an added benefit, our research also showed that companies with strong ROE saw improved returns within a dividend-paying universe. As you can see below, the top 40% of stocks (ranked by ROE) outperformed the dividend-paying universe on a 12-month average by up to 0.80%.
So, based on this research, we found that choosing stocks with higher ROEs among dividend-paying stocks provided investors two benefits historically—more reliable dividends and stocks that are more likely to outperform.
This is as relevant today as it was at the very bottom of the market two years ago!
With that in mind, let me cut to the chase by pointing out four companies that mostly fit into this category and have a "risk-reward" outlook that greatly favors more careful investors.
Let's start with a company that at the moment is mired in some deep labor issues. Freeport McMoRan Copper & Gold (NYSE:FCX) has yet another messy strike situation at its huge Grasberg copper and gold mine in Indonesia.
This may cut output by 230,000 tons of ore per day, according to an estimate from the government, which is trying to broker a resolution.
Nobody knows how long this strike will last but it has happened before and it hurts everyone involved. Once it is resolved FCX will make up for lost time and begin to make truckloads of money for its shareholders.
FCX is selling for less than 7 times next year's earnings. It's PEG ratio (5 year expected) is at an extremely low 0.48, it's ROE is soaring at over 48%, and it pays a delightful 2.4%.
When it comes to FCX I could go on and on. Its recent quarterly earnings growth (year-over-year) has more than doubled (up 104%). It's sitting on levered free cash flow (ttm) of $4.9 billion and operating cash flow (ttm) is a jaw-dropping $7.43 billion.
In the most recent quarter it had a total-cash-per-share number of $4.62, which is 4.6 times its current annual dividend. When the labor issues are resolved and the if the prices of copper and gold just stay where they are on average, this stock could rise 30% in 6 months.
How about the stocks that make up the Dow Jones Industrial Average?Jim Cramer may be correct, Alcoa Corp. (NYSE:AA) may be the most undervalued ["cheapest"] of the Dow 30 stocks today.
Alcoa produces primary aluminum, fabricated aluminum, and alumina, and participates in mining, refining, smelting, fabricating, and recycling. The Company serves customers worldwide primarily in the transportation, packaging, building, and industrial markets with both fabricated and finished products.
Trading at less than 9 times forward earnings, all one has to do is look at the following ratios to get a feel for AA as a value stock: PEG ratio of 0.29, Price/Sales (ttm) at 0.54, and Price/Book (most recent quarter) at 0.82.
Alcoa has a book value of $14.66 and the stock closed on Friday Sept 16th at $11.97. It also pays a 1% dividend. One concern is that it has more debt than I'm comfortable with ($9.35 billion).
On the bright side it has grown its quarterly earnings (year-over-year) by an impressive 137% and is sitting on a nice bundle of cash ($1.27 billion). It's ROE isn't very impressive (6.55%) but it quarterly revenue growth (y-o-y) is up 27%.
Another reason to consider owning some AA is that the Wall Street Insiders are wanting it to rally to help push up the Dow Jones Industrial Average, and if we bought some below $12 it wouldn't take much of a move up to see a 25% profit.
The 52-week low for AA is $10.99 and the 52-week high is $18.47. We may be very close to a nice buying set-up for the kind of 6 month return that makes it worth the risk.
One of the most respected and responsible companies out there reports earnings next week, and its stock looks "tempting" at just 10 times next year's earnings. I'm speaking of FedEx (NYSE:FDX), which closed Friday not that far from it's 52-week low of $71.33.
FDX looks reasonably priced considering it's respectable 10% ROE, quarterly earnings growth of 33%, low debt (less than $1.7 billion) and operating cash flow of over $4 billion (ttm).
A seldom considered but important metric is "Revenue per share (ttm)" and FDX has an impressive $125 per share of revenue. It's Total Cash Per Share (most recent quarter) is a comforting $7.32.
Even with fuel costs as high as they currently are, FDX can continue to earn healthy profits going forward, and if fuel costs subside 5% or more the earnings growth goes right to the bottom line. Take a look at this chart of FDX and notice its 50 day and 200 day moving averages:
This looks like a chart of a great company that is about to catch up with at least its 200-day moving average. If the FOMC and the situation in Europe, (what Cramer calls the "Geithner Effect") continues to encourage and sprinkle hope, FDX may pop sooner than later.
I may buy a little before the earnings report and buy more if the report and the " conference call" brings some surprises, either good or bad.
Pfizer (NYSE:PFE) is a stock and a company for people who want to be "defensive" and earn a very handsome dividend (4.3%) while they wait for the market-movers of PFE to work their magic.
Investing in the world's largest research based pharmaceutical company may be a good idea right now. Study its website, especially its "news and media" page which will show you what the company is up to.
Pfizer's "Product Pipeline" speaks for itself and should be looked at carefully. It's readily available here.
Pfizer's ROE is almost as good as FDX at 10%, and its efforts to buy Icagen (NASDAQ:ICGN), which it already owns 70% of, is yet another way for it to generate more revenue growth, an area where it could stand some improvement in.
Trading at less than 8 times next year's earnings PFE looks "good enough to me" and that's why I bought some last week. I recommend you buy it at $18 or lower, and that you study it's own reported plans to increase shareholder value. Here's its year long chart:
The buying set-up here is that if the stock markets rally on good news next week and the "risk on" trade gets hot again, PFE stock price may again fall towards $17 or lower. Then we can buy it at an even better yield-to-price and at a lower PE ratio.
Remember this about charts: They only tell us where a stock's price has been and at what points the buying or selling volume accelerates. They don't tell us where a stock's price is going, but they might indicate when it is historically undervalued.
These are the kind of value-based stock set-ups on companies with decent ROEs and shareholder-friendly boards that just may add some "growth-with-income" to our portfolios and our total return in the months ahead.