6 Undervalued Dividend Stocks With Great Upside Potential

by: Mark Bern, CFA

By Mark Bern, CPA CFA

How would you like an average dividend yield of 4.1 percent? How would you like those dividends coming from companies that have earnings growth averaging in the double digits? Now, how would you like it the average forward price-to-earnings (P/E) ratio was under 11? The six companies highlighted in this article fit those parameters.

According to T Rowe Price, dividend paying stocks have provided a higher total return than the broader market (11.6percent to 11.1 percent) since 1979. And the broader market return includes the dividend paying stocks. When dividend paying stocks are removed, the remaining stocks returned 10.7 percent. With more investors searching higher returns with less risk, dividend paying stocks are likely to grow in popularity relative to most non-dividend paying stocks. One of these companies pays a higher dividend than the yield on its own long-term bonds. Why buy the bonds in a low interest rate environment and little upside appreciation potential when you can earn more with the stock and have significantly more upside? I’ve asked plenty of questions already, so now let me provide a few answers about each company.

Royal Bank of Canada: RY.TO or RY is the largest bank in Canada and its dividend of $2.16 yields 4.2 percent on the current price of $50.96. The payout ratio is 57 percent and earnings are rising. RBC is in much better shape than it U.S. peers. Tier 1 capital ratio is 13.2 percent compared to the average of 11.1 percent for the top ten U.S. banks (after the U.S. banks have been recapitalized). RBC ‘s portfolio of uninsured mortgages has an average loan-to-value of 50 percent, giving the bank plenty of cushion in the case of a Canadian housing slump.

Microsoft: MSFT is perceived as yesterday’s darling causing the stock price to stagnate, but earnings have continued to increase bringing the P/E down to below nine times forward earnings. The company has had earnings per share (EPS) growth over the last decade similar to McDonald's (NYSE:MCD) but the perception that Apple (NASDAQ:AAPL) is the tech stock of tomorrow and MSFT is the tech stock of the past has investors passing on the stock. Cash and short-term investments of $57 billion and a payout ratio of around 25 percent imply continued growth in the dividend for me. After all, the dividend has grown every year since it was initiated in 2003 with a total increase to date of 900 percent. Further increases will help the stock price, in my opinion. One other thing that should help the stock is the launch of Windows 8 in October 2012. The P/E rose four notches in the year before the launches of Vista and Windows 7. A repeat could give investors nearly a 50 percent gain in the coming year.

Intel: INTC is one of my favorite stocks right now. The dividend yield is 3.5 percent, higher than the company’s bonds that yield less. Bond funds are actually buying the stock for the yield and potential appreciation because their managers consider the dividend as safe as the bond. They’re probably right. PC sales are actually thriving in emerging markets driving earnings growth of 25 percent in the third quarter of 2011. I expect the company to produce $11 billion in free cash flow in 2012; providing plenty of fodder for a dividend increase and more stock buybacks.

Johnson Controls: JCI is a company that is finally hitting on all cylinders. But the most promising segment of the company is its advanced batteries division with start/stop technology which shuts the engine off when idling to reduce fuel use. The technology is being used in micro-hybrid cars already available in Europe and scheduled for release is the U.S. in 2012. This is a very high margin business with very rapid growth potential. JCI pays a 2.3 percent dividend.

Enbridge Energy Partners: EEP operates as a master limited partnership (MLP) and currently yields 6.5 percent. The payment to unit holders is not considered a dividend; it is a distribution. The distribution is not entirely taxable since the payment is based upon cash flow and some of that cash flow is represents depreciation of assets and is not taxable. EEP’s main source of income is the crude oil that flows through its pipeline. The company gets paid based upon volume rather the price of oil. Much of the oil coming from the Bakken Shale in North Dakota and the oil sands in Alberta, Canada flow through EEP’s pipeline and the volumes from both those areas are expect to increase substantially over the next seven to ten years. The consensus, 12-month price target for EEP is $36 from the current price of $33.19. Add the distributions to the gain and you’ll come up with a 15 percent gain. I think that is on the low side of what total return should average for EEP over the next five years or so.

Lockheed Martin: LMT is in the defense contracting business which is facing expected cuts in U.S. government spending. However, LMT has sales of about $47 billion and an order backlog of $73 billion. That backlog should provide a significant cushion. Also, sales to foreign governments are on the rise as the U.S. is asking its allies to take on more responsibility for defense and world peacekeeping. The dividend is 4.9 percent and the company hasn’t cut its dividend since 2000. The forward P/E is 9.9.

As always, this list is intended as a starting place. Do some research on the any company that interests you to ensure that an investment suits your needs and goals.

Disclosure: I am long INTC.

About this article:

Author payment: Seeking Alpha pays for exclusive articles. Payment calculations are based on a combination of coverage area, popularity and quality.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here