Retirees: Beware Of High Dividends

Includes: MSFT, T
by: Bill Gunderson

Big fat dividend yields or high coupons on bonds are very, very tempting.

Investors must remember that investing is all about total return, not just current yield.

In most cases, it is better to have a smaller dividend yield along with capital appreciation.

I see a lot of retirees chasing big yields with little regard to their principle. Investing is about total return. Total return is dividends plus capital appreciation. The vast majority of returns in the stock market come from capital appreciation.

This is my strategy for picking stocks that I think can deliver alpha going forward.

I like stocks that still make sense from a value proposition, but they must also exhibit strong relative strength. This is a very rare combination that narrows down my universe considerably.

I call it Best Stocks Now. It does not matter if it is a Mega-Cap, Small-Cap, Micro-Cap or dividend paying stock, they must have both value and momentum at the same time

Now for my current analysis on a stock that I own in one of the four stock portfolios that I professionally manage. I currently own Microsoft (MSFT) in my Dividend & Growth portfolio.

Microsoft reported stellar earnings this past quarter, they beat on both the top and bottom lines. Their top line revenue growth came in 14% higher than the same comparable quarter last year, and their earnings growth was a very good 20% higher.

The company earned $3.88 per share last year, and if they meet their number this year ($4.59), they are looking at an annual increase of 18.0% in earnings. Not bad for a $1.06 trillion market cap company.

The consensus estimate for next year currently stands at $5.11 per share which would be growth of another 11% vs. next year.

Over the last five years, the company has had an average annual earnings growth of 13% per year and the consensus average annual estimate over the next five years is currently 12.4%. Microsoft is one of the best dividend & growth stocks in the market today.

The company develops operating systems, business software, applications for servers, PCs, and intelligent devices. Its market capitalization is currently $1.06 trillion, and it is trading at a PE ratio of 30.44.

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Back in my days as a research analyst, I learned to do 5-year target prices. After all, analysts project 5-year growth estimates, why not match them with comparable target prices?

When I extrapolate Microsoft’s current earnings estimates at their 5-year growth estimate, I come up with potential earnings of $8.03 five years from now.

I then apply a multiple that is based on the company’s growth rate and their PE history. I come up with a five-year target price of $230 per share. The stock is currently trading at $137.78 per share.

In addition to this, the stock has a current dividend yield of 1.34%. This gives the stock 73.3% total return upside potential over the next five years.

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I can already hear it. Why would you buy a growth and income stock with a paltry 1.3% dividend yield when AT&T (NYSE:T) is paying a much fatter yield of 6.3%? More on that argument in a moment.

But let’s first look at the momentum side of the Microsoft equation:

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As you can see from the above screenshot, the stock has delivered a lot of alpha over the years. It has handily beat the market over the last one, three, five, and ten years.

In fact, the stock has lapped the market three times over the last three years.

Microsoft earns a long-term performance grade of A. This is one of the best-performing total return stocks in the entire market.

The stock also currently sports a momentum grade of A+ in my proprietary grading system, I grade on the curve.

The stock also currently meets my momentum requirements.

When valuation and momentum come together, Microsoft checks win with a proprietary grade of A (Strong Buy). It is also ranked at number 67 out of 5,145 members of my database.

Microsoft has been a top-ranked stock in my database for a long time.

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Now let’s address the bigger yield in AT&T argument. AT&T’s earnings have only been growing by 7% per year over the last five years. But worse than that, the analyst consensus average annual growth rate over the next five years is a paltry 4.5%.

One of the most important facts to remember about stocks and the market in general is that stocks and indexes follow earnings.

I recently wrote an article about this subject. The main reason that the market has been going up for the last ten years is that the earnings of the S&P 500 have been going up over the last ten years.

The future direction of the market is also dependent upon earnings.

Now, let’s look at AT&T’s history of total returns over the years.

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Mediocre at best! The stock has severely underperformed the market over the last one, three, five, and ten years even with the hefty dividend yield.

In fact, over the last three years, the stock has delivered a total return of -0.9%.

I don’t want to hear the argument: “I still received my dividend!”

So what?

Your total nest egg dwindled over the last three years.

Once again, it is all about total return. You do not want to deplete your nest egg in your retirement years, you want to get your income and do your best to keep your nest egg growing. This is where earnings growth enters into the equation.

I would rather have a dividend payer that is growing its earnings as opposed to one that is just growing its dividend.

Microsoft is just just that. AT&T is not.

I also like to end my articles with a big dose of reality. Microsoft was down 44.8% in 2008. It will sell off along with most other stocks when the next recession and bear market eventually hits.

I do not want to have too much exposure to stocks when that event occurs. You have to have an emergency preparedness plan.

Microsoft is also a tech stock that could fall out of favor very quickly. Analysts’ estimates are just that - estimates. But, in the meantime, stocks trade on earnings and earnings estimates.

One other caveat, I like to own about 20-25 stocks in each of the portfolios that I manage. Over my 22 years in the business, I have found this to be about the right number of stocks.

I liken my portfolios to the baseball all-star game. I want to have the best 25 players that I can find on my team always.

For those with a conservative Income & Growth risk profile seeking alpha, Microsoft might be a nice fit.

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Disclosure: I am/we are long MSFT. 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.