While sell-side analysts (the ones making 12-month price target based buy/sell/hold recs) are often wrong, from time to time they can serve as a source of good long-term investing ideas.
On Monday, August 19th, Goldman chief U.S. equity strategist David Kostin wrote a note recommending 10 high-yield stocks.
Let's take a look at his reasoning, and more importantly, I'll walk you through how to tell which of these companies are actually potentially attractive buys right now.
Why Goldman Thinks Now Is A Great Time To Buy These 10 High-Yield Stocks
I actually find such analyst listicles useful because they can put a company on my radar, and if further due diligence indicates it's a quality dividend stock, I'll add it to the Dividend Kings' Master Valuation/Total Return Potential List.
- AT&T (T)
- Kohl's (KSS)
- Archer-Daniels-Midland (ADM)
- Valero Energy (VLO)
- Citizens Financial Group (CFG)
- AbbVie (ABBV)
- Eaton (ETN)
- Seagate Technology (STX)
- Simon Property Group (SPG)
- Evergy (EVRG)
Some of these companies I've never heard of, which means an exciting opportunity for discovery and research into potentially attractive high-yield opportunities.
But first let's take a look at Mr. Kostin's reasoning to make sure that it's reasonable and prudent (at least for conservative income investors). Goldman is bullish on high-yield stocks in general, and these 10 in particular, for two main reasons.
"With the 10-year Treasury yield at just 1.5% and the Fed likely to cut two more times this year, investors should look for opportunities in dividend stocks." - Goldman Sachs' David Kostin
The simplistic and dangerous "high-yield dividend stocks = bond alternative" idea is based on the "there is no alternative" or TINA/rate cut euphoria rally notion. If the Fed is really going to cut rates aggressively, then stocks, in general, are not likely to go up over the next year or so, because it could indicate a recession is approaching.
If stocks really were like bonds (other than generating income the two are nothing alike), then stock returns would be highest during recessions, when interest rates are their lowest. In reality, during the average recession, stocks on average decline 26% over 11 months (excluding the Great Recession and tech bubble crash).
On the other hand, Goldman's other reason for buying high-yield stocks today is 100% correct and based on irrefutable and fundamental logic.
With high-yield stocks now at their most undervalued levels relative to lower-yielding stocks in 40 years, it might indeed be time to go bargain hunting. After all, the best long-term returns are precisely achieved at times of valuation extremes such as this.
BUT, as I said in the intro, such analyst notes are merely a starting point for further research. So let me walk you through my approach, which is based on the Dividend Kings mantra of "quality first, valuation second, and proper risk management always."
Here Are The 6 Names Actually Worth Buying Today
Step one in finding a potentially good investment for your hard-earned money is to confirm a company is high enough quality to avoid purchasing a value/yield trap.
"Cheap" stocks are cheap for a reason, often because the business model is in decline, and thus cash flow is falling, putting the dividend at risk. I have zero interest in "reaching for yield" no matter how low-interest rates may or may not fall.
Remember you're not buying a ticker on a screen but a partial stake in a real company that generates real cash flow from which to pay hopefully generous, safe and exponentially growing dividends.
After researching a company, I boil down its quality into a single number, based on my three-factor quality score.
- dividend safety (based on cash flow stability, payout ratio, balance sheet, and dividend growth track record)
- business model: how high is disruption risk? Can the company continue generating positive returns on invested capital over time (in other words, does it have a moat?), does it have a realistic potential to keep growing at its historical rate?
- corporate culture/management quality: is it run by conservative and prudent capital allocators, who take a long-term view and prioritize safe and steady dividends over time (as opposed to dangerous empire builders and idiots who light shareholder money on fire like it's going out of style?)
The quality score is a scale of 3 to 11, and here's what it means
- 6 or less: too risky, below average or poor quality company, dividend unsafe, the payout isn't likely to survive a recession, the company may go under (even without a recession)
- 7: average quality company (about 2% recession dividend cut risk)
- 8: above average quality
- 9: blue-chip quality (average dividend aristocrat/king is 9.6)
- 10: Sleep Well At Night or SWAN stock (above average blue-chip)
- 11: Super SWAN, as close to a perfect dividend stock as exists on Wall Street (just 44 such companies exist that I know of)
The quality of a company determines when it's a good, strong and very strong buy, at least in my book. Any company is a "reasonable buy" at fair value or better. But to really get excited about a stock, I need to see a margin of safety commensurate with the quality of a business and its risk profile.
Dividend Sensei Quality-Based Valuation Classifications
|Quality Score||Example||What It Means||Good Buy At||Strong Buy At||Very Strong Buy At|
|7||AT&T (T)||Average quality (factoring in all quality metrics)||20% discount to fair value||30% discount||40% discount|
|8||AbbVie (ABBV)||Above-average quality||15% discount to fair value||25% discount||35% discount|
|9||Walgreens (WBA)||Blue Chip quality||10% discount to fair value||20% discount||30% discount|
|10||Caterpillar (CAT)||SWAN (above average blue-chip)||5% discount to fair value||15% discount||25% discount|
|11||Texas Instruments (TXN)||Super SWAN (as close to perfect dividend stock as exists on Wall Street)||fair value||10% discount||20% discount|
So let's take a look at the 10 high-yield stocks Goldman is recommending to see how they measure up.
|Company||Sector||Yield||Dividend Safety (5 point scale)||Business Model (3 point scale)||Management Quality (3 point scale)||Total Quality Score|
(Sources: Goldman Sachs, Dividend Kings' Master Valuation/Total Return Potential List)
Overall it's a relatively good list of high-yield stocks. It includes
- three dividend aristocrats (ADM, T, and ABBV)
- one Super SWAN (SPG)
The average quality score is 8.3, meaning above-average dividend safety during recessions (less than 2% risk of a payout cut). KSS and STX, due to very weak business fundamentals, don't make my level 7/11 or higher cut off and thus I can't recommend them.
But a generous, safe and steadily growing yield is just the first hurdle to clear. Remember my motto "quality first, valuation second, and proper risk management always."
So next we need to check to see whether or not these companies are trading near or below their fair values. The approach I use is inspired by my fellow Dividend King (and F.A.S.T Graphs founder) Chuck Carnevale, who has 50 years of experience in asset management.
He, in turn, has based his approach on the work of Benjamin Graham, the father of value investing, Buffett's mentor and one of the best investors in history.
The overall approach is based on Graham's pointing out that in the short term stocks can be hilariously/frustratingly/opportunistically mispriced. But over the long term, the market almost always correctly "weighs the substance of a company."
In other words, as long as the fundamentals are relatively stable, and cash flow, earnings, and dividends are growing at approximately the same rate as in the past, a company will eventually revert back to historical multiples.
This is backed up by the historical data from Investment Quality Trends (beating the market with nothing but dividend yield theory since 1962 on blue-chip stocks).
It's also been relatively accurate since 1954 when the Gordon Dividend Growth Model determined that over the long term total returns are a function of yield + long-term cash flow/earnings growth (which dividends track), and valuation changes cancel out.
Now it's important to remember the assumptions of these models, which all the Dividend Kings, as well as Brookfield Asset Management, have used for years or decades.
A company whose cash flow growth potential decreases will NOT mean revert to historical norms generated by faster growth periods. Dividend aristocrat Cardinal Health (CAH) is a good example, enjoying double-digit growth during its recent golden age but now likely to grow at 3% to 5% over the long term.
Assuming CAH will revert to valuation multiples of the fast growth era is not realistic, and thus you need to use a slower growth time frame. Apple (AAPL) is another example. Right now the analyst consensus backed up by its fundamentals is for 10% CAGR EPS and FCF/share growth over the next five years.
Apple's longer-term growth period includes mega-growth from the iPod/iPhone/iPad launch era, that sometimes saw it grew earnings at over 100% per year.
The longest period of 10% growth was over the last 7 years which is what I use in my multi-metric historical valuation model.
In other words, looking at a realistic growth range for the future, I then check to see what time frame corresponds (using 20-year rolling data) and then estimate the fair value of the stock based on
- 5-year average yield
- 10-year median yield
- 25-year average yield
- 10-year average PE ratio
- 10-year average P/Owner Earnings (Buffett's version of FCF)
- 10-year average P/OCF (P/FFO for REITs)
- 10-year average price/free cash flow (P/AFFO for REITs)
- 10-year average price/EBITDA
- 10-year average price/EBIT
- 10-year average Enterprise Value/EBITDA (factors in debt)
Again, I line up the time frames with the proper time period corresponding with the realistic future growth rate of the company.
The idea is that what investors paid for a company with stable fundamentals and similar growth rates factors in all the competitive advantages and risks a company faces over time. Thus, should those fundamentals persist over time, the valuation changes will cancel out over time, or mean revert to their historical levels.
Not all those metrics are industry-appropriate or even company appropriate (some give obviously crazy values). I only use industry-appropriate multiples and exclude especially egregious outliers (such as tech bubble dividend yields for some companies).
The range of fair values basically estimates what a company is worth this year based on the consensus expectations and current dividend. The range can be wide for some companies (because some industries have higher valuation uncertainties than others). But the overall range is very likely to contain the true intrinsic value of the company, again, assuming the fundamentals hold up over time.
The average of all the values is what I consider a reasonable estimate of the company's fair value today and what I apply my quality based valuation criteria to.
|Company||Current Price||Historical Fair Value||Discount To Fair Value||5-Year CAGR Total Return Potential||Recommendation|
|AT&T||$35||$42||16%||12% to 17%||reasonable buy|
|Archer-Daniels||$37||$46||19%||14% to 21%||good buy|
|Valero||$79||$64||-24%||4% to 9%||hold|
|Citizens Financial||$33||$56||41%||14% to 24%||very strong buy|
|AbbVie||$68||$121||44%||20% to 29%||very strong buy|
|Eaton||$79||$86||9%||9% to 15%||reasonable buy|
|Simon Property||$147||$206||29%||12% to 19%||very strong buy|
|Evergy||$65||$50||-29%||0% to 7%||hold|
(Source: F.A.S.T Graphs, Factset Research, analyst consensus, management guidance, Gordon Dividend Growth Model) - the historical margin of error on total return model is 20%.
As you can see, in terms of the quality companies Goldman recommends, I can recommend buying all of them except Valero and Evergy. Based on their realistic future growth rates, both companies are currently so overvalued they are likely to generate poor long-term total returns, even factoring in safe and growing dividends.
To show you what I mean, let's use Evergy as an example to show how I estimate realistic 5-year CAGR total return ranges.
Evergy was created by the 2018 merger of Great Plains Energy and Westar Energy, creating a large regulated electric utility serving 1.6 million customers in Kansas and Missouri.
The very safe dividend is courtesy of the recession-resistant nature of the cash flow, its A-rated balance sheet, and its modest 64% forward payout ratio (70% to 75% is normal for utilities). I consider this level 9/11 quality blue-chip a great company.
The trouble is that its historical fair value, based on 2019's expected results and dividend is between $37 and $58, with a reasonable estimate being $50.
At $65 red hot EVRG is trading above all those estimates, which I remind you is the price real investors, risking real money, actually valued it at over the past 11 years. This happens to be the time frame that corresponds with the analyst consensus of about 7% CAGR EPS growth over the next five years.
Mind you, 3% to 9% is the realistic growth potential for this utility which is expected to experience a temporary growth boost from the merger, synergistic cost savings, and 60 million share buyback program.
(Source: F.A.S.T Graphs)
As Chuck Carnevale would say, it's not opinion, but historical fact that the market values EVRG growing at about 7%, at 17.6 times earnings, even in a low rate environment. The earnings fair value in 2019 is $51, nearly identical to the $50 fair value estimate I'm using.
(Source: F.A.S.T Graphs)
EVRG has gone through the roof lately, primarily due to crashing US Treasury yields. That's one of Goldman's core thesis underpinning this rec. But remember that paying 23 times earnings for a slow-growing utility is asking for trouble (remember the REIT bubble of 2016 that was followed by an 18-month bear market where popular REITs delivered -20% CAGR total returns)?
(Source: F.A.S.T Graphs)
Over the next five years, assuming the low end of the realistic growth range (3%) and a reversion to its historical low-rate, fast-growth PE of 17.6, EVRG could deliver as little as 0% CAGR total returns, including the dividend.
(Source: F.A.S.T Graphs)
The best-case scenario is a return to 9% growth and a 7% CAGR total return. But beyond 2020 analysts expect just 4% growth, meaning this overvalued utility blue chip is likely to deliver low single-digit total returns over the next five years.
Only if long-term US treasury yields go negative AND stay that way over time might this company sustain such a lofty valuation. And don't forget that this would require a recession first, in which case almost all stocks fall (just 4% of dividend aristocrats and kings delivered 0+% total returns during the Great Recession, and EVRG isn't an aristocrat).
A note on Citizens Financial. While it's a fine regional bank and expected to grow about 8% over time, the actual return it's likely to deliver is probably on the lower end of that total return potential range.
There are superior alternatives in the form of larger and more diversified banks with similar yields and similar growth rates that are also highly undervalued such as:
- Wells Fargo (WFC): level 9 quality blue chip yielding 4.5%, 33% undervalued and with 10% to 17% CAGR total return potential
- Bank of Nova Scotia (BNS): level 9 quality blue chip yielding 5%, 22% undervalued and 11% to 18% CAGR total return potential
- Toronto-Dominion (TD): level 11 quality Super SWAN, yielding 4%, 12% undervalued and 11% to 17% CAGR TRP
- Cullen/Frost Bankers (CFR): level 11 quality Super SWAN, yielding 3.4%, 19% undervalued with long-term total return potential of 13% to 20%
These are four banks Dividend Kings owns across its four model portfolios that I consider to be superior alternatives to CFG.
Now AbbVie and Simon are definitely strong buys (Dividend Kings also owns those). In fact, SPG is my most recent weekly stock buy in my retirement portfolio, courtesy of being at its best fundamentals adjusted-valuation ever.
Finally, I should mention that while AT&T is a reasonable buy today, I consider its management poor, which is why I'm not too excited about its modest discount to fair value.
Telus (TU), the 4.8% yielding level 8 quality Canadian Telecom, is likely to deliver 7% to 12% long-term CAGR total returns (likely the higher end of that range), is 5% undervalued, and will probably match AT&T in total returns (due to superior management and execution).
AT&T isn't a bad high-yield stock, but just understand that its growth potential is 2% to 6%, and 2% to 4% is what it normally delivers outside of big M&A, which thus far it has an objective poor track record of. Owning AT&T means you need to have realistic expectations, which for this company involves a safe 6% yield, and inflation-matching 2% dividend growth for the foreseeable future.
----------------------------------------------------------------------------------------Dividend Kings membership includes our valuation/total return potential lists as well as
- Access to our four model portfolios (Fortress, Deep Value Blue-Chip, High-Yield Blue-Chip, $1 Million Retiree Portfolio)
- over 24 exclusive articles per month
- Our Weekly Podcast
- 20% discount to F.A.S.T Graphs
- real-time chatroom support
- an exclusive database of 650 preferred stocks
- exclusive weekly updates to David Fish's (now run by Justin Law) Dividend Champion list
From 8 AM EST Thursday to 8 AM EST Friday, you can subscribe to Dividend Kings at a 10% discount. Click here for a two-week free trial.
Disclosure: I am/we are long ABBV, SPG. 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.