Top 10 Undervalued High-Yield Income Stocks For Q2

Summary

Sometimes, it may seem like growth and momentum investing is the way to go, but in the long run, a focus on value and income stocks is a winning strategy.
Not all income stocks are necessarily attractive at a certain point - one should consider valuation before making an investment.
We share 10 attractively priced income picks that offer market-beating dividend yields and upside potential at the same time.
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Top 10 — Photo by Kameleon007/iStock via Getty Images

Article Thesis

Markets have had a great year beginning at the nadir last spring. However, not everything is overvalued and too expensive, there are still attractive deals to be made. In this article, we will explain why dividend stocks can be great picks and showcase 10 picks that are worthy of closer examination at current valuations.

Why Income Stocks?

Sometimes it may seem like searching for value and picking inexpensive income names may be fruitless - some investors are having a lot of success just buying momentum stocks that are hyped up right now. Looking at the runs in Tesla (TSLA), Peloton (PTON), Bitcoin, and others, it may seem like valuations and dividends don't matter. That is, however, only true until it isn't - all bubbles deflate one day, and the start to 2021 has shown that value can indeed outperform momentum and growth stocks.

On top of that, buying value names and income stocks can offer some protection during times when equity markets are moving sideways or down - you at least get some returns thanks to the stocks' dividend payments, which can be used for one's expenses or reinvested to boost future returns.

Studies show that Value stocks have historically beaten Growth stocks, and it has also been shown that dividend payers - and especially dividend growers - tend to outperform the broad market over long periods of time:

Source: gafunds.com

It thus seems like an opportune choice to search for stocks that combine both of these metrics, i.e. dividend-paying value stocks. This is not the only space where attractive companies can be found, and it is also not the only space I invest in, but I personally, and Cash Flow Kingdom, put our focus on this segment, and we are quite happy with the results.

There are more reasons to invest in income stocks on top of their attractive total return outlook. This is primarily due to the fact that they are one of the key ways for retirees to generate a sizeable income stream in today's low-interest-rate environment. Looking at the yield spread between treasuries and traditional income stocks, the latter look attractive by comparison:

Right now, 10-year treasuries offer a lower yield than the Dividend Aristocrats ETF (NOBL), with a yield spread of -0.3%. Backing out the crisis year 2020, we see that the yield spread had been the other way most of the time - usually, treasuries offer a higher yield than most Dividend Aristocrats. This suggests that Dividend Aristocrats are currently favorably priced compared to treasuries, which may indicate undervaluation for the former or overvaluation for the latter.

No matter what, most retirees won't be able to meet their income needs with treasuries that offer yields of around 1.7%. Opting for income stocks, that oftentimes offer yields of 3%, 4%, or even more will lead to way higher income generation at a specified portfolio size.

10 Top Picks For Q2 That Are Attractively Priced

Some of the picks we suggested at the end of December have run up quite a lot during the first quarter of 2021, which is why they may not be very attractively priced any longer. It thus makes sense to see whether other names may offer a better value and superior risk-to-reward outlook right now.

1. Canadian Natural Resources

Canadian Natural Resources (CNQ) is a leading Canadian oil sands company that operates a very attractive business. Oil sands projects usually come with high up-front costs, but once those are paid, the assets will generate oil for decades at very low variable costs. This is why Canadian Natural Resources has one of the lowest break-even prices in its industry, as the company will start generating earnings with WTI above $31. This, in turn, means that the company's business is highly profitable with oil prices around $60, where they stand right now. Due to the fact that its oil sands assets have lifespans of several decades and require low maintenance capital expenditures, Canadian Natural Resources generates very strong free cash flows. For 2021, Canadian Natural Resources forecasts free cash flows of around US$3.9 billion, after dividend payments.

With shares trading at $31 right now, investors thus get a free cash flow yield of a little above 10% on top of a dividend yield of 4.9%, or a total free cash flow yield of around 15%. That is a quite low valuation still, compared to both the broad market and most energy peers. Since Canadian Natural Resources also has a great dividend growth track record and shareholder-friendly management, the stock seems worthy of a closer look for sure.

2. Enbridge

Enbridge (ENB) is a leading North American energy midstream company that owns a large pipeline network and a wide range of additional assets, including renewable energy projects such as wind parks.

Enbridge has been as steady as a rock during the 2020 oil price crash and the economic fallout that was caused by the pandemic, showcased by the fact that its distributable cash flows and EBITDA actually went up during that crisis year.

2020 Financial Results Summary ($ millions)

Source: Enbridge presentation

DCF per share rose by 2% in 2020, and 2021 will be an even better year. The company forecasts DCF per share growth of around 4% for this year, and the medium-term target range is 5%-7% annual growth. This will be achieved through a combination of rising returns on existing assets (e.g. toll escalators) and new assets being placed into service, such as new pipelines or wind parks coming online. Enbridge has an outstanding dividend growth track record, with annual increases for 26 years in a row, and shares offer a dividend yield of 7.2% today. Even if the dividend grows by a lot less than the 6% forecasted DCF growth rate, it is still quite reasonable to assume that Enbridge will deliver total returns of ~10% a year going forward. Trading for around 10 times DCF, Enbridge is also a rather inexpensive pick still, despite solid gains in 2021.

3. Merck

Merck (MRK) is a leading pharma company that owns a large and diversified portfolio of drugs. Among other drugs, it produces and sells Keytruda, which is set to become the world's best-selling drug in the foreseeable future. The cancer compound has shown strong results in a wide range of indications, including major ones such as lung cancers.

Merck is also active in vaccines, which it sees as a key market going forward. Merck works with Johnson & Johnson (JNJ) on the latter's COVID vaccine but also plans to invest many billions into its vaccine manufacturing network over the coming years to strengthen its position in this large global market.

Merck is, like many other healthcare stocks, not at all expensive. Based on current estimates, Merck trades for just 11.8 times forward earnings, while its dividend yield is 3.4% - roughly twice as much as the broad market's yield. Merck is not an extremely high growth name, but it has a solid growth outlook, a very safe dividend with a sizeable yield, and its low valuation could allow for meaningful multiple expansion going forward.

4. AbbVie

AbbVie (ABBV) is another biotech/pharma name that continues to reward shareholders handsomely. AbbVie owns the world's largest drug, Humira, which will get off-patent in about two years. This will lead to some pressure on sales in 2023, but management expects that revenues will start to grow again shortly after and hit new record highs by 2025.

AbbVie is highly profitable - including during the pandemic - and offers highly attractive dividend growth and a compelling yield of 4.8%. Together with regular double-digit increases, this makes AbbVie look like a favorable dividend growth investment. AbbVie should benefit from some reopening tailwinds once the pandemic has ended for good, e.g. through its cosmetic Botox franchise, which saw sales decline during the current crisis.

Since shares are very inexpensive, trading for less than 9 times forward earnings, AbbVie has considerable upside potential once the market realized that the Humira patent expiry will not be a disaster, as new drugs such as Skyrizi take over. AbbVie is one of the healthcare stocks that has been bought up by Buffett's Berkshire Hathaway (BRK.A)(BRK.B) in recent quarters, which underlines the attractive value proposition (this also holds true for Merck).

5. Medical Properties Trust

Medical Properties Trust (MPW) is a healthcare REIT that owns hospitals primarily, its more than 400 properties are mainly located in the US, the UK, and the EU. Healthcare is a very non-cyclical business, as people that require treatment do so whether the economy is in good share or not. This means that demand for Medical Properties Trust's assets is always there, and the trust's properties have very low lease terms which further minimizes the risks to its business model. It is thus not surprising to see that Medical Properties Trust has been a very steady, resilient performer in the past.

Medical Properties Trust makes major acquisitions regularly, which have increased the trust's asset base quite a lot in recent years. Those acquisitions were partially financed via the issuance of new shares, but that was not to the detriment of shareholders, as these deals have been accretive on a per-share basis as well. Medical Properties Trust has shared this growth with its owners, which have benefitted from steadily growing dividends in recent years:

Earlier this year, Medical Properties Trust raised its payout by 4%, which is quite attractive in combination with a dividend yield of 5.3%. In total, Medical Properties Trust seems like a compelling pick that combines resilience, growth, an above-average dividend yield, and a valuation that isn't expensive - shares are trading for just 12 times this year's funds from operation.

6. Lockheed Martin

Lockheed Martin (LMT) is an aerospace & defense company that primarily manufactures combat aircraft such as the F-22 and the F-35. These projects can run for decades and have price tags of hundreds of billions of dollars, even before maintenance costs. Having contracts in place thus more or less guarantees that Lockheed Martin will generate solid revenues and earnings for the foreseeable future.

Lockheed Martin is manufacturing weapon systems, rotary systems, etc. on top of that, and investors also get exposure to two other, potentially highly attractive, industries. First, Lockheed Martin has exposure to space (satellites, spacecraft), and second, Lockheed Martin is working on nuclear fusion tech. It is not at all guaranteed that those will become major profit centers eventually, but the combination of a low-risk legacy business with some potential high-growth kickers seems attractive. Lockheed Martin has a great dividend growth track record, offers a dividend yield of 2.8%, and its shares trade at a discount to the historic norm:

All in all, there is a lot to like, and I think that Lockheed Martin could be a nice buy-and-hold dividend growth investment.

7. TCG BDC

TCG BDC (CGBD) is the business development arm of Carlyle (CG). The BDC was, like many other BDCs, sold off in 2020, but as it turns out, worries were way overblown. TCG BDC continued to generate sizeable net investment income in 2020, and even though its net asset value declined slightly during the year, the fallout hasn't been nearly as high as what the share price suggests.

TCG BDC's net asset value per share stood at $15.40 at the end of Q4, which means that shares trade for around 90% of NAV right now. TCG BDC offers a very compelling dividend that yields 9.7% right now, not factoring in special dividends, which are declared regularly. Net investment income stood at $1.54 during the crisis year 2020, easily covering the dividend, and analysts expect that profits will continue to cover the dividend without a lot of issues in 2021. Shares have run up quite a lot from the lows already, but due to the fact that shares are still offering a yield of around 10% and trading at a discount to net asset value, they still look like a solid value. TCG BDC's valuation is below the average before the pandemic, thus there is some upside potential for shares, especially if further stimulus spending and successful vaccination efforts drive considerable economic growth in 2021 and beyond, which would reduce risks across the company's portfolio further.

8. Realty Income

Realty Income (O) is one of the highest-quality REITs you can invest in. The triple-net lease REIT that primarily invests in properties that are leased out to tenants such as grocers, drug stores, dollar stores, etc. has been very resilient in 2020, despite the pandemic that wreaked havoc on some retailers.

Realty Income's FFO per share actually grew in 2020, proving its excellent business model that is not threatened by external shocks, be it a pandemic or a recession. Realty Income continues to invest heavily, including through the issuance of equity, but like Medical Properties, Realty Income is doing this in an accretive manner. For 2021, more growth is expected, even on a per-share basis, which is what matters most for investors. The company is forecasting FFO per share of around $3.47, which means that shares are trading for around 18 times this year's FFO right now. That is not a low valuation in absolute terms, but when we consider that Realty Income is clearly a REIT with above-average quality, and when we factor in that the REIT has historically traded at high valuations, then the 18 times FFO multiple doesn't seem extremely high at all. Shares have not risen much this year, which means that there may be some upside potential, especially when we consider that shares were trading around 30% higher before the pandemic - when earnings were lower. Realty Income also offers a monthly dividend with a yield of 4.5%, which is attractive in today's environment.

9. OFS Capital

OFS Capital (OFS) is another BDC that offers a highly attractive dividend yield, at 9.1%. OFS Capital is not the biggest BDC by far, and also not an extremely low-risk choice, but it has well-aligned and very experienced management, which is a major bonus for BDCs. We also like that OFS Capital is primarily investing in senior secured loans, which limits risks in its portfolio considerably.

Interest rates are still very low, but they have risen considerably in 2021 so far, and inflationary pressures are growing as well. That is, in general, a great environment for companies like OFS Capital that lend out at floating rates while borrowing at fixed low rates. OFS Capital could thus experience significant tailwinds for its earnings in 2021 and beyond, and on top of that, shares are trading on the inexpensive side of the historic valuation range:

The combination of a high dividend yield and some upside potential, together with potentially beneficial macro tailwinds, makes OFS Capital worthy of consideration.

10. Pfizer

Pfizer (PFE) is another pharma pick that combines an attractive dividend yield, an inexpensive valuation, and a solid growth outlook. In 2021 and the foreseeable future, Pfizer should feel a major impact from its COVID vaccine that was developed with BioNTech (BNTX). This vaccine is forecasted to add $15 billion to the company's top line this year, while growth across its drug portfolio will likely lead to a mid-single-digit revenue growth rate when the COVID vaccine impact is backed out. Revenue growth at that rate for its core portfolio outside of the vaccine is not at all unattractive, as earnings will likely grow a little more in the long run due to fixed cost degression and the impact of buybacks.

Analysts are forecasting long-term earnings per share growth of around 8.5%, but even if actual growth comes in a couple of percentage points below that, Pfizer could likely deliver returns of 8%-10% a year in the long run, thanks to a dividend yield of 4.3%.

When we consider the fact that shares are not expensive, trading for 11 times this year's earnings, Pfizer seems like an overall relatively solid pick that should deliver attractive risk-adjusted returns.

Takeaway

Some growth investors and momentum traders hit it big, but this is not an approach we focus on. Instead, we like to buy undervalued companies with strong cash flows, especially when they make attractive dividend payments. Studies prove that this approach of focusing on underpriced stocks and dividend payers can lead to market-beating results in the long run.

Not all income stocks are necessarily priced attractively at the same time, but there are always solid buys available. The above list of 10 income names at or below fair value seems worthy of consideration for those seeking to enter or expand positions in the near term. We welcome our readers to share their opinions on these picks, as well as their own ideas with us in the comment section below!

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This article was written by

Jonathan Weber

49.56K Followers

Jonathan Weber holds an engineering degree and has been active in the stock market and as a freelance analyst for many years. He has been sharing his research on Seeking Alpha since 2014. Jonathan’s primary focus is on value and income stocks but he covers growth occasionally.

He is a contributing author for the investing group Cash Flow Club where along with Darren McCammon, they focus on company cash flows and their access to capital. Core features include: access to the leader’s personal income portfolio targeting 6%+ yield, community chat, the “Best Opportunities” List, coverage of energy midstream, commercial mREITs, BDCs, and shipping sectors,, and transparency on performance. Learn More.

Analyst’s Disclosure: I am/we are long ABBV, MRK, MPW, O, ENB, CGBD, JNJ, LMT, CNQ. 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.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.