Why Dividends Are Vital And 5 Strong-Yield Plays To Analyze

by: Bio Insights

In this article, I'm going to propose that given the current economic climate, dividend stocks are the closest thing an investor can get to a win-win situation, not bonds.

Why dividend stocks over bonds? Simple - yields in the fixed-income market are incredibly low. This is a recurring theme in my own investment strategy for a few reasons. As I've outlined in prior articles, any bond that yields significantly less than 2% is in serious deflation territory (based on the fed's target inflation rate). This includes the majority of T-bills.

The real returns on almost all treasury and triple A bonds are in the red, so what has driven the yields so low? It's not because people are holding these things for the yield - it's just one big mess induced by liquidity constraints. T-bills are easily moved, whereas stocks aren't. I'm sure bank asset managers have nightmares about liquidity all the time, especially these days.

So then, remember that us little guys have an entirely different agenda. We should care about yields more than liquidity. Set aside money that you can afford to spare for long periods of time, and maximize the returns given your risk appetite.

The only problem now is that macroeconomic indicators are leading us to believe that another recession (or depression if we're really that unlucky) is possible in Europe. As a result, we've seen major capitulation in the last few weeks. Stock market declines have been outpacing dividend payments, which can be scary. Without dividends, shareholders will lack passive income [this can be very stressful, just ask Bank of America (NYSE:BAC) shareholders].

I'm actually beginning to think that the selling could continue a while longer as more data points to even weaker economic growth abroad, but it's getting to the point where investors may want to begin watching the heavily undervalued dividend stocks for large-scale buy opportunities. Here are five value dividend plays on my watch list that may pique your interest if you have the cash.

1) Seadrill (NYSE:SDRL)

The first thing that will jump out at you is the sheer size of this stock's yield, sitting at about 9.3% right now. That is enormous, which brings up the next thought - is that thing sustainable?

Petroleum-associated investments can be notoriously volatile, since it is the lifeblood of a modern-day economy. Macroeconomic data can drive fickle oil traders around the globe into bullish/bearish frenzies very quickly. WTI crude has recently suffered a major pullback (about 14% in the last month) on renewed fears out of Europe, dollar strength, and most importantly a continuation of China's economic slowdown.

Seadrill is an offshore driller that has been boosting its revenue very consistently since 2004, and has provided its shareholders with outrageously high dividends since 2010. The sustainability depends a lot on the payout ratio, which reached an alarming 106% last year. This means that Seadrill had to issue debt of some sort to pay its shareholders.

What drives the payout ratio is, of course, the actual earnings reported by the company. Since 2009, EPS has been hovering just under $3/share, which is a bit lower than the dividend after its most recent hike. So, factoring depreciation into the equation, we had better see a recovery in oil prices or we may see cuts in the dividend. As a dividend investor, I would consider waiting for a more reasonable payout ratio.

2) Total S.A. (NYSE:TOT)

This French energy giant has suffered egregiously with the European debt fiasco (and continues to do so). Crude prices do indeed fluctuate based on the macroeconomic data, but in the long run I believe that world demographics should provide a safety net on the demand side. Despite its slowdown, China's consumption of oil continues to expand, along with population powerhouse India.

It's true that Total's business in Europe will be affected by sovereign debt to some unknown extent, but its yearly revenue has been very consistent. This provides ample support of its 6.84% dividend, which is the most valuable aspect of the stock anyway. The payout ratio has hovered around 20-30% for many years, with only one spike (53%) in 2009 which is not too significant given the severity of the financial crisis. This stock is a buy on the dividend alone.

3) Telefonica S.A. (NYSE:TEF)

Telefonica has suffered a scary 16% drop in the last month, but offers the highest dividend on this list. TEF shares offer a substantial 8.5% yield, which would allow an initial investment to double in 10 years even if the stock stayed flat.

The obvious concern is sustainability, which is quite an issue for Telefonica in particular. There's a reason why the stock is trading at a P/E of 9.36. Operating income in Q1 2012 relative to 2011 is an astounding 53% lower, and there is €53 billion in debt lying around.

Under these conditions, the strain that the dividend is putting on the company seems quite unbearable despite their positive trend in revenue. There's no question that the stock is fundamentally cheap on its financial data, but since this article is focused on the dividend, I can't recommend a stake in TEF until the payout ratio becomes reasonable (it is well over 100% based on last quarter's information).

4) Exelon Corp. (NYSE:EXC)

Exelon is the leading competitive energy provider in the U.S., and has been having a bad 2012. Indeed, the stock has dropped 15% since the very beginning of the trading year. Given its position in a rather defensive industry, this is shockingly poor price action.

A 70% decline in earnings (Year/Year) due to costs associated with the integration of Constellation Energy has sent the stock in a firm downtrend on reduced enthusiasm for the company's prospects. Financial data seems to indicate the Exelon is a stagnant company.

Even if it is, dividend-focused investors should appreciate the very sustainable 5.7% yield. Assuming that the stock stays close to $37/share and never boosts the dividend, we can almost view this as a bond that is paying 5.7%. This is still a vast improvement over bonds, and fits the dividend strategy we are using in this article.

5) Intel (NASDAQ:INTC)

Intel has shocked us with its earnings time and time again. Along with the earnings growth came dividend growth, which bolstered share appreciation. Since October 2010, when analysts were slamming the stock due to its lack of presence in the smartphone market, the stock has appreciated almost 40%.

Intel has one of the best looking cash-flow and revenue trends amongst giant technology firms. The rise in EPS has supported a substantial growth in the stock's dividend, which has also induced share appreciation. Is it sustainable? Well, the payout ratio in 2011 was 33%, which is well within reasonable dimensions.

Even after recent inflow of investor capital, INTC still yields about 3.3%, which is significantly lower than the other companies on the list. The tradeoff is that Intel's earnings/dividend growth is more rapid, and the stock is low-risk.

Disclosure: I am long TOT.