Don't just chase stocks with big dividend yields. Look for cash flow, too

  • By Lawrence C. Strauss,
  • Barron's
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Valuations of stocks with high dividend yields are the cheapest they've been since the late-1990s, according to the firm Wolfe Research. But investors need to look before they leap.

As a group, those stocks trade at a price-to-earnings ratio relative to the broader market of 0.7, compared with an average of 0.85 over the last 30 years.

Those high yielders include Macy's stock (M), which was recently yielding 6.2%; General Motors stock (GM) at 4.1%; Kellogg stock (K) at 4.1%, and Verizon Communications stock (VZ) at 4.2%.

These stocks were a lot more expensive in 2011, 2012, and 2013, even trading at a premium to the market on some occasions.

Still, buyers should beware, warns Chris Senyek, chief investment strategist at Wolfe Research. High yields don't always reflect strong earnings growth.

Senyek says it's important to add another layer when analyzing high-yielding stocks, notably strong free cash flow.

Free cash is the capital a company has left over after making the necessary investments in its business. Its uses include paying dividends and buying back stock.

Why pay more attention to free cash right now?

"Later in the cycle, it pays to own higher-yielding stocks with higher free cash flow to avoid dividend cut traps," Senyek says.

One example is Kraft Heinz (KHC), which in February slashed its quarterly dividend by 36%, to 40 cents per share from 62.5 cents. It was recently yielding 4.9%.

Since 1990, the strategy of combining stocks with high dividend yields and high free cash flow yields has outperformed the broader market by nearly six percentage points on an annual basis, according to Wolfe Research. The firm defines the market as the largest 1,000 U.S. companies by market capitalization.

"Given all of the concern out there in the market, this is an attractive area to find value—and these stocks tend to be defensive," Senyek says.

All five of the companies in the accompanying table qualify in terms of having high dividend and free cash flow yields. Those companies also have another factor in their favor: strong dividend growth.

Dividend trifecta

These are examples of companies with strong dividend growth plus high dividend and free cash flow yields.

Company Ticker Sector Recent price Market value (bil) Dividend yield 12-month return 2019E P/E
Abbvie ABBV Healthcare $80.76 $119.4 5.3 -8.0% 9.3
International Paper IP Materials $45.21 18.1 4.4 -9.0 8.6
Prudential Financial PRU Financials $91.46 37.4 4.4 -7.0 7.2
Broadcom AVGO Technology $297.03 117.6 3.6 25.0 12.8
Best Buy BBY Consumer Discretionary $70.50 19.0 2.8 8.0 12
All market data as of March 27. E=estimate Sources: Wolfe Research; FactSet

Those three factors—high dividend and free cash flow yields along with dividend growth—are "the common key metrics" for stocks that outperform, according to Wolfe Research.

In a note this week, Senyek argues that the current environment is favorable for dividend stocks, thanks in part to lower bond yields. In a short period of time, the U.S. Federal Reserve has gone from signaling additional rate hikes this year to a more dovish stance, possibly even with a rate cut in the offing.

The 10-year U.S. Treasury Note was recently yielding 2.38%, down from more than 3.2% last November. In theory at least, the lower bond yields mean income stocks have less competition. The S&P 500's (.SPX) average yield is about 2%.

Senyek, however, doesn't see that persisting for too long. He expects "long rates to increase globally in the second half [of 2019] on the back of a trade deal and Chinese stimulus measures starting to take hold."

Whatever the case, investors need to be careful about chasing the wrong high-yielding stocks—especially with lower bond rates these days.

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