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Watching CNBC can be like tuning into a horse race with stock prices as the thoroughbreds. But the racing action in stock prices only tells part of the story.
"Total returns" are what count for many professional investors, and now some financial advisers recommend focusing on total returns when it comes to picking stocks for your portfolio, too.
With stocks, total return refers to the combination of price gains and dividend income shareholders receive. If a stock rises 4% in a year, for instance, and yields 3% due to its dividend, then your total return would be 7%.
When stocks are rallying, investors earn more returns from price gains. But the markets go through long stretches where stock prices stagnate, like the 1970s and 2000s, and dividend income becomes more important. Since 1926, in fact, dividend income has produced more than 50% of the S&P 500's (.SPX) total return, according to data from Strategas Research Partners.
In a slower-growth world, some investing pros now see dividends as the foundation of total returns again. Corporate earnings growth weakened during the past year and the S&P 500 is now trading at 18 times trailing 12-month earnings, points out Barry James, co-manager of the James Balanced Golden Rainbow Fund (GLRBX).
That's higher than the average P/E of 15.5 going back to 1918. And at today's levels, "you wouldn't expect a major bull market to break out," he says.
If the economy were healthier, investors might expect stronger stock returns. But the economy is growing slowly, and the markets could be in for a volatile ride due to ongoing budget battles in Washington, the recession in Europe and political turmoil abroad. Historically, stocks have also fared poorly in the year after a presidential election, according to James, returning an average 2% since 1883.
All this highlights the importance of total returns, with dividends as the core. Dividend-paying stocks tend to be less volatile than the market overall, providing a bit more stability in a portfolio, notes James Morrow, co-manager of the Fidelity Equity-Income Fund (FEQIX). And it's still possible to find companies with a good mix of earnings growth, dividend income and modest valuations.
"The market may go up or down 10% in a year," he says. "But if you start with a 3-4% yield, you're limiting your downside."
What follows are seven stocks with good potential for total returns, based on our interviews with managers of top-rated funds and our own research. The list includes both large- and mid-cap stocks, and some are riskier than others. You should do your own research and check how these stocks fit with your other holdings before investing.
General Mills (GIS) may never soar like a high-tech superstar. But the maker of Cheerios, Haagen-Dazs and other household brands has racked up steady gains for decades: The stock returned an average 13% a year from 1961 to 2011, including reinvested dividends, compared to 9% for the S&P 500, according to company data.
General Mills stock has been a dud over the past year, rising just 5.6% compared to a 14.2% gain for the S&P 500. Still, revenues and earnings are growing at a steady clip and the company has a stable of quality brands to sustain earnings growth in the future, says Mark Freeman, co-manager of the Westwood Income Opportunity Fund (WHGIX), which owns the shares.
Yielding 3.1% at a recent share price around $42, the stock would only have to climb 5% to generate a roughly 8% total return. The company, based in Minneapolis, also pays out less than 50% of earnings in dividends, giving it plenty of leeway to boost the cash payout going forward.
The downside: Costs for the raw ingredients in General Mills' food products could increase more than expected and sales growth may not pick up this year, pressuring the stock.
Cruise a drugstore and you'll see Johnson & Johnson (JNJ) brands like Tylenol and its well-known Baby Shampoo. But J&J's lineup goes well beyond consumer products, and includes cancer drugs, diabetes treatments and medical devices. The range makes J&J one of the most diversified health care companies with sales expected to grow 7.2% this year to about $72 billion, according to Wall Street forecasts, on average.
That's respectable growth for such a large company, according to Freeman, who owns the stock. And he figures growth could accelerate from here, boosted by a new wave of pharmaceutical products and rising consumer sales.
Granted, New Brunswick, N.J.-based J&J is facing a legal onslaught over hip implants it was forced to recall, already costing the company $3 billion in charges. And the stock isn't cheap based on its multiple relative to its earnings growth rate.
Still, Freeman argues the stock's valuation is justified given the company's stable, sustainable earnings. Profit growth is accelerating, he says, and the company has a solid balance sheet with a top AAA credit rating. It has also raised the dividend 8% a year over the last five years.
ConocoPhillips (COP) is at the heart of the domestic drilling boom with 21 million acres in North America — one of the largest holdings in the domestic oil-and-gas industry. The company, based in Houston, aims to boost production 3% to 5% a year, and it's been selling less profitable assets in a bid to increase earnings and returns to investors.
All that makes the stock attractive, says Gary Bradshaw, co-manager of the Hodges Equity Income Fund (HDPEX), which owns the stock. He estimates ConocoPhillips will earn $6.75 a share this year, providing ample cash to cover its dividend and boost production of oil and gas.
Granted, the company is now spending more than it's earning on production, covering the difference with asset sales. Those sales aren't a "permanent solution" to the cash-flow gap, according to Raymond James analyst Pavel Molchanov, a gap that could widen if oil prices weaken.
Bradshaw expects energy prices to stay strong as the economy improves, however, and he figures Conoco's rising production will lift earnings over the next few years, supporting a higher dividend.
Defense contractors like Lockheed Martin (LMT) have rallied as worries of big cuts in defense spending have eased in recent months. A Pentagon budget cut of $10 billion could still be in the cards this year, and the stock may be volatile as Congress wrangles over a deal. But the Defense Department seems to be focusing on cost savings in manpower while equipment programs should avoid major cuts, according to analyst Robert Stallard of RBC Capital Markets.
That could be good news for Bethesda, Md.-based Lockheed, the largest U.S. defense contractor with around $45 billion in annual revenues.
At roughly $87 a share, the stock looks attractive, says the fund manager James, who owns shares in the James Balanced Golden Rainbow Fund (GLRBX). With a P/E around 11, it trades at a discount to the market, and the stock's 5.2% yield looks solid, he says. Indeed, Lockheed raised its quarterly dividend by 15% to $1.15 a share last year and paid out 45% of earnings to shareholders — providing ample room to increase the dividend. The company is also buying back shares at a healthy clip, says James. "That should improve shareholder value despite the headwinds they face from the government," he adds. Analysts expect Lockheed's earnings per share to climb 6.2% in 2014.
The downside: Defense spending cuts could be larger than expected and Lockheed's new F-35 fighter jet program has faced some setbacks in testing, which could mean lower profits on the plane.
Industrial conglomerate Eaton (ETN) makes hundreds of products from hydraulics systems to the seals on the Curiosity rover now exploring Mars. Last year, Cleveland-based Eaton bought Cooper Industries for $11.8 billion, broadening its lineup to include power management systems and energy-saving products. With the acquisition boosting profits, Wall Street expects the company to deliver 7.8% earnings growth this year and 17% growth in 2014.
Eaton's stock looks attractive too, says Don Wordell, manager of the RidgeWorth Mid-Cap Value Equity Fund (SMVFX), which holds shares. At a P/E of 13 based on 2013 earnings it doesn't look particularly cheap. But with earnings rising, the stock looks less expensive based on 2014 estimates, trading at 11 times earnings, below the 12.5 average P/E for major industrial stocks. Wordell figures Eaton could reach $66 a share over the next year, from $59 recently, while yielding 2.6% — generating total returns of roughly 14.5%.
The downside: Global industrial demand could slow, and the acquisition of Cooper may generate less cost savings than anticipated. Wordell thinks those are low-risk scenarios, though. "We're comfortable with the stock and like the story," he says.
Based in Houston, Enterprise Products Partners (EPD) owns energy assets ranging from natural gas pipelines to storage facilities and terminals. As a master limited partnership (MLP), it makes most of its money from fee-based contracts, creating steady income that doesn't depend on the price of the commodity. It also pays out most of its cash to shareholders in a quarterly distribution, which increased 6.1% in the third quarter — the 33rd consecutive quarterly increase. Financially, the partnership looks well-positioned, according to Raymond James analyst Darren Horowitz, who recommends it. Fee-based contracts should increase from 70% of earnings to 80% by the end of this year, he wrote in a recent research note. The partnership has "excellent financial flexibility to pursue growth" and should be able to increase its distribution at a 6% annual rate over the next few years, according to Horowitz.
The downside: Higher interest rates would raise financing costs for MLPs and make projects less profitable, pressuring their stock prices. Still, the fund manager Freeman, who owns shares in the MLP, says it's one of the "highest quality names" in the industry and he likes the stock long-term for its total return potential.
Co-founded by real estate mogul Sam Zell, Equity Residential (EQR) is the largest publicly traded U.S. landlord with more than 119,000 apartment units. The Chicago-based real-estate investment trust (REIT) has benefited from a tight rental market in recent years and it made a big acquisition last year, spending $6.5 billion in cash and stock to buy 60% of apartment owner Archstone.
Wall Street expects Equity Residential's earnings to sink 42% this year to $1.29 a share, partly because the REIT issued stock to fund the Archstone deal. That makes the REIT look pricey based on its price/earnings ratio.
Yet it's one of the least expensive apartment REITs based on the rental income it earns, says the fund manager Wordell, who owns the stock. If inflation picks up, apartment owners should be in a good position to raise rents faster than costs, he adds, and the REIT has "great assets in major metropolitan cities."
The downside: A weaker economy could pressure rents and rising interest rates would hurt REITs in general by raising financing costs and pressuring property values.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services. He owns a position in Enterprise Products Partners.
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