If you listen to what the market’s saying right now, you might think it’s time to shift away from dividend-paying stocks.
Real estate investment trusts (REITs), utilities and other big dividend payers all took big hits lately before rebounding with the broader market.
Over the last few years, investors chasing yield had streamed into these sectors and “it had become a crowded trade,” says David Ruff, lead manager of the Forward International Dividend Fund (FFINX).
The recent spike in bond market interest rates brought that trend to an end. Investors may have fled on worries that higher rates would pressure profits at these companies, slashing their price-earnings ratios as well.
Yet while the climate may be tougher for companies that pay dividends, these stocks can still provide attractive income and returns, some professional investors say. The key, these experts say, is finding companies with dividends that are sustainable, have room to grow and are backed by profit growth.
The dividend 'sweet spot'
One of the best ways to identify these stocks is to look at a company’s dividend payout ratio, says Ruff. That’s the percentage of earnings a company pays in dividends. The “sweet spot,” Ruff says, is 30% to 60%.
Dividend policies put pressure on management teams to be more mindful of the company’s cash, essentially committing them to pay out a certain amount of company cash to shareholders. If they pay out less than 30% of profits they may squander money on acquisitions or other investments that fail to create shareholder value. Conversely, if a payout ratio exceeds 60%, the company may not be reinvesting enough to grow the business.
“If the yield and payout ratio are high, it doesn’t take a genius to figure out the dividend isn’t sustainable,” says Ruff. Instead, investors should look for the “triple play”: companies with an attractive yield, room for dividend growth and earnings than can help lift the share price.
Following are seven dividend stocks with those characteristics, based on our research and interviews with fund managers.
Remember: Buying individual stocks is riskier than owning a diversified mutual fund. Each stock carries its own risks — for example, an unforeseen event that will sink the company’s shares. Some of these stocks are also volatile and may be suitable only for small positions in a well-diversified portfolio.
As always, you should consult an adviser or do your own research before investing.
Dividend stocks for growth and income
|Exxon Mobil (XOM)||2.8%||11|
|Baxter International (BAX)||2.8||15|
|Cisco Systems (CSCO)||2.8||12|
|Omega Healthcare Investors (OHI)||5.9||23|
|Senior Housing Properties Trust (SNH)||6.0||28|
Sources: Thomson Reuters Datastream, Fidelity.com | P/E ratios are based on 1-year forward earnings estimates
The energy sector
One energy-related stock Ruff likes is drilling company Ensco (ESV). Based in London, the company owns a fleet of drill-ships, submersible drills and “jackup” rigs used for shallow-water drilling. With offshore energy production expanding around the world, demand for rigs and other drilling gear has been growing and Ensco is seeing the benefits, says Ruff.
Analysts expect Ensco’s sales to jump 18% to $5 billion this year with earnings per share climbing 19.7% to $6.55, according to consensus Wall Street estimates. The stock trades around 9 times forward earnings, roughly half its earnings growth rate. And its dividend payout ratio is around 30%, indicating the company should have plenty of cash to keep growing the dividend, says Ruff.
The downside: The stock is more volatile than the broader market, according to Thomson Reuters. It would likely decline if energy prices fall substantially.
Exxon Mobil (XOM), based in Irving, Texas, is the world’s largest “super major” energy producer and has a “fortress balance sheet,” says Tom Forester, manager of the Forester Value Fund (FVALX), which owns the stock.
Forester views Exxon Mobil as a defensive energy play: The company benefits from higher oil prices, and it should outperform rivals if oil prices slump since it also makes money in natural gas, refining and other parts of the industry. Plus, Exxon Mobil has a long history of raising its dividend, which accounts for just 23% of earnings, according to Thomson Reuters.
The downside: A plunge in energy prices would likely pressure the stock. The company is spending heavily to replenish its oil reserves, which could dwindle if new drilling projects don’t pan out. Earnings are getting a lift from share buybacks and cost cutting, which may be unsustainable.
Big tech and dividends
Several large tech companies have started paying dividends, aiming to return more cash to shareholders as their growth rates slow.
One stock in that camp: Intel (INTC). The Santa Clara, Calif.-based chipmaker earns most of its money on microchips for PCs, a slow-growth market. But it recently launched a new line of chips for the faster-growing mobile devices market, a move that could boost earnings, says John Leslie, a portfolio manager with Miller/Howard Investments in Woodstock, N.Y., which owns the stock for clients. Meanwhile, the company hiked its annual dividend 7% to 90 cents a share last year. The stock yields 3.7% and it looks inexpensive, says Leslie, trading around 13 times estimated earnings.
The downside: The stock could falter if Intel’s mobile chips fail to gain traction or PC sales weaken.
Known for its networking gear, Cisco Systems (CSCO), based in San Jose, Calif., is expanding into tech services that have higher profit margins and more “predictable” revenue streams, says Christopher Baggini, manager of the Turner Titan Fund (TTLFX), which owns the stock. That should help lift growth, he says, adding that Cisco is also launching products for data centers that are benefiting from cloud computing trends.
With a yield of 2.8%, Cisco pays more than 10-year Treasury bonds, even with the recent jump in bond yields, notes Baggini. Plus, the company aims to return at least 50% of free cash to shareholders through dividends and stock buybacks.
The downside: Cisco’s core networking equipment business is becoming more of a commodity market, potentially lowering the profitability of its products. Overall profit growth could slump if government and business spending on tech equipment slows down.
Health care and REITs
Baxter International (BAX) is a health care conglomerate that makes IV solutions and products for conditions such as hemophilia and renal disease. The company, based in Deerfield, Ill., bought Swedish firm Gambro last year, bolstering its position in kidney dialysis equipment. And it’s growing steadily in emerging markets, which account for 20% of revenues and are expected to reach 30% in the next five years, according to the company.
Baxter should generate solid growth with its product lineup and a new plant being built near Atlanta, says Baggini, who owns the stock in his fund. Analysts expect earnings to jump 11.5% to $5.19 a share in 2014, and Baxter’s dividend has room to grow, accounting for 30% of earnings, according to Thomson Reuters.
The downside: Baxter received a warning letter from the FDA in May about problems at some of its manufacturing plants. A plant shutdown or other manufacturing issues could send the stock down. Profits could decline due to health care cutbacks and lower reimbursement rates.
If you’re looking for income, two REITs may be worth considering: Senior Housing Properties Trust (SNH) and Omega Healthcare Investors (OHI), according to the money manager Leslie, who owns the stocks for clients.
Based in Newton, Mass., Senior Housing owns a variety of residential properties, medical centers and other facilities for seniors. Omega, headquartered in Hunt Valley, Md., focuses on skilled nursing and assisted living properties. Both REITs generate steady revenue from leasing their properties to health care operators and tenants, and they have solid financial profiles, says Leslie.
The stocks look pricey based on their P/Es but operating expenses are well-covered by rental income, Leslie notes. They also pay out most of their net income as dividends — Senior Housing yields 6% and Omega 5.9% at recent stock prices.
The downside: REITs are sensitive to interest rates and a sharp rise in rates could hurt the stocks. Lower Medicare reimbursements or payments from private parties could pressure profits. REIT dividends are generally taxed as ordinary income, making the stocks more suitable for a tax-deferred or non-taxable account.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.