January flew by, and I thought it would be a good time to pass along a few ideas for the income component of your investment portfolio.
For long-term value investors, income/dividends are key. The safety cushion they provide is as powerful as the “margin of safety” concept itself. You would be shocked, however, by how many clients we speak with who don’t know what is going on with their investments and what kind of income streams their dividends generate.
The reality is most people are focused on capital gains. Of course capital gains are nice – who doesn’t like seeing stocks appreciate in value? – but it is sometimes equally rewarding (mentally anyway) to see your stocks depreciate in value while at the same time still generate a sizeable return. This is only possible because of the dividends those stocks throw off.
Your financial institutions will be sending your 2016 end of year financial statements soon, if they haven’t arrived already. Check the financials and assess how much you earned in dividends last year. Force yourself to calculate how much of the total return was generated from the income stream, or how much of your total loss was offset because of the income stream.
Remember, the more protection you have built into a stock the better.
When it comes to investing in stocks for income, we look for companies that:
- Are well established, have strong sustainable competitive advantages and have produced stable cash flows for a long period of time.
- Have not rejected or reduced their dividends at any point over the last few economic cycles.
- Have a history of repeatedly raising dividends.
- Are liquid and have easily manageable short-term and long-term debt loads.
- Earn high returns on invested capital.
- Pay an acceptable percentage of earnings and free cash flows as dividends, cushioning the firms against economic downturns.
- Are approximately fairly priced or moderately underpriced.
- Are in, or are entering, a horizontal or upward sloping trend channel.
We try to avoid companies that do not have strong sustainable competitive advantages or that offer dividend yields below 2%. We also tend to avoid companies offering yields above 8% as many of these firms are in serious trouble and will likely have to cut their dividends in the near future.
Unfortunately, finding great dividend-paying stocks that meet these criteria isn’t that simple. Sure, there are lots of companies offering high yields with long dividend track records, but many of these companies are still unsafe poor investments. Just consider all the supposedly “safe” dividend-paying energy stocks that got hammered over the last few years. If you’re going to invest in stocks for dividends, you’ve got to target those stocks that pay nice dividends of 2% but are still selling at or below the fair value. Within the current market environment, we think there are many attractive dividend-paying stocks selling at reasonable valuations.
Let’s take a look at three of our top dividend-paying stocks for 2017.
Bank of Nova Scotia
Bank of Nova Scotia (BNS, Financial) is an international bank and a financial services provider in North America, Latin America, the Caribbean and Central America and parts of Asia. The bank offers a range of advice, products and services including personal and commercial banking, wealth management and private banking, corporate and investment banking and capital markets.
Shares were significantly undervalued at the start of 2016 and have moved up by over 40% on the market’s delayed realization of how strong the company really is and how much residual income it generates relative to competitors. The current dividend is $2.88 per share annually, making the current yield 3.6%. In 2017, analysts predict Bank of Nova Scotia will earn $6.45 in diluted earnings per share and $6.87 in 2018, which puts the payout ratio at a modest 45%. Bank of Nova Scotia could suffer an approximate 45% drop in earnings and still be able to make its dividend payments.
Over the long term, Bank of Nova Scotia’s dividends are well intact and will continue uninterrupted. Its shares are approximately fairly valued and will offer investors an approximate 6.7% annual rate of capital appreciation.
Johnson & Johnson
Johnson & Johnson (JNJ, Financial) is a holding company engaged in the research and development, manufacture and sale of health care-related products including consumer, pharmaceutical and medical devices. This includes baby care, oral care, skin care, over-the-counter pharmaceutical, women's health, wound care, therapeutics, immunology, oncology and cardiovascular and metabolic products. Its research facilities are located in the U.S., Belgium, Brazil, Canada, China, France, Germany, India, Israel, Japan, the Netherlands, Singapore, Switzerland and the United Kingdom.
Johnson & Johnson is another company with a nice stable dividend stream. Shares of Johnson & Johnson yield about 2.7% annually. Dividends have grown at an annual rate of about 6.7% per year over the last 3 years. This is ranked higher than 54% of the 284 companies operating in the Global Drug Manufacturers industry.
Johnson & Johnson is a well-diversified company and is largely insensitive to major economic swings. The company has taken on a bit of debt over the last few years, but this debt is easily manageable and could be paid off with less than two years of annual earnings. Johnson & Johnson’s low debt position and recapitalization strength combined with its moderate payout ratio of 53% of free cash flows, should reassure investors that the dividend is safe. Trading at 16.2x forward earnings per share, Johnson & Johnson is reasonably valued and represents a good long-term holding.
Quest Diagnostics (DGX, Financial) is a provider of diagnostic information services and products. This includes developing and delivering diagnostic testing information and services to patients, physicians, health plans, hospitals, commercial laboratories, employers and others. It also offers a range of solutions for insurers and healthcare providers including risk assessment services. Quest Diagnostics offers a dividend yield of about 2%. This is better than 73% of the 94 companies in the Global Diagnostics and Research industry.
Like many firms in the industry over the last year, shares of Quest Diagnostics witnessed an impressive surge, rising by over 40%%. The company continues to generate solid sales and earnings, producing a return on invested capital of 9.4% versus a weighted average cost of capital of 7.7%, signaling continued value creation. The company’s stock trades at $93.56.
Free cash flows are also impressive. The company produced almost $776 million, or $5.47 per share, in free cash flows for 2016 while only paying out $223 million in dividends. This leaves the company substantial wiggle room and is exactly what we like to see to be comfortable that its dividend is safe.
Disclosure: We currently hold a position in the Bank of Nova Scotia.
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