The market has come a long way since the lows in March early this year. The broad market index, the S&P 500, has not only recovered all the losses from the coronavirus-induced correction but has gone to make new all-time highs. As of this writing, the S&P 500 sits nearly 5.0% above where it was on Feb. 19, 2020. The Nasdaq-100 has gained nearly 27% since the same day. However, if you were to consider the equal-weighted S&P 500 (RSP), it’s still down about -4.70% from Feb. 19, 2020. Sure, this bull market rally has been led by the technology companies. Much of the outstanding performance of S&P 500 also has been led by some of the big technology companies. Just the five big tech companies, namely Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), Facebook (FB), and Alphabet (NASDAQ:GOOG) (GOOGL), now constitute nearly 22% of the S&P 500. So, if you are a DGI investor, and your portfolio is not doing as good as the S&P 500, don’t despair, you are not alone.
Obviously, the big question on everyone’s mind is where do we go from here. Will this rally continue, or will it fizzle out leading up to the big election in November? Needless to say, there are many challenges and uncertainties that remain, and it’s very difficult to know the future with any degree of certainty, especially in the current environment. However, we should look at investing as a long-term game plan and not on the basis of day-to-day or week-to-week gyrations.
S&P 500 ETF (SPY) one-year chart, courtesy YCharts.
As long-term dividend investors, we need to pay less attention to the short-term movements of the market and pay more attention to the quality of companies that we buy and buy them when they are being offered relatively cheap. The goal of this series of articles is to find companies that are fundamentally strong, carry low debt, support reasonable, sustainable, and growing dividend yields, and also trading at relatively low or reasonable prices.
The market is not easy to navigate in the best of times. However, it remains extremely uncertain right now in these difficult times. Nonetheless, we remain on the lookout for companies that offer sustainable and growing dividends and are trading cheap on a relative basis to the broader market as well as to their respective 52-week highs. We believe in keeping a buy list handy and dry powder ready so that we can use the opportunity when the time is right. Besides, we think, every month, this analysis is able to highlight some companies that otherwise would not be on our radar.
This article is part of our monthly series, where we scan the entire universe of roughly 7,500 stocks that are listed and traded on US exchanges, including over-the-counter (OTC) networks. However, our focus is limited to dividend-paying stocks only. We usually highlight five stocks that may have temporary difficulties or lost favor with the market and offering deep discounts on a relative basis. However, that’s not the only criteria that we apply. While seeking cheaper valuations, we also demand that the companies have an established business model, solid dividend history, manageable debt, and investment-grade credit rating. Please note that these are not recommendations to buy, but should be considered as a starting point for further research.
This month, we highlight two groups of five stocks each that have an average dividend yield (as a group) of 2.74% and 5.25%, respectively. The first list is for conservative investors, while the second one is for investors who seek higher yield but are still reasonably safe.
Note: Please note that when we use the term “safe” regarding stocks, it should be interpreted as “relatively safe” because nothing is absolutely safe in investing. Also, in our opinion, for a well-diversified portfolio, one should have 15-20 stocks at a minimum.
Goals For The Selection Process
Regular readers of this series could skip this section to avoid repetitiveness. However, we include this section for new readers to provide the necessary background and perspective.
We start with a fairly simple goal. We want to shortlist five companies that are large cap, relatively safe, dividend paying, and trading at relatively cheaper valuations in comparison to the broader market. The objective is to highlight some of the dividend-paying and dividend-growing companies that may be offering juicy dividends due to a temporary decline in their share prices. The excess decline may be due to an industry-wide decline or some kind of one-time setbacks like some negative news coverage or missing quarterly earnings expectations. We adopt a methodical approach to filter down the 7,500-plus companies into a small subset.
Our primary goal is income that should increase over time at a rate which at least beats inflation. Our secondary goal is to grow the capital and provide a cumulative growth rate of 9%-10% at a minimum. These goals are by and large in alignment with most retirees and income investors as well as DGI investors. A balanced DGI portfolio should keep a mix of high-yield, low-growth stocks along with some high-growth but low-yield stocks. That said, how you mix the two will depend upon your personal situation, including income needs, time horizon, and risk tolerance.
A well-diversified portfolio would normally consist of more than just five stocks and preferably a few stocks from each sector of the economy. However, in this periodic series, we try to shortlist and highlight just five stocks that may fit the goals of most income and DGI investors. But at the same time, we try to ensure that such companies are trading at attractive or reasonable valuations. However, as always, we recommend you do your due diligence before making any decision on them.
The S&P 500 currently yields less than 1.90%. Since our goal is to find companies for our dividend income portfolio, we should logically look for companies that pay yields that are at least better than the S&P 500. Of course, the higher, the better, but at the same time, we should not try to chase high yield. If we try to filter for dividend stocks paying at least 1.90% or above, nearly 2,000 such companies are trading on US exchanges, including OTC networks. If we further limit our choices to companies that have a market cap of at least $10 billion and daily trading volume over 100,000 shares, the number comes down to roughly 380 companies. We also will check that dividend growth over the last five years is positive.
We also want stocks that are trading at relatively cheaper valuations. But at this stage, we want to keep our criteria broad enough to keep all the good candidates on the list. So, we will measure the distance from the 52-week high but save it to use at a later stage. After applying the current criteria defined so far, we got a smaller set of about 342 companies.
Criteria to Shortlist
- Market cap >=$10 billion
- Daily average volume > 100,000
- Dividend yield >= 1.90%
- Dividend growth past five years >= 0%
By applying the above criteria, we got roughly 342 companies.
Narrowing Down the List
As a first step, we would like to eliminate stocks that have less than five years of dividend growth history. We cross check our list of 342 stocks against the CCC list (list of Dividend Champions, Contenders, and Challengers created by David Fish and now maintained by Justin Law). The CCC list currently has 757 stocks in all the above three categories. The CCC list currently includes 136 Champions with more than 25 years of dividend increases, 271 Contenders with more than ten but less than 25 years of dividend increases, and 350 Challengers with more than five but less than 10 years of dividend increases. After we apply this filter, we are left with 165 companies on our list. However, the CCC list is quite strict in terms of how it defines dividend growth. If a company had a stable record of dividend payments but did not increase the dividends from one year to another, it would not make it to the CCC list. We also want to look at companies that had a stable dividend history of more than five years, but maybe they did not increase the dividend every year for one reason or another. At times, some of them are foreign-based companies, and due to currency fluctuations, their dividends may appear to have been cut in US dollars, but in reality, that may not be true at all when looked in the actual currency of reporting. So, by relaxing this condition, a total of 70 additional companies qualified to be on our list, which otherwise met our basic criteria. After including them, we had a total of 235 (165+70) companies that made our first list.
We then imported the various data elements from many sources, including CCC-list, GuruFocus, Fidelity, Morningstar, and Seeking Alpha, among others, and assigned weights based on different criteria as listed below:
- Current yield: Indicates the yield based on the current price.
- Dividend growth history (number of years of dividend growth): This indicates the dividend growth rate during the last five years.
- Payout ratio: This indicates how comfortably the company can pay the dividend from its earnings. This ratio is calculated by dividing the dividend amount per share by the EPS (earnings per share).
- Past five-year and 10-year dividend growth: Even though it’s the dividend growth rate from the past, this does tell how fast the company has been able to grow its earnings and dividends in the recent past. The recent past is the best indicator that we have to know what to expect in the next few years.
- EPS growth (mean of previous five years of growth and expected next five years growth): As the earnings of a company grow, more than likely dividends will grow accordingly. We will take into account the previous five years’ actual EPS growth and the estimated EPS growth for the next five years. We will add the two numbers and assign weights.
- Chowder number: This is a data point that’s available on the CCC list. So, what’s the Chowder number? This number has been named after well-known SA author Chowder who first coined and popularized this factor. This number is derived by adding the current yield and the past five years’ dividend growth rate. A Chowder number of “12” or more (“8” for utilities) is considered good.
- Debt/equity ratio: This ratio will tell us about the debt load of the company in relation to its equity. We all know that too much debt can lead to major problems, even for well-known companies. The lower this ratio, the better it is. Sometimes, we find this ratio to be negative or unavailable, even for well-known companies. This can happen for a myriad of reasons and not always a reason for concern. This is why we use this ratio in combination with the debt/asset ratio (covered next).
- Debt/asset ratio: This data is not available in the CCC list, but we add it to the table. The reason we will add this is that, for some companies, the debt/equity ratio is not a reliable indicator.
- S&P’s credit rating: Again, this data is not available in the CCC list, and we will add manually. We get it from the S&P website.
- PEG ratio: This also is called the price/earnings-to-growth ratio. The PEG ratio is considered to be an indicator if the stock is overvalued, undervalued, or fairly priced. A lower PEG may indicate that a stock is undervalued. However, PEG for a company may differ significantly from one reported source to another, depending on which growth estimate is used in the calculation. Some use past growth, while others may use future expected growth. We are taking the PEG from the CCC list, wherever available. The CCC list defines it as the price/earnings ratio divided by the five-year estimated growth rate.
- Distance from 52-week high: We want to select companies that are good, solid companies but also are trading at cheaper valuations currently. They may be cheaper due to some temporary down cycle or some combination of bad news or simply had a bad quarter. This criterion will help bring such companies (with a cheaper valuation) near the top, as long as they excel in other criteria as well. This factor is calculated as (current price – 52-week high) / 52-week high.
- Adjustment for Financial Companies: During the last few months, we have observed that due to several factors there’s somewhat of overcrowding by banks and financial companies in our top 50 list. This is partly because the financial sector has generally been trading much below their 52-week highs, and also, they all tend to have much higher credit rating due to the nature of business. Moreover, there are simply many more companies in this sector. So, to provide an equitable chance to other sectors and stay diversified, we will be adjusting the total weightage for banks and financial services by four points, and insurance companies by two points, prior to making our list of 50.
Below is the table with weights assigned to each of the 10 criteria. The table shows the raw data for each criterion for each stock and the weights for each criterion and the total weight. Please note that the table is sorted on the “Total Weight” or the “Quality Score.” The list contains 235 names and is attached as a file for readers to download if they so desire.
A sample of the table with the top 25 rows (in order of quality score) is displayed here as well:
[Source: Author/ Financially Free Investor]
Selection of the Final 25
To select our final 25 companies, we will follow a multi-step process:
We will first bring down the list to roughly 50 names by automated criteria, as listed below. In the second step, which is mostly manual, we will bring the list down to about 25.
- Step 1: We will first take the top 25 names in the above table (based on total weight or quality score).
- Step 2: Now, we will sort the list based on dividend yield (highest at the top). We will take the top 10 after the sort to the final list.
- Step 3: We will sort the list based on five-year dividend growth (highest at the top). We will take the top 10 after the sort to the final list.
- Step 4: We will then sort the list based on the credit rating (numerical weight) and select the top 10 stocks with the best credit rating. However, we only take the top two from any single industry segment, because otherwise, some of the segments tend to overcrowd.
From the above steps, we have a total of 55 names in our final consideration. The following stocks appeared more than once:
Appeared two times: ADP, BAC, BSBR, C, CSCO, EPD, IMBBY, TD, TSN
Appeared three times: XOM
After removing eleven duplicates, we are left with 44 names.
Since there are multiple names in each industry segment, we will just keep a maximum of three or four names from the top from any one segment. We keep the following:
- Financial Services, Banking, and Insurance:
Financial Services: (PRU), (AMP)
Banking: (NYSE:C), (BK), (TD), (BAC)
Insurance: (ALL), (AFL), (MET)
- Consumer/ Retail/ Others:
(TSN), (HRL), (BTI)
• Communications/ Media:
(MDT), (JNJ), (MRK)
(INTC), (TXN), (CSCO), (HPQ), (AVGO)
(XOM), (EPD), (OKE)
TABLE-2: List of Final 29
[Source: Author/ Financially Free Investor]
Final Step: Narrowing Down to Just Five Companies
This step is mostly a subjective one and based solely on our perception. The readers could select any of the above 29 names according to their own choosing or as many as they like.
The readers could certainly differ from our selections, and they may come up with their own set of five companies. We make two lists for two different sets of goals, one for safe and conservative income and the second one for higher yield. Nonetheless, here’s are our final lists for this month:
Final List-1 (Conservative Safe Income):
Final List-2 (High Yield, Moderately Safe):
It goes without saying that each company comes with certain risks and concerns. Sometimes these risks are real, but other times, they may be a bit overblown and temporary. So, it’s always recommended to do further research and due diligence.
Nonetheless, we think these five companies (in the first list) would form a solid group of dividend companies that would be appealing to income-seeking conservative investors, including retirees and near retirees. Our final list of five has, on average, 31 years of dividend history (including three dividend-aristocrat), 12.32% and 12.34% annualized dividend growth during the last five and 10 years, excellent average credit rating, and trading on an average of 13.5% discount from their 52-week highs. Their average dividend/income (as a group) is decent at 2.74%. In addition, they all have a credit rating of “A” or higher. We could have gone for higher dividends with some other stocks, but for A-list, we just want to stick with quality and conservative names with excellent credit ratings.
The second list (B-list) includes a couple of names that are a bit riskier, however, only one company has less than stellar credit rating. This group offers a much higher average yield of 5.25%. EPD is one name on this list that comes with a slightly higher risk. EPD is a midstream energy company and owns a vast array of incredible midstream assets, including 19,900 miles of NGL pipelines and 5,300 miles of crude oil pipelines, besides 22 natural gas processing facilities and liquified petroleum gas and ethane export terminals. Please note that EPD is a partnership and comes with the additional burden of K-1 income tax compliance. That said, at this time, EPD’s yield is fully covered and appears pretty safe. This list offers an average yield of 5.25%, an average of 20 years of dividend history, excellent past dividend growth, and a nearly 21% discount from their 52-week highs. Readers also should look at our extended list of 29 stocks and pick according to their needs, preference, and suitability.
Below is a snapshot of five companies from two groups:
Table-3A: List-1 (Conservative Income)
[Source: Author/ Financially Free Investor]
Table-3B: List-2 (High Yield)
[Source: Author/ Financially Free Investor]
We have used our filtering process to narrow down our large list of stocks to a very small subset. We presented two groups of stocks (five each) with different audience and goals in mind. The first group of five stocks is for conservative investors who prioritize the safety of the dividend over higher yield. The second group reaches for higher yield but with slightly less safety. However, both sets of stocks support an excellent overall credit rating. The first set has all stocks with “A” or better ratings. The second group also consists of four (out of five) stocks that have “AA-” or better credit rating. The first group yields 2.74%, whereas the second group yields 5.25%. We believe these two groups of five stocks each make an excellent watch list for further research and buying at an opportune time.
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Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, UNH, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, PRU, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LMT, LYB, ARCC, AWF, CHI, DNP, EVT, FFC, GOF, HCP, HQH, HTA, IIF, JPC, JPS, JRI, KYN, MAIN, NBB, NLY, NNN, O, OHI, PCI, PDI, PFF, RFI, RNP, STAG, STK, UTF, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. The author is not a financial advisor. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. The stock portfolios presented here are model portfolios for demonstration purposes.