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26 Conservative Dividend Stocks That Should Beat Bonds
by: Alan Brochstein September 27, 2010 | about: ADI / ADP / AGG / BMY / CVX / GD / GPC / HCBK / HRB / IEF / INTC / ITW / JNJ / KO / LLY / LO / MAT / MHP / MRK / MRO / MSFT / NOC / NSM / RTN / SJM / TRV / VFC / XOM

There has been a lot of debate recently about the implications of "cheap dividend payers." I first wrote about the gift the market was offering this summer (maybe a bit early), arguing that Dividend Payers are likely to beat Bonds. I gave some scenario analysis that showed over longer time-frames, Dividend Payers had very little chance of underperforming intermediate-term bonds. Here is the graphic I shared at the time (click to enlarge):



Of course, the recent Barron's article featuring Whitney Tilson's thinking on the subject as he discussed the common stock of Johnson & Johnson (JNJ) relative to its bonds priced in mid-August, generated a lot more interest than my article a couple of months ago! Roger Nusbaum shared his perspective recently, warning that stocks and bonds aren't interchangeable. It was an excellent article that generated a lot of thoughtful comments, but I think the author is too conservative. His basic argument is that stocks can go down a lot, but bonds mature at par. Maybe I simplify, but the point is that the price risk of stocks is inherently so great that an investor shouldn't try to substitute but should rather shorten maturities for bonds. At an extreme, if bonds yielded 1% and stocks had a 5 PE, clearly we wouldn't be having this discussion. While the current numbers aren't that extreme, I do believe that they are wide enough apart that investors should be considering a dramatic cut in their bond exposure.

I would be the last one to disagree with the notion that stocks are typically riskier than bonds. The post-Great Recession pricing of stocks, though, has presented an opportunity that I don't recall seeing since I have been investing: The chance to buy very high quality stocks at earnings yields in excess of 2.0% or more relative to 10yr investment-grade bonds. It's not that bonds are necessarily expensive (if we have very low inflation they will be fine), it's that stocks are too cheap. Quite simply, they haven't yet incorporated the likely low interest-rate environment that will persist for years to come.

So, I while I wouldn't say to dump all your bonds and just buy any old dividend payers and hope for the best, I would instead suggest that you can safely allocate a very high proportion of your long-term bonds into high quality stocks that just happen to pay dividends too. "High Quality" takes into account many variables, some of which are more important to different investors. A company that has no debt or that has a lot of cash is certainly higher in quality than one that is burdened with debt. Historical record of earnings growth might be another. Commanding market share and high barriers to entry are another facet. Because we discussing substituting for bonds, I am going to be most focused on the balance sheet.

While I don't purport that all of these companies merit investment, I think that the following exercise is a good starting point to identify potential "high quality" dividend payers. In the table below (click to enlarge), I offer 26 S&P 500 stocks that meet the following criteria:

* Trailing PE <18X (this is an earnings yield >5.5%)
* Dividend Yield > 2.5% (> 5yr Corporates)
* Low Debt: Net Debt to Capital < 20%

These are large companies paying market-rate or higher dividends with strong balance sheets:

26 Conservative Stocks



I highlighted some of the ones I find interesting. I happen to own Johnson & Johnson (JNJ) , Coca Cola (KO) and Chevron (CVX) in my Conservative Growth/Balanced Model Portfolio. Many of the holdings in that model don't make the list because they aren't Large-Caps. I also am willing to take a slightly lower yield if the payout ratio is low.

This list pulls from 7 of the 10 economic sectors, so it can support a diversified portfolio. In aggregate, the list has a 3.5% dividend yield on a 40% payout ratio. Net debt to capital is low at 7%, but many of these companies have more cash than debt. Both the trailing and the forward PE ratios are below 12 (8.7% earnings yield). I included some additional information, including S&P Quality rating, Price to Tangible Book (low is better than high, but it isn't anything other than a potential source of support if things go wrong with earnings) and earnings revisions for 2011. Here, a large decline might suggest a deterioration. Rather than discuss the merits or risks of all of these names, suffice it to say that JNJ isn't the only example out there.

I want to be clear. I am not suggesting trying to find high-dividend payers that entail risk. Rather, I am trying to make the case that one can pick up more compensation than is reasonable by investing in low-debt Large-Caps with low valuations (and increase the current income) rather than low-yielding moderate to higher quality corporates. The win can take place even without valuations ever improving - the dividends should grow. The big payoff comes, though, when the market reprices these stocks. In my view, these companies should trade at 16-20 PE in a sustained low-interest rate environment. If it happened tomorrow, it would be a 50% rally (12 PE to 18 PE). I don't expect it to happen tomorrow, and there is a chance that rates rise such that the PE expansion doesn't materialize to the full extent. But, in that case, holding a 10-year bond yielding 3% that turns into a 7-year bond in three years but with a higher interest rate will be a big loser.

How does that work? Let's look at that 10-year JNJ bond that was issued at about 3.18% yield (about .43% more than the Treasury). What would that look like in 3 years if rates rose 2% (let's assume that the 7-year rises by that much and that the spread stays roughly constant. Right now, that bond is priced at about 97.5 (3.10% yield)? Under this downside scenario, it would yield 4.5%. The price would drop by almost 18 points to 79.80. That loss would be 3X the income generated! In that scenario, it's likely that the stocks would go up (earnings growth and a modestly higher PE).

The real question, though, is: What's the risk in the equity substitution strategy? It's easy to look back to the damage a couple of years ago and conclude that we could have that type of scenario again (where bonds end up retaining their value but stocks just plunge). While I think it's not likely, the recent "Flash Crash" shows that anything can happen in the short-run. So, what can an investor who wants to replicate his or her current income but gain the tremendous potential upside as the markets reprice do to protect? This is a little outside of my own expertise, but I looked at LEAPS pricing and found the Jan 2013 puts to be a potential hedge.

How does this work? One can buy JNJ common at 62.14 and buy the 57.50 put that floors the downside of the trade (you could lose 4.64 or 7.5% maximum over the next 27 months). Of course, you would in almost all likelihood also collect dividends of 4.86, which would offset that loss. The cost to have upside on JNJ with no risk (except the reduction or elimination of the dividend)? About 7.2 (11.6%). I think that this is a reasonable price to pay. Over the next nine quarters, assuming the dividend is paid, the stock would have to rally just 5% to cover that cost. The rest is upside, and it could be big. OK, now, here is where it gets more "bond-like" if you think that cost is too high: Sell Calls. The January 2013 70 LEAPS sell for about 2.90, though it might make more sense to pocket the 1.65 on the Jan 2013 70s and then to roll another year later. Let's go with the 2013 calls. We already established that in a disaster, we are out 11.6% roughly. At the upside, we pocket the dividends (4.86 or more), the move to 70 (another 7.86 points) and eat the net premium (a loss of 4.30). Thus, it generates a net total return of about 13.5%. I am not so sure I would sell the calls, as I think that JNJ is worth a lot more, but this illustrates something in my view. The worst-case is down 11.6%, while a rise of 2% in the bond yield over the next 9 quarters would lead to a loss of over 25% in price. The total return would approximate -18%. What's the upside on those bonds? Will rates drop even 1%? If so, the price would rally 17% (total return of about 24%). The 10-year bond is more volatile than the hedged stock.

I think over time the capital markets will start to seize on the tremendous upside opportunity in these low-debt Large-Caps. With volatility low (at least back to a normal kind of number), protection can be purchased that allows investors to "pay a little extra" for their stock and still get a similar current income than through high-quality bonds. In the case of JNJ, buying the stock and paying for the protection of the LEAPS makes the purchase price go to 69.34. The dividend of 2.16 (assuming they quit hiking!) results in a yield of 3.1%. You get the same yield but have less downside and probably more upside in most reasonable scenarios. To be fair, there are scenarios where the stocks could lose their max while the bonds could get that big upside, but the converse is more likely. In a steady (slow economy without recession again) or strong economy, the bonds will likely lose value while the stocks gain.

Disclosure: Long KO, JNJ and CVX in a model portfolio


About the author: Alan Brochstein

Alan Brochstein, CFA has worked in the securities industry since 1986. He founded AB Analytical Services (www.ABanalytical.com) in 2007 in order to provide independent research and consulting to registered investment advisors.