Situation: When you’re an income investor, your primary focus is generating consistent cash flow from each of your liquid investments. The basic question, then, is whether to buy bonds or high-yielding stocks. Which companies can we expect to sustain dividend yields that are high and stable enough to compete with the iShares 20+ Year Treasury Bond ETF (TLT) in terms of safety and efficacy? Individual stocks lack the safety of US government bonds. But the Vanguard High Dividend Yield ETF (VYM), which is composed of the ~400 companies in the Russell 1000 Index that reliably pay an above-market dividend yield, is almost as safe as TLT and even more effective: VYM currently yields 2.8%, has a dividend growth rate of 6.0%/yr and a valuation (P/E) of 20.
In this month’s blog, I’ll argue that some stocks in VYM consistently outperform (provide less risk of bankruptcy and faster dividend growth than VYM). Their combined dividend yield and dividend growth rate is ~10%/yr. That would give you dividend income (quarterly checks in your mailbox) that will likely grow ~4%/yr faster than inflation.
Mission: Identify companies in VYM that appear to have a sustainable dividend yield.
Execution: see Table.
Administration: We have to confine our attention to A-rated companies. To be A-rated means that a company a) is in VYM, b) issues common stock that has been traded on a public exchange for at least 20 years, c) is rated B+/M or higher by S&P, d) issues bonds that are rated A- or higher by S&P, e) has a ratio of Price to Book Value for the most recent quarter (mrq) that is a positive number, and f) has positive Earnings Per Share (EPS) for the Trailing Twelve Months (TTM). The hard part is choosing which A-rated companies are strong enough to sustain their policy of paying a good and growing dividend. To find those, I’ve added 4 requirements: 1) that the company be in the iShares Top 200 Value ETF (IWX), 2) that the company have an S&P stock rating of A-/M or higher, 3) that the company’s stock remains reasonably priced in an overheated market, meaning Price/Book is no higher than 6.0, and 4) that current dividend yield is at least 2.2%/yr.
Analysis: Warren Buffett’s favorite metric is addressed in Column R of the Table: Return on Net Tangible Capital Employed. He thinks anything over 20% for the last fiscal year (lfy) is a good number. One company (INTC) meets that standard. His second point -- that the company is “run by able and honest managers” -- is addressed in Morningstar reports (see Column AL) and is negatively impacted by the degree to which managers and directors choose to capitalize their company by issuing long-term bonds rather than common stock (see Column T). Two companies (APD and INTC) have a BUY rating from Morningstar, and 6 companies have a Long-Term Debt to Equity ratio that is less than 1.0 (APD, INTC, BK, USB, PNC, GD). Mr. Buffett has also stated that high Free Cash Flow Yield (Column I) reflects good management because Retained Earnings allow the company to expand (or pay down debt) at zero cost. Six companies (INTC, JPM, BK, USB, PNC, GD) have Retained Earnings, meaning some Free Cash Flow is left after dividends have been paid. His third point -- that the stock be available “at a sensible price” -- is addressed by the 1-year and 3-5 year Forward PEG ratios (see Columns M and N): Two companies have estimated PEG ratios at both time points that are no higher than 2.0 (APD and BK). I favor companies in The 2 and 8 Club, meaning A-rated companies that have grown their dividend at least 8%/yr for the past 5 years (see Column J). Six companies meet that standard (APD, JPM, BK, USB, PNC, GD). Note in this analysis that I’ve cited 3 companies 4 times: INTC, APD, BK.
Bottom Line: Even though these 8 companies have twice the dividend yield, twice the dividend growth, and half the P/E of SPY (the S&P 500 ETF), only two have had a higher total return over the past 10 years (JPM and PNC). But total returns aren’t the point-of-main-interest here. We’re trying to answer a different valuation question: Is there a group of individual stocks that will likely give you a safer and more rewarding stream of income than you’d get from US government bonds? Those bonds yield only half as much as our 8 almost-as-safe stocks. But which are the most safe and most effective sources of retirement income? I’d say the 5 Dividend Achievers in Column AQ of the Table (APD, JPM, BK, PNC, GD).
Risk Rating: 5 (where 10-yr US Treasury Notes = 1, SPY = 5, and gold bullion = 10).
Full Disclosure: I dollar-average into AEP, INTC, JPM and USB, and also own shares of APD and GD.
"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com All rights reserved.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
