2023-10-11 03:01:26 ET
Summary
- Many companies are showing up as bargains right now, I cover my five favorites.
- Utilities may not be as good of a bargain as they seem, as their dividend yields are influenced by interest rates.
- Retailers and banks are showing up as potential bargains, but investors should be cautious and consider the risks associated with these industries.
With the recent market drop, more companies are showing up on my screens as potential bargains. The primary initial screen I use for tracking is the variance from historical dividend yields, or dividend yield theory (DYT).
Dividend yield theory is mean reversion on dividend yield. It says that over time, a company's dividend yield will return to its long-term average. While this is a fantastic way to screen for potential dividend growth bargains, it should only be used as an initial screen for possible deals.
One of the most significant factors that can affect DYT is payout ratios. A company that drastically increases its payout ratio quickly can alter the yield significantly in a way that other fundamentals might not keep up with.
Examples are Broadcom ( AVGO ), which increased the payout ratio from 17% to 50% in a few short years, and Tractor Supply Company ( TSCO ), which went from 24% to 40% in just over a year. Overnight, these companies appeared as bargains based on the higher dividend yields. However, other underlying fundamentals remained unchanged.
Another factor of significance using DYT is the time period chosen for comparison. This is especially true since 2009 when, until recently, we were in a steady state of falling interest rates. While this caused the overall market to inflate, perhaps no industry is a better example than utilities.
Are utilities a bargain?
During the zero-interest rate years, investors often saw utilities as a bond substitute with a safe and steady income. Unsurprisingly, the dividend yield on utilities fell over this period. The chart below shows the 10-year government bond yield and NextEra Energy ( NEE ) dividend yield, although any utility would show the same trend.
Today, NEE is touted as a bargain given its highest yield in years, which appears to be a great deal if we are only looking at the last decade. However, it doesn't look like a great bargain when we see that the dividend yield moves with the 10-year note. Of course, if the yield on government bonds were to fall steeply in the coming years, buying today would look like a smart move in hindsight.
Methodology
I use a multiple buy point system when tracking companies. My first buy point is at the top 25% of historical dividend yields, the second is the top 10%, and the third is the top 5%. Of course, this is just an initial indicator that a company may be a bargain. I always use follow-up evaluations before purchasing and recommend that everyone does additional research.
Currently, there are 87 companies that I track. At present, 13 are at the third buy-point, 11 are at the second, and nine more at the first. Many are sitting right on the edge, and the list fluctuates daily. The tables below show the companies at each buy point, ranked by distance from the 1st buy point.
Wyo Investments
It's easy to see that many of the highest-rated bargains are companies with significant question marks right now. Of course, that is why they are bargains. There are two groups of companies worth mentioning as a whole: Banks and Retailers.
Banks
I only track a few banks; US Bank ( USB ), Toronto-Dominion ( TD ), and Morgan Stanley ( MS ) are all showing as good bargains. However, regardless of where you believe the economy is headed, there are massive risks in banks from the commercial real estate sector, and it is being priced in. Many experts believe that the collapse of Silicon Valley Bank last spring was just a foreshadowing of what is coming.
Retailers
Several retailers are showing on my lists as potential bargains. Retailers are driven significantly by the economy and have different factors for an investor to consider when using DYT. Several of the deals showing up, like Home Depot ( HD ), are showing a dip in earnings for next year. The question to be asking is how accurate are the earnings estimates? Is the economy weakening or getting stronger? These answers may not matter to long-term investors, but they should understand that real pain is possible.
I always look at the yields a company offered during a significant market downturn to get an idea of what is possible. For example, Home Depot offered better than a 4.5% yield in 2009. That's a far cry from today's bargain yield of 2.9%. An investor jumping on today's bargain could be in for some disappointment should an actual recession develop. However, there is a bright side for the dividend growth investor.
These companies have a much larger variance from a good yield to a great yield than a staples company like PepsiCo ( PEP ). However, they tend to bounce back quickly as the economy recovers. So, buying at a historically good yield will pay off over time, even if it means enduring short-term pain. The biggest risk (for the dividend growth investor) with retailers is that the dividend is cut during an economic downturn, not missing out on the absolute best yield.
Anyone buying retailers (or any cyclical) today should understand that much better bargains are possible if a recession develops. Out of the retailers, I like Tractor Supply Company ( TSCO ) the best for its strong consistency, even in a recession. Best Buy ( BBY ) is attractive for its significant yield and dividend growth, but as beaten down as it is, it could offer a massive yield in a bad economy. Target ( TGT ) is intriguing, near its all-time high yield set in 2017 when the company had similar issues as today.
My Favorites Right Now
One of the biggest challenges when investing limited funds is deciding which deals deserve your attention. It's a matter of weighing the magnitude of its current deal, the likelihood of a better future yield (price falling), and its future dividend growth prospects, then comparing it to every other potential bargain.
There are additional factors right now as well. With cash and individual bonds offering appealing yields, often much better than stocks, there is no reason to rush into perceived bargains. Additionally, with so many companies at historically high yields, it's reasonable to choose a quality dividend growth ETF like Schwab US dividend Equity ETF ( SCHD ), which yields close to 3.8% and has a 10-year dividend growth of over 10%.
I hold a significant amount of cash, making small daily SCHD buys, and occasional stock purchases. Here are some of my favorite deals today:
Kroger ( KR )
Kroger has been raising the dividend rapidly for the past 18 years. The 5 and 10-year dividend growth rates are both close to 14%. The last increase was 11.5%, following a 20% one the year before. During this time, the payout ratio has remained relatively consistent between 20 and 25%, although it is currently at the high end of this range.
As a grocery chain, the company's earnings are buffered against an economic downturn. Additionally, the company can reasonably pass on inflation. The most significant risks lie with its larger competitor, Walmart (WMT), being better able to absorb inflation with margin loss. The chart below shows the historical yields of Kroger.
United Parcel Service ( UPS )
While UPS is beaten down over its newest labor contract, the future looks bright for the company. Online shopping will continue to grow, and UPS will continue to grow with it. While a recession would undoubtedly hurt the company's stock, this looks like a good entry point. Because the payout ratios have jumped and look to remain elevated for a few years, I expect muted dividend growth.
UPS has been raising the dividend for 14 years, with 5-year and 10-year growth rates of over 10%. Last year's increase was much lower at 6.5%, but this was on the heels of a whopping 50% increase.
Nexstar Media Group ( NXST )
Nexstar is a speculative pick. The company is not in the most favorable industry, being best known as a local television channel operator. However, they have a diverse group of media businesses, and the company generates substantial cash flows. In recent years, they have rewarded shareholders with massive share buybacks and significant dividend increases. This is shown in the chart below.
The company has grown the dividend massively over the past decade, with 5 and 10-year growth rates above 25%. Last year's increase was 50%, which does make the company look like a bigger bargain than it is when using DYT. Even with the significant increases, the payout ratios remain very low.
Note that Nexstar has an S&P credit rating of BB+, which is below investment grade. For this reason, any investment should be considered speculative.
Texas Instruments ( TXN )
Texas Instruments has rewarded investors with large dividend increases for over 19 years. They have 5 and 10-year growth rates well north of 15%. However, the last two have been smaller, with this year clocking in at just under 5%. This year's smaller increase was expected, given the global slowdown and the company's capital investments. While the capital investments will pay off in the future, investors should expect smaller increases for the next few years.
While Texas Instruments is a historically good buy at a 3.3% yield, it has been stuck for a while. Like Medtronic (MDT), the company could remain in bargain territory for an extended time. In the chart below it can be seen that TXN is trading near historically high yields.
Visa ( V )
While Visa pays a significantly lower dividend than the other companies, it is one of the safest, most consistent growers available. The company has increased the dividend by more than four times in the last decade while maintaining a payout ratio of around 20%.
Visa has rarely exceeded a 0.8% yield. With the upcoming increase, it will likely see its highest yield in history. While the low payout isn't for everyone, this is a fantastic place to buy for the dividend growth investor with a lot of time. This is shown in the chart below showing the percent change in the dividend since 2011.
Target ( TGT )
Target is shrouded in controversy right now. However, this isn't new to the company. It faced similar times in 2017 when the stock last hit a 4% yield. While the earnings appear to be returning to the pre-COVID trend line, cash payout ratios remain below 30%, even with the significant dividend increases over the past decade. Below is a chart of Target's historical dividend yields, showing the significant opportunity today.
The company has increased the dividend for 56 straight years. The 5 and 10-year dividend growth rates both exceed 10%. The company went from a 25% dividend increase in 2022 to a sub 2% increase this year, making an investor wonder if management really knows what's going on in the business. While Target could be the next Walgreens (WBA), the fundamentals look much better, and despite management's missteps, they have a long way to go to match Walgreens.
For further details see:
Diving Into Dividends: Bargain Opportunities In Dividend Growth