Given the recent volatility and downward movement in the stock market, many pundits are arguing whether we are in the midst of a bull market correction (a downward movement of 10% or so from recent highs) or whether the market will return to the lows that were experienced in March 2009. Investors are placing their bets by either buying stocks at what they believe are cheap prices or are shorting the market in the belief that it will go lower. Those who believe that the market will recover quickly point to the positive macroeconomic data in the United States. Those who believe that the market will continue to fall emphasize the recent troubles in Europe and the impact this will have on the world economy.
Predicting which way the stock market will move, particularly in the short term, is risky. However, if you are a longer term investor, I believe that you can make money regardless of which way the market will move by investing in companies with sizeable dividends that are secure. If the market goes down, you will be collecting significant income while you wait for a recovery. If the market goes up from here, you will earn the dividend and benefit from a potential capital gain on the price appreciation of the stock. The key is to choose stocks with dividends that are not in danger of being cut.
In order to assess whether a dividend is secure, I like to compare the amount that a company is paying out as a dividend with the amount of levered free cash flow that it is generating. Levered free cash flow refers to the amount of after-tax net operating profit that a company generates less capital expenditures, interest, and principal repayments on any debt. You can calculate this figure yourself by using the company’s financial statements, or find a service that does this for you. For instance, Yahoo! Finance provides levered free cash flow numbers for companies in the “Key Statistics” section of company profiles.
Many financial analysts rely on the dividend payout ratio to assess a company’s ongoing ability to pay dividends at the same rate. This is usually computed by dividing dividends per share by earnings per share. The problem with the dividend payout ratio is that it relies on accounting earnings, which may not equate to actual cash to the firm. As well, it ignores the full impact of a company’s debt.
Many analysts seek companies with dividend payout ratios that are less than 100%. I think that such a threshold is too high. In tough economic times, I believe that levered free cash flow should exceed the dividend payout by at least 40% and preferably more. This way, if a company hits tough times and cash flow suffers, the dividend is not necessarily in jeopardy.
The following is a list of companies from the Dow 30, S&P 500, and Nasdaq 100 indices that I have compiled that provide a dividend yield of at least 4% and have at least 40% excess levered free cash flow compared to the amount of money paid out as dividends:
Company Name (Dividend Yield)
Reynolds American (7.0%)
Verizon (6.8%)
AT&T (6.8%)
Pitney-Bowes (6.5%)
Qwest Communications (6.4%)
Eli Lilly (5.9%)
Cincinnati Financial (5.9%)
CenterPoint Energy (5.9%)
Bristol-Meyers Squibb (5.6%)
R.R. Donnelley (5.6%)
Lorillard (5.4%)
Philip Morris Int'l (5.2%)
DTE Energy (4.7%)
Leggett & Platt (4.6%)
Nicor (4.6%)
Dupont (4.5%)
Maxim Integ Products (4.5%)
Kimberly-Clark (4.3%)
ConocoPhillips (4.3%)
Federated Investors (4.2%)
Genuine Parts (4.2%)
ONEOK (4.1%)
Obviously, this is just the first step in analyzing whether these stocks are appropriate investments. For instance, there are rumors that AT&T may cut its dividend in order to fund projects. This could potentially have a negative impact on the stock when it occurs. This information only comes to light when one conducts a more in depth analysis of each company, which is a time consuming endeavor.
However, my analysis does show that there are companies in diverse sectors that provide significant income through dividends. Keep in mind that high dividend stocks tend to be mature, lower growth companies that will not necessarily perform well relative to other stocks in a strong economy. Yet, they should provide significant return through dividends with less risk than many of their counterparts.
As well, realize that this is a list of large cap companies with very specific characteristics. There may be smaller U.S. companies or international firms that provide significant dividends as well. For instance, I have recently invested in GlaxoSmithKline, a United Kingdom pharmaceutical company, which yields 5.5% and pays out less than half of what it generates in levered free cash flow as dividends. As an added bonus, I think that the market has paid too much attention to GSK’s patent losses and not enough to its strong pipeline.
Keep in mind that investing in a secure dividend yield locks in your rate of return from dividends. For example, if I invest in a stock that is priced at $50 and it pays an annual dividend of $2.50, I will earn 5% from dividends each year provided that the dividend payments do not change. Even if the stock price rises or falls, this rate does not change since the price I paid for the stock (i.e., $50) is still the same. Thus, I’ll continue to earn 5% on my money as long as the dividend payment is secure. So if the market dips in the short-term, it doesn’t matter!
