With interest rates near historic lows, many income investors have flocked to high-yielding dividend stocks. That shift enabled many slow-growth blue chips to outperform the S&P 500, but also inflated their stock prices while reducing their dividend yields to historic lows. As a result, many of these dividend darlings could quickly deflate if interest rates rise.
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Investors looking for fundamentally cheaper stocks with decent yields might consider looking at "hated" dividend stocks that have underperformed the S&P 500's 6% gain over the past 12 months.
In this article, I'll narrow that field to stocks that trade at lower multiples than the S&P 500's price-to-earnings ratio of 25, while paying higher yields than the S&P 500's 2.1% yield. I'll also explain why these companies underperformed the market, how they're turning around their businesses, and why they might be better buys at current prices than more popular income plays.
Gap
Apparel retailer Gap's (GPS 1.05%) stock has dropped as much 35% over the past 12 months and as of Oct. 12 was down about 1% over the past year. The stock remains volatile due to its six consecutive quarters of revenue declines as its three core brands -- Old Navy, Gap, and Banana Republic -- continue to struggle against "cheap-chic" rivals like H&M, Forever 21, and Zara.
Last September, Stefan Larsson, the former H&M exec who turned Old Navy into Gap's fastest-growing brand within three years, left to become the CEO of Ralph Lauren. A fire at Gap's distribution center campus in Fishkill, New York, reduced the company's comps growth in September, and will further reduce its October comps.
But amid those challenges, there are glimmers of hope. Its September comparable-store sales fell 3%, but still beat expectations for a 3.6% decline. Comps rose 4% at Old Navy, indicating that its leading brand remains strong without Larsson, though that growth was offset by a 10% decline at Gap and a 9% drop at Banana Republic. Gap also noted that Old Navy's merchandise margin came in above expectations, allaying fears that the brand was merely boosting comps with bigger discounts.
Image source: Gap.
Gap is also taking steps to strengthen its other core brands. Last month, it hired reality TV star and socialite Olivia Palermo as its first global brand ambassador for Banana Republic to spark interest in the lagging brand with new marketing campaigns and limited edition styles. It's also trying to speed up its supply chain to match the fast turnaround of styles at its fast-fashion rivals. In other good news, The Consumer Confidence Index hit its highest monthly level since the recession in September, and a recent William Blair survey found that teens were gradually returning to malls, which could both boost Gap's holiday sales.
Analysts expect Gap's revenue and earnings to respectively fall 3% and 21% this fiscal year, but estimate a 7% uptick in earnings in the next fiscal year. While a turnaround takes time, Gap's trailing P/E of 15 remains much lower than the industry average of 24 for apparel retailers. Moreover, Gap's forward yield of 3.5% is easily supported by its payout ratio of 52%, and it's hiked that dividend for six straight years. These two factors indicate that while Gap's upside may be limited until a clearer turnaround emerges, its downside should be limited by its low multiple and high yield.
IBM
IBM (IBM -0.35%) has posted 17 consecutive quarters of year-over-year revenue declines, due to sluggish enterprise spending, competition from smaller rivals, and its painfully slow transition toward the higher-growth cloud, AI, analytics, mobile, social, and security businesses -- which Big Blue dubs its "strategic imperatives." That decline won't end anytime soon -- analysts expect IBM's revenue to fall 3% this year and stay nearly flat next year. That pressure caused IBM's stock to advance just 1% over the past 12 months.
On the bright side, IBM's strategic imperatives continue to grow, with revenue rising 12% annually last quarter and accounting for 38% of Big Blue's top line over the past 12 months. The annual revenue run rate of its higher growth cloud "as a service" business, which competes against platforms like Amazon's AWS and Microsoft's Azure, rose 50% to $6.7 billion. The key problem, however, is that these businesses still aren't growing fast enough to offset the big declines in its IT services, software, and hardware businesses.
In previous years, IBM's earnings were greatly inflated by buybacks. But after reducing buybacks last year, its bottom-line growth looks a lot less impressive, with analysts expecting earnings to fall 9% this year but rebound 4% next year. However, IBM's trailing P/E of 13 remains much lower than the industry average of 21 for IT services companies.
Furthermore, IBM's forward yield of 3.6% is supported by a low payout ratio of 43%, and it has raised its dividend for 16 straight years. Like Gap, IBM probably won't rally anytime soon, but its low multiple and high dividend should set a floor under the stock.
The key takeaway
Income investors who see their favorite dividend stocks are trading at premiums to the market and their industries, with yields that have fallen to historic lows, might be wise to consider less appreciated dividend stocks like Gap and IBM, which aren't precariously perched atop rallies fueled by low interest rates.
