The 4 Biggest Contrarian Dividend Plays Out There

A big dividend yield is one of the most alluring statistics in all of investing. It feels like free money. In fact, you often hear the related phrase, "this company is paying you to own its stock."

And when the market is also underestimating the value of a dividend stock, you have the opportunity to get paid while you watch the stock price appreciate.

That is absolute nirvana for a contrarian dividend investor -- getting large dividends and large capital gains. Today, there are four stock plays that could provide just such an opportunity.  

Contrarian dividend play No. 1: dogs of the S&P 500
My colleague Dan Dzombak made a list of the 10 S&P 500 stocks with the largest dividend yields -- ranging from 5.6% to 8.4%. Five telecom stocks dominated that list, with Frontier Communications (NYSE: FTR  ) sporting the largest yield.

The S&P 500 is made up of the largest, most venerable companies in the U.S. But what you have to watch out for is the dividend payers on the way down -- companies on this list that have run out of growth options and are just paying out their cash flow. For example, I worry that this may be the case for mail processor Pitney Bowes (NYSE: PBI  ) . Hence, despite its 6.7% dividend yield, I'd require a very low normalized earnings multiple to buy into that stock.

Conclusion: This list is definitely worth investigating for beaten-down prospects.

Contrarian dividend play No. 2: mortgage REITs
I've warned in the past about the dangers of taking a huge dividend yield at face value, and no stocks have bigger face values than mortgage REITs. Annaly Capital (NYSE: NLY  ) , American Capital Agency (Nasdaq: AGNC  ) , and Hatteras Financial (NYSE: HTS  ) all have dividend yields between 15% and 20%. Yowza!

They have similar business models -- borrowing short-term at cheap interest rates and buying longer-term, higher-interest rate mortgage-backed securities that are guaranteed by government agencies or government-sponsored entities like Fannie Mae.

How is this a contrarian play? Because investors haven't bid up share prices to lower these dividend yields. That's because they know that this party ends at some point, when interest spreads will contract and these companies won't be able to support such high dividends.

But Ben Bernanke's announcement yesterday that the Fed will again start buying government bonds -- $600 billion worth -- shows that this interest rate party may last quite awhile. Even after the party's over, it's possible these companies will stick around with lower but still attractive dividend yields.   

Conclusion: This is something to consider for advanced investors who want to make a bet on the government's will to keep interest rates low. But read this warning before proceeding.

Contrarian dividend play No. 3: bank stocks
I've said it before and I'll say it again: The financial industry is a ripe area for contrarians these days. I love areas of the market that investors don't even consider considering. So many people got burned by the dividend cuts of the thought-to-be-safe banks that a large percentage of former bank investors are once bitten, twice shy.

Small banks provide great opportunities. But today, I want to highlight the opportunity in two big banks that have cut their dividends to basically nil. Because of the uproar over the foreclosure mess, Bank of America and JPMorgan Chase are trading at price-to-tangible book values of 0.9 and 1.3. That's impressive considering anything under 1.5 catches my eye.

Besides more clarity around foreclosures, dividend increases could be a share price catalyst for these two (and all the big banks).

Conclusion: If you believe the foreclosure headlines are overblown (I do) and if you're willing to roll the dice on banks with virtually no balance sheet visibility and virtually no current dividends, these two banks are quite cheap.

Contrarian dividend play No. 4: defense stocks
When the big kahuna of clients -- Secretary of Defense Robert Gates -- announces he wants to cut $100 billion over the next five years from a $700 billion annual U.S. defense budget, you can bet defense stocks of all stripes react negatively.

But here's the thing. Even though stock prices across the industry are depressed, individual players will have different outcomes. Sales at the big defense contractors are chunky. A big win at the expense of your competitors can negate a lot of the ill effects of newfound government thrift.

Picking out the winners is tricky, but the prices we're seeing make it worth the effort. Lockheed Martin (NYSE: LMT  ) , General Dynamics (NYSE: GD  ) , and Raytheon all have forward earnings multiples below 11 ; Lockheed also has a trailing multiple below 10 and pays the highest dividend yield of the group -- 4.2%.

Conclusion: It would be great if defense companies were rendered obsolete, but strife isn't going anywhere. I'll definitely be looking further into these three to determine if any will be less affected than the group.

The next step
These four dividend plays -- the dogs of the S&P 500, mortgage REITs, banks, and defense stocks -- are being given short shrift by the market. It's left to us contrarians to profit from their neglect.

If you'd like to read about some more dividend opportunities, we've put together a five-page free report: 13 High-Yielding Stocks to Buy Today. Just click here to take a look.

Anand Chokkavelu doesn't own shares of any company mentioned. General Dynamics is a Motley Fool Inside Value selection. The Fool owns shares of Annaly Capital Management, Bank of America, and JPMorgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 04, 2010, at 6:15 PM, MichaelHamilton wrote:

    If you like cheap bank stocks take a look at MFG, 6 month results due out soon

  • Report this Comment On November 04, 2010, at 8:04 PM, ddepperman wrote:

    These are not good companies, almost across the board. either--sometimes astoundingly--high debt levels or incredible swings in prices, and so on. Think I'll go down to the dog track.

    Bet on the blind St. Bernard.

  • Report this Comment On November 05, 2010, at 12:10 AM, TMFBomb wrote:

    @ddepperman,

    Remember these are contrarian ideas...almost by definition they're not going to look good on the surface. It's like going shopping at an overstock retailer...a lot of digging to find one bargain.

    @Notfooled1,

    Thanks. You can report spam by clicking the little hand in the comment. I did so, so it should be gone soon.

    -Anand

  • Report this Comment On November 05, 2010, at 8:06 AM, bigkansasfool wrote:

    @GermanInvestor - If "The market is always right...." then no one could beat it overtime. The fact is that the market is made up of manic depressive people and that prices of stocks are often way different than their intrinsic value.

  • Report this Comment On November 05, 2010, at 8:17 AM, gavinstokes wrote:

    What I usually do, is use http://www.phoenixmir2.com/dividend to check dividend yields and then I don't go for the highest yields (which usually aren't sustainable, or just caused by a low stock price), but I look in the 6-8% range. I try to find the stocks that have taken a hit, but where the future seems to be more positive.

  • Report this Comment On November 05, 2010, at 4:05 PM, unfatcat wrote:

    Usually the warnings against high dividends refer to companies whose earnings per share are way out of whack with their dividend payments and companies carrying loads of debt. In the case of the REITs, their earnings and dividends align nicely and their debt is, uh, just what you'd expect from a company that makes its money from the spread on borrowing.

    The Fed will eventually raise its rates but by that time the other stocks in you nicely balanced portfolio will probably be going great guns.

  • Report this Comment On November 05, 2010, at 5:13 PM, Glycomix wrote:

    Thank you Mr. Chokkavelu

    Lockheed-Martin looks like a good investment.

    Technically, they've just had a double bottom (head and shoulders) and their current stock price of $73.27 is above the neckline today. They're poised for at least a dollar move to the upside from $73.27 to resistances at $75 and $76.10

    Lockheed's value ratios are also impressive. LMT seems to be at a fairly good price with a current PE of 10.16 and a forward year PE of 10.71. It has a 4.17% dividend, and has an excellent Return on Equity of 75%.

    Lockheed is guaranteed a continuing funding worldwide from their manufacture of the C130 transport which is used by by many countries worldwide: cf European countries, Saudi Arabia, Austria, Chili and Pakistan They have also produced a supersonic, stealthy replacement to the Harrier that has been accepted by the US military and by the British.

    Lockheed's only real negative is its debt burden. It has a debt to equity ratio of 120% of equity and a current ratio of only 1.20.

    I'm not sure that we should buy and hold Lockheed-Martin more than a month. However, for the next 1-3 months it looks like a good investment. If you buy by Nov 25 and hold for a month you get an increase in the stock price and a 4.17% dividend.

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