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Which Cheap Stock Is the Best Dividend Stock?

By Sean Williams – Jul 14, 2016 at 12:42PM

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Combine a mid-single-digit forward P/E with a 5%-plus dividend yield, and you get this top dividend stock.

Image source: Getty Images.

You might want to keep your motion sickness pills handy, as it's been a bumpy ride for U.S. stocks in 2016. Following the worst start to the year in history, the S&P 500 staged its biggest intra-quarter rally in 83 years. This wild move in Q1 was followed more recently by the Brexit-based swings after British voters chose to leave the European Union.

All of this means one thing for the stock market and investors: turbulence.

Cheap stock + dividend stock = Yes, please!

When the market gets turbulent, investors have a tendency to seek out seemingly cheap stocks that they think can add to their portfolios for the long term. Everyone's definition of a "cheap stock" tends to differ, but I like to think of a cheap stock as one that's valued well below its peers and/or the average fundamental metrics of the broader-based S&P 500. The trick is finding out whether a stock is cheap because it's simply following the market turbulence in sympathy, or if there are underlying problems adversely affecting the business model.

Fluctuating markets also prompt investors to seek the comforts of dividend stocks. Dividend stocks tend to have proven business models -- otherwise, they wouldn't be sharing a percentage of their profits with shareholders. Dividends can also provide a downside hedge for investors, and they allow for reinvestment into more shares of stock, thus compounding the dividend paid and the stock owned over and over.

Ideally, investors would love to buy cheap stocks with a great dividend yield. But not every cheap dividend stock is necessarily a great buy.

Image source: GameStop.

Cheap stocks with great dividends aren't always in good shape

For example, video game and accessories retailer GameStop (GME -1.98%) is currently valued at just six times next year's profits, has a PEG ratio (a metric that measures a company's P/E against its future growth rate) of 0.9 -- anything below 1 is typically considered a bargain -- and its dividend yield is a delectable 5.2%. Everything looks great on the surface. Dig a bit deeper, though, and it could be game over for GameStop.

GameStop has always been a traditional brick-and-mortar gaming and game accessories retailer. However, with the advent of streaming online games and mobile games, the need for brick-and-mortar gaming retailers is dwindling. GameStop could also struggle to find any sort of pricing power as e-commerce sites boast low overhead costs and pressure its margins. GameStop's coping mechanism has been to close underperforming stores and cut costs to maintain margins, but cost-cutting isn't a long-term growth strategy.

I'll say GameStop isn't completely hopeless, as its own push into streaming and mobile downloads paid off with 41% sales growth in the first quarter. But with next-generation consoles still likely years out, there simply aren't any intriguing catalysts to entice investors to own this cheap dividend stock.

Image source: Getty Images.

Close, but no cigar

Another incredibly cheap stock that could catch the attention of dividend investors is MetLife (MET 0.30%), provider of life insurance and financial products and services. At the moment, MetLife is trading at only six times next year's profit estimates, has a PEG ratio of around 0.6, and yields 4%.

Unlike GameStop's business model, MedLife's has numerous redeeming qualities. Specifically, insurers possess some of the best pricing power of any industry in the world. Insurers can use periods of higher claims as justification to raise premium prices in order to rebuild their cash float. But insurers can also raise premiums in times of minimal claims, with the justification that claims aren't a matter of "if," but "when." This strong pricing power makes MetLife an attractive option for income seekers.

But where MetLife comes up short is its dual reliance on interest rates. Insurers are constantly investing their float (i.e., pooled premium payments that haven't been paid out as a claim) in safe, interest-bearing, short-term assets. With debt around the world near record-low yield territory, insurers are netting very little investment income. Low yields could also make selling annuities difficult, as fewer consumers will want to lock in the returns we're seeing today. Being so dependent on interest rates makes MetLife a good, but not great, choice for investors.

Image source: General Motors.

The best dividend stock that's dirt cheap

If you're looking for the market's best dividend stock that also happens to be dirt cheap, I'd suggest looking no further than Detroit automaker General Motors (GM 0.87%).

General Motors has hit its fair share of bumps in the road, including the 2014 recall of more than 30 million cars, some of which were tied to its high-profile ignition switch issue. The total cost of recalls for GM reached more than $4 billion.

Despite the recalls, new vehicles have remained a hot commodity in the United States and abroad, even in a weaker global growth environment. The U.S. industry delivered the highest annual sales on record in 2015, with 17.5 million vehicles moving off dealer lots. This strength has continued into 2016, and it shows little sign of abating. GM's sales in China are up 5.3% during the first half of 2016, with SUV performance especially strong. China is already the world's largest auto market, but it could just be ramping up, given the country's burgeoning middle class. In the U.S., GM has gained market share in 13 of the past 14 months, and retail sales are up a bit more than 1% in the first half of 2016.

Two factors continue to work in General Motors' favor. First, the low-yield environment that's crushing MetLife is pushing GM forward. With abundant access to cheap capital, consumers are not only buying more new vehicles, but also purchasing trucks and SUVs like they're going out of style. Trucks and SUVs carry juicier margins for GM.

Secondly, GM's innovation continues to shine through. It's focused on delivering in-cabin luxuries by making its cars technologically smarter and more user-friendly, thus appealing to a younger population and perhaps setting the stage for a new generation of lifetime GM owners.

Valued at only five times next year's earnings, yet yielding 5.4%, General Motors is not only a cheap stock but, in my opinion, the best dividend stock to consider owning today.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool has the following options: short July 2016 $28 puts on GameStop. The Motley Fool also recommends General Motors. 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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Stocks Mentioned

MetLife Stock Quote
$76.95 (0.30%) $0.23
General Motors Stock Quote
General Motors
$40.46 (0.87%) $0.35
GameStop Stock Quote
$26.17 (-1.98%) $0.53

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