Retirees should invest in companies that are well capitalized, pay decent dividends, and aren't overvalued relative to their industry peers. However, low interest rates and macroeconomic uncertainties recently caused "defensive" dividend plays like Johnson & Johnson and General Mills to rally, resulting in higher valuations and lower yields.
Therefore, retirees looking for cheap dividend stocks with higher yields need to consider less loved companies like IBM (NYSE:IBM) and Apple (NASDAQ:AAPL). Let's see why these two out-of-favor stocks might be great additions to your retirement portfolio.
At first glance, IBM doesn't look like a great investment. Its revenue has declined for 17 straight quarters due to sluggish enterprise spending, competition from smaller rivals in the business services market, and the strong U.S. dollar. Revenue fell 3% annually last quarter as net income plunged 29%. For the full year, analysts expect Big Blue's revenue to fall 3% and earnings to decline nearly 10%.
However, IBM's revenue from its "strategic imperatives" of cloud, AI, analytics, mobile, social, and security rose 12% to $8.3 billion and accounted for 38% of IBM's revenue over the past 12 months. Total cloud revenues rose 30%, and the annual run rate of its cloud services grew nearly 50% to $6.7 billion. As IBM continues to invest in the growth of these businesses while divesting slower-growth ones, sales and earnings growth should eventually return.
That transition will take time, but IBM's downside is now limited by its fundamentals. The stock trades at 12 times earnings, which is well below the industry average of 17. It pays a forward annual dividend of 3.5%, and it has raised that payout annually for the past two decades. It's only spent 35% of its free cash flow on dividends over the past year, so it has plenty of room to raise the dividend to reward patient investors.
Apple was one of the hottest stocks of the past decade, but many investors are now avoiding it because sales of all three of its core hardware products -- the iPhone, iPad, and Mac -- are slowing down. The slowdown in iPhone sales is particularly worrisome, because it generated 65% of Apple's sales last quarter. As a result, analysts expect Apple's revenue and earnings to respectively decline 8% and 11% this fiscal year.
However, Apple still has a few tricks up its sleeve. The services segment -- which includes Apple Pay, Apple Music, the App Store, and iTunes -- could eventually become a major source of sales growth and lock in iOS users. Its expansion into wearables, smart homes, and those long-rumored electric cars might eventually diversify its top line away from mobile devices. With over $200 billion in cash and marketable securities (although most of it is overseas), Apple can buy plenty of companies to complement those efforts and enter new markets.
This transformation won't happen overnight, and many fickle investors aren't waiting around to see if Apple will succeed. However, it now has a price-to-earnings ratio of 11, compared to the industry average of 15. It pays a forward annual yield of 2.3%, and it has raised that payout annually over the past three years. That yield might seem low for income investors, but Apple only spent 22% of its free cash flow on dividends over the past year -- meaning that it will likely keep raising its payout for the foreseeable future.
The bottom line
IBM and Apple are both out-of-favor stocks with low valuations, solid free cash flows, and decent dividends. That's probably why billionaire Warren Buffett, the poster child for long-term investing, owns shares of both companies. Neither stock will likely rally unless their turnarounds start bearing fruit, but their downside potential is limited -- making them solid income-generating picks for retirees.
Leo Sun owns shares of Johnson and Johnson. The Motley Fool owns shares of and recommends Apple and Johnson and Johnson. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. 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.