Passive income is a phrase that gets thrown around a lot these days, and for good reason. The idea of making money by doing nothing has a lot of appeal. But it's easy to go astray searching for outsize returns from investment vehicles that generate periodic payments.
One tried-and-true method for earning passive income is by investing in companies with a track record for growing their earnings and consistently raising their dividends. However, some folks don't want to go with a stodgy consumer-staples company with organic growth in the low single digits.
Investors looking for a little bit more upside potential (along with a dividend they can count on) have come to the right place. Buying shares of Target (TGT 0.76%), United Parcel Service (UPS 0.55%), and Caterpillar (CAT -0.47%) as a group will give an investor an average dividend yield of 2.5%, as well as exposure to a diversified portfolio. Here's what makes these three powerhouse dividend stocks a great buy now.
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1. Target is a retail winner too cheap to pass up
Target stock got taken to the cleaners last month after its earnings came out and the stock fell about 25% after the report's release. Apparently, the company found itself woefully unprepared for slower consumer spending.
It's no secret that Target has to stock up on inventory several months in advance, which leaves it vulnerable to sudden shifts in buyer preferences, as well as the broader economy. It's a tall order to try to predict what customers will want to buy (and how much) far in advance, let alone manage the complex supply chain and distribution channels -- in-store and online -- to meet that demand. Although Target has a track record for doing this very well over the long term, there's no denying it missed the mark this time around.
The question is whether shares sold off too much, given the news. I think the risk/reward for the stock now looks as attractive as ever. Target has a forward price-to-earnings (P/E) ratio of less than 15, which is below the S&P 500's forward P/E estimate of 19.4. What's more, Target is a Dividend King, having paid and raised its dividend annually for 50 consecutive years. Down big from its high, with a dividend yield of 2.2%, Target looks like a great all-around buy even if there's an impending recession.
2. UPS stock isn't expensive, and its dividend yield is sizable
UPS investors have had a lot to be happy about over the last few years. Since taking the reins as CEO in March 2020, Carol Tomé has done an impeccable job of boosting shareholder value through revenue and earnings growth, as well as through share buybacks and the largest dividend raise in company history. But like Target, UPS's performance can be cyclical.
UPS makes more money if residential customers are ordering more stuff online. Similarly, the company does better when businesses are relying on it to expedite shipments, and transport more parts, components, raw materials, and other inputs. In short, an economic downturn is not a good thing for transportation stocks. But 2020 was a rare exception because consumers shifted purchases online during the pandemic, which was a net positive for UPS.
However, UPS makes up for its cyclicality with a 3.3% dividend yield backed by impressive revenue, earnings, and free-cash-flow (FCF) growth. It is in its best shape in company history and is better positioned than ever for a recession. Even if its growth slows, it should generate plenty of free cash flow (FCF) to support its dividend.
As the industry-leading package delivery company, UPS should be able to take market share during a recession, not lose it. Shipping and logistics is an industry that depends on scale and efficiency. The company has both, and it wouldn't be surprising if it seeks acquisitions during a time of weakness for the broader industry. Like Target, investors need not worry if UPS can make it through a downturn. With a forward P/E of 14.1, it looks like an inexpensive dividend stock to buy now.
3. Caterpillar can afford for the construction industry to slow
Caterpillar is even more cyclical than Target and UPS. It manufactures equipment and machinery used across the industrial and energy sectors -- in construction, energy, power generation, mining, marine and rail transportation, and agriculture. So if those industries are doing well, customers might be more inclined to purchase or finance new products from Caterpillar.
What makes Caterpillar uniquely positioned in today's economy is that the weakness in construction is being offset by strength in energy, transportation, and mining. Whereas in typical economic downturns, the majority of Caterpillar's business units are either boom or bust. It's worth understanding that the combined revenue and earnings from mining, energy, and transportation are larger than Caterpillar's construction segment alone. So it would gladly trade a slowdown in residential and commercial construction if it meant more demand for its mining, energy, and transportation equipment.
But despite eight-year-high oil and gas prices, Caterpillar has yet to see the oil and gas boom translate into record sales growth in its energy and transportation business -- yet.
If oil and gas prices remain high, we could see capital spending increase, which could lead to growth for Caterpillar. This opportunity presents a lot of upside. In fact, don't be surprised if the company produces record results in 2022 even if the economy worsens.
In the meantime, Caterpillar stock has a forward P/E of 17.5 and is a Dividend Aristocrat with a yield of 2%.
Three similar dividend stocks to consider now
Despite being in three completely different industries, Target, UPS, and Caterpillar have a lot in common as investments. All three stocks trade at forward P/E ratios that are below the market average. All three companies are also leaders in their respective industries. Target and Caterpillar have consistently raised their dividends every year for decades, while UPS generates FCF that far exceeds its dividend even after its recent raise.
The beauty of all three companies is that their dividends add a layer of consistency on top of an otherwise cyclical business model -- which makes economic cycles less painful. For investors looking for quality companies and reliable sources of passive income, Target, UPS, and Caterpillar are three companies that are worth a closer look.
