One of the biggest stories over the past year or so has been rising interest rates. You may have heard that the yield curve is now inverted, which means that the 10-year Treasury rate is actually less than the two-year rate.
More specifically, the 10-year Treasury rate is currently 3.5% compared to 4.1% for the two-year rate and 4.7% for the three-month rate. An inverted yield curve indicates that investors believe interest rates will decline in the future, which typically happens during a recession, when the cost of borrowing becomes cheaper to stimulate the economy.
Dow Inc. (DOW -0.10%), Watsco (WSO 2.31%), and NextEra Energy Partners (NEP 7.39%) are three dividend stocks that each have a dividend yield that is higher than the 10-year Treasury rate and have a path toward steady growth over time. Here's what makes each company worth considering now.
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Dow Inc. is a worthy value stock
Daniel Foelber (Dow Inc.): Dow Inc. is a chemical company, operating in a cyclical industry. It mostly sells its products to other businesses that then use those chemicals to make finished goods for the automotive industry, as well as packaging, infrastructure, and consumer products. Dow tends to see an uptick in business when manufacturing rises. It is also impacted by energy and other commodity prices since it must pay for those to run its factories.
Despite these risks, Dow is a heavily entrenched company with mature business segments and a solid balance sheet, and does a good job of managing costs. In short, it looks like a value stock whose boring business, inexpensive valuation, and high dividend yield tend to be overlooked because of its low growth.
Perhaps the most glaring red flag for investors is that the company has not raised its dividend since spinning off from DowDuPont in 2019. However, dividends tell only part of the valuation story for Dow. In the third quarter of 2022, the company earned $1.43 billion in free cash flow, paid $493 billion in dividends, and spent $798 billion on share repurchases. It was the largest quarterly buyback since the spinoff.
Dow's decision to ramp up buybacks instead of raising the dividend may benefit shareholders more in the long run. The stock already has a yield of 4.8%, which is higher than the risk-free rate of a three-month Treasury. Reducing the outstanding share count and thus boosting earnings per share (EPS) could result in more value over time.
The company is expected to see a sizable earnings slowdown in 2023, down to an estimated $3.40 per share at the average compared to $6.25 in 2022. But even then, Dow's forward price-to-earnings ratio would be only 13.9 -- which shows that the company is still an excellent value even if its earnings drop.
Dow may not be the flashiest business. But it is a staple of the industrial economy with all-around balanced fundamentals that makes a lot of sense in a value-orientated income portfolio.
An industry leader that's going places
Lee Samaha (Watsco): This heating, ventilation, air conditioning, and refrigeration (HVACR) parts distributor is the market leader in a highly fragmented market. Management has built the company up over the years through the acquisition of myriad small distributors, generating more than double the sales of its nearest competitor. The acquisitions have added scale and geographic reach and enabled value creation by giving the new distributors access to Watsco's relationships with vendors and its technology platform (including e-commerce websites and apps to help contractors quickly order parts).
It's a model that's worked over the years and offers plenty of potential for the future. That said, Watsco's heavy exposure to the U.S. residential market means it could face challenges in 2023. Around 90% of its sales go to the U.S., and 65% to 70% of its sales are in its residential segment, with 10% to 15% in new housing. While the new housing exposure is relatively small, a bump in house prices could lead to homeowners forgoing upgrading and replacing HVACR. Similarly, the company enjoyed a boom in sales from the stay-at-home measures encouraging spending on the home -- comparisons that will be difficult to overcome in the near term.
But demand for replacement parts is relatively recession-resistant and will grow over the long term as the installed base of HVACR equipment will need servicing. In addition, a decline in the market over the near term could create attractive acquisition opportunities for Watsco. Meanwhile, investors can enjoy a 3.6% dividend yield -- larger than the 10-year Treasury rate -- while management executes its highly successful business strategy.
Charge up your passive income stream with NextEra Energy Partners
Scott Levine (NextEra Energy Partners): Whether they are young or old, every investor should have a portion of their portfolio carved out for conservative investments such as Treasury notes. But for those comfortable accepting more risk to potentially increase their passive income stream, shares of NextEra Energy Partners and their forward dividend yield of 4.3% deserve a look.
In addition to the dividend, there's the potential to benefit from capital appreciation from this utility stock that has recently outperformed the market. Over the past five years, for example, the 107% total return of NextEra Energy Partners has nearly doubled the 54.5% total return of the S&P 500.
While NextEra Energy has some natural gas assets in its portfolio, the company is largely dedicated to renewable energy. The company reported in November that it had about 63 gigawatts (GW) of clean energy assets -- including wind, solar, nuclear, and battery storage -- in its portfolio. And there's more coming down the line; NextEra Energy Partners ended 2022 with a company record 19 GW of renewable and energy storage projects in its backlog.
A stock that offers a high-yielding dividend is great, but it means little if the company is unable to sustain the payout, a situation that doesn't seem to apply to NextEra Energy Partners. According to its Q4 2022 earnings presentation, the company expects to grow adjusted earnings per share at a compound annual rate of 6% to 8% -- from $2.90 in 2022 to between $3.63 and $4.00 in 2026. And investors should directly benefit from that earnings growth. On the fourth-quarter conference call, management said it recognizes "12% to 15% per year growth in per unit distributions as a reasonable range of expectations through at least 2026."
