Potential bargains come from many different places and in many different forms. Companies that have caught my eye lately, though, have these traits in common: dividend yields greater than the 2.1% offered by the S&P 500 (that average does not include companies without a dividend) and a stock price near its 52-week low.
Of these promising stocks, General Motors
There is one more thing these companies share: problems. GM's car business is suffering and dragging down GMAC (its financial-services arm) in the process. Maytag's high production costs threaten both its competitiveness and its dividend. When Washington Mutual became aggressive with its hedging practices, its earnings took some hits. Some of these problems are relatively easy to solve; some are not.
You don't always find bargains at companies where everything is running smoothly, however. Investors chase those stock prices up. In any case, even if there are issues, we want to ensure a few things -- first, that the company's dividend is relatively safe, and second, that there is a catalyst to drive the stock price up in the future.
Under the right circumstances, a high yield and a low valuation can double our chances to find excess returns.
To find other unloved but high-yielding stocks, I developed the following criteria for my MSN Finance stock screener:
- Dividend yield greater than 3.5% but less than 8%.
- Current price near 52-week low (a nice option in the tool).
- Market cap greater than $5 billion.
- Guaranteed to produce 25% returns per year. (OK, I made that one up.)
Some interesting ideas
I didn't know exactly what to expect when I looked over the results, but it came as no surprise to see many telecom, auto, and pharmaceutical stocks on the list.
Of the companies that made it, though, I found these to be the most interesting.
Albertson's, the second-largest supermarket and drugstore chain in the United States, is composed of brands such as Albertson's, Osco Drug, and Sav-On. With more than 2,500 stores under its umbrella, it generates almost $40 billion in revenue.
The problems: Like most supermarket chains, Albertson's has slumped recently. Despite rising sales, margins contracted from 1.58% in 2003 to 1.11% in 2004. The labor dispute in Southern California cost the company via lost sales and margins last year. According to Albertson's, sales have rebounded but margins have not. In addition, it has been lowering prices and margins in the battle for market share. The lowest-cost producer wins in the supermarket business, and Wal-Mart
The catalysts: Albertson's spent 61% of its capital budget to open, purchase, and remodel stores. These will all help the company continue to grow sales. And according to its 10-K, over 90% of the stores have been remodeled. In addition, the company is working to reduce its cost structure and make its assets more productive by using technology to tie the supply chain together from customer to supplier. It plans to reduce costs by another $250 million by 2006.
Turnarounds are difficult in a competitive environment, and Wal-Mart will fight hard to keep as many consumers flowing through its stores as possible. Albertson's must use its size as an advantage to keep prices low and customers content. Getting paid 3.8% along the way could make the wait a bit easier.
Verizon is the largest wireline communications and second-largest wireless communications company. Yes, telecom is tough, but hear me out.
The problems: Verizon competes in a capital-intensive business. Its networks must be upgraded continuously to keep customers satisfied with high-quality, reliable service. Not only that, but it is surrounded by tough competition. Comcast
The catalysts: Despite the industry and competitive challenges, Verizon has been a very capable competitor. It continues to generate free cash flow even though tons of capital has to be reinvested back into the business just to keep things running. Despite Qwest's
Today, Verizon pays a 4.5% dividend yield and has a P/E of 13 and a 21% return on equity. To me, it has a good chance of producing market-beating returns in the future.
Merck, an Income Investor recommendation, is one of the great innovators in the pharmaceutical industry. It boasts a long history of producing breakthrough drugs and one of the best sales forces in the business.
The problems: The Vioxx issue is on every investor's mind. The loss of revenue combined with millions of dollars in potential damages from the lawsuits (Merck has set aside $675 million for them) have put a strain on the company's near-term financial performance.
It also doesn't help that Merck has been on the receiving end of some early patent expiration judgment for its osteoporosis drug Fosamax. Intellectual property is very important, because it allows that company to reap the benefits of its discoveries long before generics erode the margins.
Lastly, negative press has followed pharmaceutical companies, with the government on their case for the high price of prescription drugs.
The catalyst: To me, the bottom line is that, in spite of the Vioxx ordeal, Merck hasn't forgotten how to conduct R&D or how to sell. Those capabilities are still intact and will adjust to the new environment required to bring new drugs to market. And with its R&D spending adding up to over $4 billion per year, Merck is committed to growing its pipeline of products. It has 20 compounds in phase 1 trials, 18 in phase 2, and six in phase 3. The company also expects to submit production applications for four of those six in phase 3 by the first quarter of 2006.
Despite its recent run-up from a low of $25, there's still an opportunity to purchase a piece of Merck at bargain prices. The 4.5% yield remains above the historical average of 1.4% over the past five years. Merck remains committed to growing the dividend and repurchasing shares via cash flow from operations. As a result, I think Merck still has all of the pieces in place to be a tremendous force in the pharmaceutical industry and the potential to generate above-average returns.
The power of dividends
Dividends can do amazing things for a portfolio. And doubling up with great yields at reasonable prices can really juice up returns. Mathew Emmert, lead analyst for Motley Fool Income Investor, knows the power of dividends -- his dividend-paying selections overall have outperformed the market. Take a 30-day risk-free trial and find out how to power up your portfolio returns.
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