Savvy bond fund marketing will try to convince you that bonds can do everything from save your portfolio to clear up an embarrassing rash, but in my recent article Broken Bonds, I relayed my general distrust of the bond market as a timely investment. However, I felt it unfair to leave those investors seeking safety and income out in the cold, so I decided to find some solid stocks that fill the void.
With that said, it's worth mentioning these stocks should ultimately be desirable to nearly all investors, as these companies were chosen because they are high-quality businesses that pay you while the economy, and the market, is on the mend.
In order to compile this list, I began with the basics. They had to be safe, proven companies. All these firms have a demonstrated ability to maintain and grow earnings in the most challenging environments. Another benefit of stable earnings is that I've found them a better indicator of low volatility than beta. In order to eliminate particularly small companies, I set the bar for market capitalization at $1 billion (though most in the final list are above $10 billion).
Gotta get paid
Next, we want income. I've long been an advocate of dividend-paying stocks. Market historians note that dividends have accounted for nearly half the S&P 500's long-term returns. And in this market, it can be nice to get something tangible that can also be used to pay the light bill.
Given that desire, I only looked at stocks with yields over 3%. Of course, dividends are worth pocket lint if they aren't sustainable -- just ask shareholders of Ford (NYSE:F) or utility stock TXU (NYSE:TXU), Williams (NYSE:WMB), and Xcel Energy (NYSE:XEL). In order to avoid companies that stifle future growth by paying out too much of their profits, I selected only firms that pay out relatively small amounts of their free cash flow. Every company in the list pays out less than half, save Altria (NYSE:MO), a special case, and even they pay out only 55%, leaving plenty to grow and manage the business.
Dud free
The last criterion was meant to eliminate those companies that have little chance for share-price appreciation. I mean really, just because we've got a nice safe company with a great dividend yield doesn't mean we're content to simply tread water. To that end, I sought good values with low price/earnings ratios and positive earnings growth (past and projected).
I'm truly excited about this final group. All of these firms have a great chance of outperforming the market over the long haul, while giving you a chance to buy lunch along the way. I'll keep track of this group, and let you know how they're performing from time to time. Without further ado, here goes -- we'll cover the first two companies today and then I'll continue with more in this space next week.
Smothered, covered, and coated
The first company in this classy collection is RPM International (NYSE:RPM), a world leader in manufacturing specialty coatings products. From consumer products like Rust-Oleum to industrial waterproofing and plastic sealants, they're a coater's dream come true. Perhaps not the most exciting stuff in the world, but profitable when you're as innovative as these guys.
The firm is teetering dangerously close to my $1 billion market cap cut-off, but only because the stock has fallen by over 40% recently. Somehow, I imagine that doesn't exactly make you feel better, but keep in mind this company has been providing outstanding results for over half a century.
Since 1975, RPM shares have produced an annual compounded rate of return (including dividends) of approximately 18%, and the firm has increased its dividend for 28 consecutive years. Over its life, it has achieved 52 consecutive years of record earnings. It is expected to grow earnings 13% this year and 10% annually for the next five years, and it has a return on equity of over 14%.
OK, there's no question these folks know how to create value, but let's get back to that whole "40% drop" thing. The stock has suffered recently, falling from its 52-week high of $17.87 to its present $9.20, mostly due to fears over asbestos claims. I know investors shudder when they hear the word asbestos, and I'm not terribly fond of the idea of billions of microscopic fibers clogging my lungs either, but in this case it's an overreaction.
RPM has been successfully managing the asbestos issue for nearly 20 years now. In its January quarterly report, the company noted that costs associated with its 1,490 active asbestos cases were actually down sequentially from quarter to quarter for fiscal 2003.
Now I'm not complaining about the overreaction. In fact, I love overreaction. Overreaction makes me giddy. It's overreaction that gives us an opportunity to buy a company with a solid balance sheet and great cash flow at less than nine times this year's earnings. And even better, the company has an astounding 5.65% yield, but pays out only 40% of its free cash flow in dividends. In other words, we can afford to wait for the stock to come back.
Smoke rises
I'm not going to get into the morality of owning tobacco companies, but from a business standpoint, they're quite lovely. Good or bad, tobacco is a cash-generating machine, and Altria, the artist formerly known as Philip Morris, is the best in the business.
This is a company that generates over $8 billion in annual free cash flow, a little over half of which it pays out in the form of dividends. In addition, the tobacco giant recently announced it would buy back an additional $3 billion in shares this year.
It is carrying over $19 billion in debt on the books, and some argue the cash should be used for debt reduction. However, servicing the debt in 2002 only cost around $1.15 billion, or just under 6%, whereas repurchasing shares produces a return of at least 10%. This proves the firm has its sights set on the most efficient ways to create value for shareholders.
You may be a little pessimistic about the U.S. tobacco business, and rightly so. Altria's U.S. tobacco sales fell 5.2% in 2002, but the real story is the international business, where sales climbed 8.1%.
Legal ease
Due to litigation risks, there can be periods of volatility in the shares, but often those can create buying opportunities for patient investors. Altria is currently trading at a paltry eight times this year's earnings, and has a current yield of 6.87%. At that price, any litigation risks are priced into the stock, and the legal environment has actually improved somewhat in past months.
Despite the fact competitor R.J. Reynolds (NYSE:RJR) offers a higher yield, I prefer a more diversified firm. Altria owns 84% of Kraft Foods (NYSE:KFT), and maintains a 36% stake in international brewer SABMiller. The Kraft stake alone is worth over $24 per share, and offers a level of diversity and safety not available from other pure tobacco firms. That along with the SABMiller stake means you're getting the rest of the business at fire-sale prices.
[Do you think Mathew's blowing smoke, or do his stock ideas have merit? Head over to our Fool on the Hill discussion board and post your thoughts.]
Mathew Emmert thinks lung candy is not for children. He has owned shares in Altria for several years. You can view all of his holdings in his profile. The Motley Fool is investors writing for investors.
