Sweet Dividends—With a Cherry on Top
With returns on high-yield bonds hitting record lows, Barron's hunted for dividend stocks that could prove more rewarding. Some picks: GE, Amgen.
For bond investors, "junk" and "high-yield" used to be synonyms. No longer. Today's bonds from issuers with elevated risk of default simply don't pay all that much. Junk indexes from Barclays and Bank of America Merrill Lynch both hit record low yields of around 4.9% this past week. How low is that? One-year Treasury bills, about the safest investment ordinary investors can buy, have yielded an average of 5.1% since 1953. In other words, the dodgy stuff now pays less than the safe stuff used to.
Of course, junk bonds pay much more than today's Treasuries, whose yields have been suppressed by the Federal Reserve in an effort to stoke the economy. Investors have continued to pile into junk for this relative yield advantage. But then, with the one-year Treasury paying less than 0.1%, scratch-off lottery tickets almost compare favorably. That's no reason to buy them.
From here, junk-bond investors may have more to lose than to gain. In a rosy scenario, the economy gradually improves while the corporate default rate remains exceptionally low, and good junk-bond fund managers earn mid-single-digit returns over the next year. A gloomy scenario looks like 2008, when a popular exchange-traded junk fund, SPDR Barclays High Yield Bond (ticker: JNK), lost 26%. Bank of America Merrill Lynch is predicting total returns for U.S. high-yield of 4% to 5% this year. That's not bad—but the SPDR junk fund has already returned 4.4% year-to-date, implying little upside from here.
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Illo: Stuart Goldenberg for Barron's
Earlier this month, JPMorgan Chase recommended that yield hunters cut junk-bond exposure and switch to stocks. We recently ran a search for stocks that should appeal to junk-bond refugees. It turned up six names, including Amgen (AMGN), Eaton (ETN), and National Oilwell Varco (NOV).
These shares aren't the highest-yielders around. That's for the best, because high yields often come attached to companies with limited growth potential. We began our search by looking only for those with current yields over 2%, roughly the dividend yield for the Standard & Poor's 500 index. But we also looked for estimates of peppy growth in coming years in both profits and dividend payments. For long-term investors, these shares have potential to become high-yielders over time. A 2.5% yield today becomes a 4.9% yield in seven years, assuming a company can increase its payment by 10% a year, and that its share price doesn't change. Of course, rising dividends can attract buyers, sending share prices gradually higher, resulting in handsome total returns.
Stocks are not a direct substitute for bonds. Both are important for investors who wish to keep overall portfolio risk in check. The ideas that follow are alternatives for investors who find that their junk-bond allocation has grown larger than they would like. That could have happened easily: The SPDR junk ETF has now returned an average of 12.6% a year over the past five years, according to Morningstar, versus 4.8% for its high-grade sibling, SPDR Barclays Aggregate Bond (LAG).
AMGEN IS ONE OF the world's largest biotech companies, with sales last year of $18.7 billion, but it has room for growth. Nearly 80% of its revenue comes from the U.S., which leaves plenty of potential to launch medicines overseas. And the company, which specializes in treatments for cancer, kidney disease, and inflammation, has a pipeline of 10 key drugs in late-stage clinical trials with results due through 2016.
Those should more than offset potential revenue declines from legacy drugs facing new competition. Overall revenue for Amgen is expected to increase only modestly, but free cash flow should grow much faster as research spending falls as a percentage of revenue. This year, free cash flow is expected to rise 13% to $6.4 billion. In three years, Wall Street expects it to hit $8.4 billion, or over 9% of the company's current stock market value. Amgen announced a 30% dividend hike in December, but with a yield of just 2%, payments look likely to keep rising at a double-digit pace in coming years.
General Electric (GE) raised its dividend payment 16% this year and plans to lift payments in line with earnings from here on. That looks like a good deal for yield-seekers. Shares already pay 3.3%. GE hopes to buy the power division of France's Alstom (ALO.France), which would cut into share repurchases this year and keep earnings-per-share growth modest, but Wall Street predicts 7% growth next year rising to 12% in three years. In September we predicted that GE stock, then $24, would rise more than 30% to $32 in two years (Sept. 23, 2013, "GE: Not Too Big to Grow"). It's close to $27 now. Keys to GE reviving growth include divesting itself of underperforming businesses, using software and analytics to sell new services to industrial clients, and, in the event of an Alstom deal, making good use of new sales inroads.
Just 13% as big as GE by stock market value, Eaton, which makes power, hydraulic, filtration, and other industrial equipment, isn't struggling to grow. Its earnings per share are expected to rise 15% this year and 17% next year. But Eaton faces a near-term risk in the form of a long-running antitrust case with Meritor (MTOR), which says Eaton used its clout unfairly in selling truck transmissions. A jury agreed. A judgment, which triples economic damages in such cases, could run $1.4 billion to $2.4 billion based on Meritor's claims, versus Eaton's projected earnings of $2.2 billion this year. Morgan Stanley views an award that large as unlikely and says investors should look past the litigation to Eaton's attractive growth prospects, because the stock could get a lift once the matter is resolved. Shares yield 2.5% and payments are expected to grow by nearly one-third over the next two years.
INVESTORS WHO HEED JPMorgan's advice to swap junk bonds for stocks might want to consider shares of JPMorgan Chase (JPM) itself. Its first-quarter profit tumbled 19% on declines in bond trading and mortgages. Many banks saw similar results, driven by the Federal Reserve scaling back bond purchases and by mortgage rates rising. JPMorgan has been investing in technology for its bank branches and new products for its asset-management business that should pay off once the climate turns healthier for banks. Wall Street predicts its earnings per share will top $7.40 in three years, versus a forecast of $5.38 this year. Dividend payments are expected to rise even faster. Shares currently yield 2.8%
International Paper (IP) posted a first-quarter loss on poor weather in North America, a mill shutdown, and a fall in the Russian ruble cutting into results for a joint venture in that country. But the results may understate the company's true earnings power. Box shipments are projected to grow modestly in the U.S. and faster overseas, which bodes well for containerboard demand. Mill restructurings should improve profit margins over time. And the Russian joint venture enjoys low materials costs and hence potential for healthy profits as production ramps up later this year. Free cash flow is expected to total $1.6 billion this year, rising to $2.2 billion in two years. The latter figure is more than 10% of International Paper's stock market value. Shares yield 2.9%. Management has recently spent roughly as much on share repurchases as on dividends.
At the end of May, National Oilwell Varco completed the spinoff of its distribution business NOW (DNOW). The remaining company, which makes equipment and components for oil and gas drilling, is valued at $34 billion. It holds $3.7 billion in cash and $3.1 billion in debt, and is expected to generate free cash of $2.2 billion this year, rising to $3.1 billion in 2016. Shares yield 2.3%, and analysts expect the company to spend its free cash on rising dividends—with payments hitting 3% of today's price within two years. In January we recommended shares of National Oilwell Varco for the company's potential to set the industry standard for floating oil production, storage, and offloading platforms, just as it has done for offshore drilling rigs. Shares since then have returned 12%, adjusted for the spinoff. They still look plenty affordable at 13 times this year's earnings forecast.