Monday, July 28, 2008

DJIA - Diving in Deeper

I recently profiled an eight stock basket chosen from the 30 stock Dow Jones Industrial Average (DJIA) that I felt would, over the next 2-3 years, outperform the DJIA.

It was essentially chosen using a Dogs of Dow strategy, wherein I used the dividend yield to provide clues to potential mispricings. With one exception (Procter & Gamble), all had yields in the top half of the DJIA.

Certainly, you can't view all of these stocks as a monolithic pick. Generally, the stocks with payouts at high ratio relative to their earnings, had dividend yields at the high end of the range, suggesting that the market considers that either the dividend is at risk itself, or the prospect is for limited dividend increases over the next while.

Having said that however, six of the eight stocks have had meaningful (excluding special dividends) dividend increases in virtually every one of the past five years. The two stocks that don't meet that criteria are Merck and Verizon, with a total dividend increase of under 7% each over the entire five years.

In my view, the dividend payments generally appear safe over the next year or two, given that the lowest yielders have comfortable payment ratios, generally not above 55% of earnings.

For the ones above that, such as Verizon and AT&T, these telecomm's spin out plenty of cash, with cash-flows running at a 2:1 or better ratios compared to earnings over the past five years. This suggests that, even while payout ratios may appear high against earnings, there's plenty of cash spinning off the business to support the current dividends.

In terms of Pfizer and Merck, there's lots of cash on the balance sheet, together with reasonable cash-flow to easily support dividend payments for some time. Nevertheless, given the long winter in drug firm valuations and share price growth, I think you've got to be willing to take a bit of a flyer that the drug pipelines will provide additional earnings growth five years out, if you want to be comfortable with those particular purchases over the longer haul.

Tomorrow, I'll cover the two of these eight stocks that I think comprise the best combination of safety, dividend yield (and dividend growth), and potential share price growth over the next two to three years.

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