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When searching for new candidates for possible addition to our Income Portfolio, my staff and I are always on the lookout for high-dividend stocks with strong long-term growth potential. We are constantly scouring the investment landscape in an effort to pack our portfolios with top performing stocks that produce market-beating returns. When it comes to our Income Portfolio, we carefully screen our picks not just for their dividend yields, but also for their total return potential -- a combination of dividends plus capital gains (less taxes). After digging through countless press releases, financial statements and news reports, we came up with a handful of fresh investing opportunities that we're now considering as possible new additions to our Income Portfolio. In an effort to predict whether each firm can be counted on to pay a sizable dividend PLUS deliver steady capital appreciation in the coming years, we established a list of certain benchmark criteria that each stock was required to meet. These included minimum requirements for dividend yield and payout ratio, as well as dividend payment records and long-term growth prospects. Yield -- A company's dividend yield indicates the annual return that a stock delivers in the form of dividends. The yield can be calculated by dividing the firm's annual dividend payment per share by the company’s stock price. For instance, oil company Royal Dutch Petroleum (RD, $48.90) -- the first company we highlight below -- pays a $1.73 annual dividend on each share owned. Its stock is currently trading in the $49-range. Its annual dividend yield is therefore +3.5% (1.73/49.00). That’s fairly high compared to an average yield of just +2% for the 356 dividend-paying stocks in the S&P 500. In an effort to hone in on companies with above-average dividend yields, we required a yield above +2.5%. Payout Ratio -- We want high returns on our investment, but we’re careful to watch for too much of a good thing. A company's dividend payout ratio indicates what percentage of the firm's earnings management is paying out to shareholders. The payout ratio can be calculated by dividing the stock's annual dividend payment (called the “dividend rate”) by its annual earnings per share. The average payout ratio for the S&P 500's component stocks is 26%. However, this figure varies greatly from industry to industry. For example, electric utility Southern Company (SO, $30.15), which we profile below, pays a $1.40 dividend on earnings of $2.02. The stock's payout ratio is therefore 69% ($1.40/$2.02). That’s a fairly average payout ratio when it comes to slower-growing stocks like utilities or banks. Since these firms have fewer growth and investment opportunities, they tend to pay out a larger percentage of their earnings than higher growth stocks. Meanwhile, real estate investment trusts (REITs) such as Developers Diversified Realty (DDR, $38.31), which we profile below, also boast large payouts since they are required by law to pay out 90% of their earnings in dividends to maintain their tax-advantaged status. In identifying potential new income stocks for our portfolio, therefore, we scanned for company payout ratios that were in line with industry averages. Reliability -- Companies are under no legal obligation to continue paying dividends. Therefore, we want to find companies we can count on to maintain -- and hopefully even increase -- their quarterly dividend payments. When searching for fresh income ideas, we looked for companies that have paid dividends for at least five consecutive years. We also looked for firms with a strong record of increasing those dividend payments. Chemical maker RPM International (RPM, $15.35), which we feature below, has shown a steady increase in dividend payments for 29 consecutive years. A dividend record like that is convincing evidence of a company’s commitment to shareholders. Total Return -- Although dividends are certainly an important part of the picture, they don't represent the whole story. In the end, the total return that a stock delivers is really a combination of its dividend yield and capital appreciation, after taxes. A stock may pay a decent annual dividend, but if its share price declines year after year, then the net effect could be a flat, or possibly even money-losing, investment. Although income investors are typically willing to trade capital gains for the relative safety of predicable income, we prefer to look for stocks that offer the best of both worlds -- rich dividend payments AND solid long-term growth potential. For example, below we will introduce you to a stock -- US Bancorp (USB, $28.22) -- that delivered +60% in capital gains last year on top of its +3.5% dividend yield. With earnings expected to increase at an above-average +11% clip this year, the shares should continue to rally. Finally, income investors should also be mindful of the after-tax rate of return they earn on any investment. A stock may pay a good dividend and its shares may outperform the market, but if those gains are taxed at a stiff rate, then this may neutralize some of your gains. Last year, the tax rate on most dividend income and capital appreciation was equalized at 15%. However, dividend income from REITS is still taxed as ordinary income up to 38.6%. Despite the higher tax rate, many REITS generate returns that are far superior to other income stocks. Investors, therefore, may wish to shield REIT dividends by placing those stocks in tax-advantaged accounts, such as an IRA. Below we present you with five income-oriented investment ideas. These firms operate in a diverse array of industries, including oil and gas, utilities, real estate, banking and chemicals. However, the all have several things in common. For starters, each of these firms possesses a convincing long-term track record. In addition, they all boast the financial strength to deliver both high dividend yields and steady long-term capital gains in the years ahead. ROYAL DUTCH PETROLEUM (RD, $48.90) -- The Royal Dutch-Shell Group (Shell) is the world’s third largest oil company. The conglomerate operates in 145 countries in three business segments: oil and gas (90% of revenue), chemicals (8%), and power generation (2%). In the oil and gas business, the firm's exploration and production operations produce 3.9 million barrels of oil per day. Meanwhile, its refining and marketing unit processes up to 4.4 million barrels a day, which it then distributes to 55,000 Shell service stations around the world. The firm's 2002 purchase of automotive consumer products giant Pennzoil-Quaker State extended Shell’s presence into the lubricants market. Meanwhile, Shell Aviation supplies over 23 million gallons of fuel daily to some 20,000 aircraft at over 800 airports in 90 countries. Shell is owned 60% by Netherlands-based Royal Dutch Petroleum holding company (RD, $48.90) and 40% by British-based Shell Transport (SC, $41.09). The 114-year old company boasts a long history of profitable results. Although Shell’s performance is often affected by cyclical fluctuations in oil and gas prices, the company’s integrated operations help to cushion the impact of this volatile market. The company posted a +35% jump in earnings to $3.66 a share last year. A cash powerhouse, Shell generated record cash flow of nearly $22 billion in 2003, up from some $16 billion the year before. Management is now using this cash, together with $4.5 billion in asset sales, to reduce debt, fund capital spending and pay dividends to shareholders. Analysts expect the company to continue to grow at a +10% annual clip for the foreseeable future, a rate well above its industry peers. The stock boasts an above-average dividend yield of +3.6%. In addition, management has demonstrated its commitment to shareholders by boosting its dividend payments +28% over the past three years. In recent announcement the firm has reiterated its goal of providing future dividend increases that at least match the level of local inflation. Shell's shares came under pressure recently after the company revealed earlier this year that it had overstated its global energy reserves by roughly 20%. Investors responded to the news by slashing the firm's share price -10% and placing some intense pressure on existing management. For value-oriented income investors, the recent flap has created an opportunity to buy a high-quality, high-yield company at a significant discount to its peers. SOUTHERN COMPANY (SO, $30.15) -- In the post-Enron market, it’s nice to find a stable, well-managed power producer such as Southern Company. With 4 million customers and some 40,000 megawatts of generating capacity, Southern is one of the country’s largest electric utilities. The Atlanta-based firm, which is already the dominant producer in the southeastern U.S., is now seeking to expand into other high-usage markets. Its diverse operations include a solid retail segment as well as a strong wholesale industrial business. In addition, the company operates an energy-trading spin-off and a fiber optics/wireless communications network that covers 127,000 square miles in the firm's core operating region. While electricity demand is always volatile, depending as it does on economic and other factors, over the long haul the utility market will continue to provide stable results. With a five-year earnings growth rate of +5.4% in an industry marred by a declining earnings history, Southern boast an impressive earnings record. Although the firm's earnings are expected to come in flat this year, analysts expect Southern's net income to ramp up by +3.6% in 2005 and continue at a steady +5% a year beyond that. When it comes to the stock's income characteristics, Southern Company has delivered a steady annual dividend for over half a century now. The stock currently yields a generous +4.6%. In addition, its reasonable 68% payout ratio leaves the company with plenty room to raise its annual dividend payment in line with its earnings growth. So far this year, the company has already upped the ante, increasing its annual dividend payment nearly +4% to $1.40. The stock is attractively priced at a P/E of 15 times next year’s earnings, compared to the industry average of 19. The shares have trended steadily higher over the past few years, and over the long-term the company’s solid growth prospects should continue to be reflected in its share performance. In the meantime, investors will benefit from the firm's sizable dividend payment. DEVELOPERS DIVERSIFIED REALTY (DDR, $38.31) -- Property real estate income trusts (REITs) such as Developers Diversified generate income from a portfolio of real estate assets. Established nearly 40 years ago, the company owns a portfolio of roughly 360 shopping centers in 44 states across the country. These properties contain 82 million square feet of leasable space. The firm's assets also include 35 business centers with 4 million square feet of leasable space in 12 states. Developers has expanded its asset base throughout the years thanks to a steady stream of both acquisitions and new development. Most recently, the firm acquiring 6 million square feet of under-developed space through a merger with JDN Realty. Occupancy rates at the firm's shopping center locations have averaged an astounding 94% or higher over the past four decades. Its malls are anchored by such major, long-term retail tenants as Wal-Mart, Lowe’s, Kohl’s, T.J. Maxx and Kmart. These tenants typically hold leases of up to 20 years, thus providing the firm with a stable income stream. With large-scale chains as anchors, the company is then able to attract specialty retailers on shorter, but much more profitable, leases. Contributing roughly half of the company’s revenue, short-term leases renewed at higher rates have been one of the main drivers of Developers' earnings growth. The company's earnings and funds from operations (FFO), a key industry measure of profitability, have grown steadily over the past five years. Fueled by acquisitions and redevelopments, earnings more than doubled last year to $2.27 a share. Meanwhile, the firm's FFO of $2.54 a share represented a steady +5% increase over the prior year (+11% excluding certain items). This growth was due in large part to gains from asset sales and profits from the improved performance of its JDN Realty acquisition. Looking ahead, company earnings are expected to grow +27% this year to $2.88 a share and analysts project a five-year growth rate of +6.8%. Like other REITS, the company uses debt to purchase income-producing assets. However, Developers' debt-to-equity ratio of 2 is not only manageable, but it is also considerably lower than the industry average of 2.6. In recent years the firm's conservative management team has focused on strengthening its balance sheet by refinancing preferred debt and reducing its exposure to variable interest rates. DDR's annual dividend payments have grown an average of +8.5% a year over the past five years, and management recently boosted this figure by another +12%. As the firm's earnings have increased, its payout ratio has continued to decline and now stands at only 74%. That fairly low number (relative to most REITs) bodes well for future dividend increases. Given its solid financial performance, Developers Diversified should have no trouble paying -- and likely increasing -- its current lofty +4.8% dividend yield for years to come. The shares have gained ground recently, returning +67% in the past year alone. But with a P/E of 17, the stock is trading at roughly half the value of its peers. Its strong track record and bullish growth projections make this stock a bargain-basement play for income-oriented investors.
US BANCORP (USB, $28.22) -- With some 2,200 locations in about half of all U.S. states, US Bancorp is the fifth largest bank in the country. This Minneapolis-based regional bank has a dominant position in the fast-growing West and Midwest markets. In addition to its retail operations, the bank’s corporate trust business ranks among the top three in the U.S. The firm holds in trust more than $1.4 trillion of municipal bonds, corporate bonds, and other fixed instruments. The bank also runs a highly profitable transaction processing business that handles ATM and card payment transactions for businesses and banks. In December 2003, the company spun off brokerage firm Piper Jaffray. A product of the 2001 merger of US Bancorp and Firstar, the bank is looking to capitalize on Firstar’s strong customer service focus by hiring hundreds of financial advisors to provide investment and mortgage advice. The bank is also expanding in existing markets by opening 163 branches in Safeway supermarkets in Los Angeles, Las Vegas, and San Francisco, among other cities. The company estimates this low-risk expansion strategy will cost about $250,000 for each branch -- far cheaper than the $1.5 million for a stand-alone branch. The bank’s steady expansion in high-growth markets has proven to be a highly successful strategy. In the past five years, earnings have grown at a rapid +14% rate -- more than twice that of its competitors. And looking ahead, this growth shows no signs of abating. Last year the company's earnings jumped +17% to $1.93 a share, and that figure is expected to grow another +11% both this year and next year. Equally important for a regional bank, US Bancorp earns top marks for excellent capital efficiency. The firm's return on equity (how efficiently it uses shareholder money) sits at a respectable +19% and its return on assets (how efficiently it uses its assets to generate earnings) now hovers around +2% -- both above the industry average. Meanwhile, US Bancorp's efficiency ratio -- a measure of how well a company uses assets in relation to operating costs -- is an enviable 45%, showing impressive cost control. This well-managed bank not only offers superior capital appreciation potential, but its management team has also demonstrated its commitment to returning company profits back to shareholders via dividends. With its hefty +3.5% dividend yield and strong share performance, the stock provided shareholders with a market-beating +45% total return on their investment last year. And at a P/E of just 12 times this year's earnings, US Bancorp still represents a compelling value/income play. RPM INTERNATIONAL (RPM, $15.35) -- This little-known company is one of the world’s largest producers of specialty chemicals and protective coatings, including paints, sealants and adhesives. The firm operates 67 manufacturing plants worldwide and sells its consumer and industrial products in about 130 countries. However, RPM still derives majority of its sales (75%) from the U.S. market. The company supplies such major discount retailers as Home Depot (HD, $36.09), which accounts for 12% of total sales, and has fueled its growth over the years via a string of new acquisitions, both corporate and product. The company is rebounding from asbestos-related legal challenges and is starting to post record earnings results. In May 2003, RPM took a $140 million charge to cover insurance on existing and estimated future claims. That, together with a 10% share dilution from a secondary offering in 2002, resulted in an earnings shortfall for the year. However, earnings for the first half of fiscal 2004 have grown by +11% over year-ago results and analysts are projecting full-year earnings of $1.19, a four-fold increase over last year. This dramatic turnaround is a testament to management’s successful restructuring efforts, which it initiated in 1999 as a response to asbestos litigation. To cut costs, the company closed 17 plants, reduced its workforce by 10% and slashed some $25 million in overhead. As a result of these and other improvements, RPM's earnings are expected to grow +12% next year and the company boasts an estimated long-term growth rate of +9%. RPM pays a healthy +3.7% annual dividend, and
management has steadily increased the firm's payout for several
consecutive decades. Despite the recent run-up of its shares, the
company’s P/E of less than 12 times next year’s earnings suggests it
still has room to move. And while shareholders wait for the company to
recover fully from its recent setbacks, they'll enjoy a solid +3.7%
annual dividend yield.
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