3 Income Stocks on Solid Ground

02/10/2012 8:00 am EST

Focus: INCOME

Richard Moroney

Editor, Dow Theory Forecasts

Income stocks have been on a tear for months, but there’s no need to pay a premium for great stocks with healthy and growing yields, writes Richard Moroney of Upside.

With bond yields at historically low levels, investing in high-yield dividend stocks may seem like a no-brainer.

But high-yield stocks outperformed handily in 2011, partly because income-starved investors pumped $31 billion into US equity income funds last year—even as $79 billion was yanked out of all US equity funds.

Utility stocks in the S&P MidCap 400 and SmallCap 600 indexes, most of which yield more than 3%, outperformed their broader indexes by more than 15% last year. For the broad market, the top one-fifth of stocks based on dividend yield outperformed the average stock by more than 10%.

Investors’ appetite for dividend stocks has left many high-yield stocks looking expensive relative to historical norms. The top one-fifth of S&P 600 stocks based on dividend yield trade at an average of 21 times trailing earnings, a 10% premium to the 17-year average P/E. The average P/E for all S&P 600 stocks is 22, a 1% premium versus historical norms. In the S&P 400, top yielders trade at an 11% premium to historical norms, on average, while all S&P 400 stocks trade at a 7% discount.

Rather than chasing stocks with the highest yields, income-minded investors are likely to do better focusing on companies positioned to extend a record of strong dividend growth. It also pays to consider stocks with current dividend yields above their own historical norms. Back-tests indicate that both strategies will deliver better long-term returns than simply buying the highest-yielding stocks.

One useful tool for finding likely dividend growers is our Big, Safe Dividends (BSD) rating system. The BSD system uses ten factors to rank stocks from 0 to 100, with 100 the highest.

BSD considers such dividend-specific metrics as payout ratio, yield, and three-year growth rate. It also considers a company’s operating growth and outlook, while applying quality checks for the balance sheet and earnings.

A surge in the number of small- and mid-cap dividend payers has opened up a lot of choices. About 62% of S&P 400 stocks and 46% of S&P 600 stocks pay a dividend—at or near the highest rates in the past decade. Below, we review three picks that seem capable of both outperforming the market and continuing to grow their dividend.

AmTrust Financial Services’ (AFSI)
This company’s five-year dividend growth rate of 47% ranks in the top 2% of our research universe. Yet AmTrust pays out just 13% of earnings, leaving plenty of flexibility for continued growth.

The stock earns the maximum score of 100 in our Big, Safe Dividends (BSD) rating system. Dividend growth, including a 13% hike announced in July, reflects AmTrust’s outstanding operating momentum.

In four of the last five years, revenue has grown at least 29%, and net income at least 25%. In the first nine months of 2011, net income rose 20% on a 42% revenue gain. AmTrust produced $185 million of free cash flow for the nine months ended September, versus a negative $26 million in the year-earlier period.

AmTrust provides small businesses with property and casualty insurance. It maintains a solid balance sheet and conservative investment portfolio, with 83% of its fixed-income holdings rated at least A and 45% rated AAA.

AmTrust, yielding 1.4%, seems capable of 10% to 15% annualized profit and dividend growth over the next five years. Modestly valued at less than nine times the 2011 consensus profit estimate, the stock is rated Buy.

Ensign (ENSG)
By delivering annualized growth of 17% for sales, 25% for net income, and 48% for cash provided by operations in the past three years, Ensign has been able to expand its quarterly dividend at an annualized rate of 11%.

Although Ensign has no formal dividend policy, the payout has equaled 5% to 15% of annual net income every year since its initiation in 2002. Through nine months of 2011, dividend distributions represented 9% of net income. In November, Ensign assured investors that its newly established share-repurchase program will neither replace nor reduce the dividend.

Ensign supports its operating momentum with a steady diet of acquisitions, often of underperforming health-care facilities. Among US public companies, Ensign ranked ninth last year for the most deals completed, according to Dealogic.

Medicare lowered payments to nursing centers by 11% in October, eliminating an estimated $29.5 million to $32 million of Ensign’s annual revenue. However, management increased its 2011 profit guidance in November, and now projects 17% to 19% growth. Consensus estimates project a 5% decline in per-share profits for 2012, but Ensign seems capable of exceeding that target if it sustains its recent pace of acquisitions.

Looking out, the consensus projects earnings per share will climb at a 13% annual clip over the next five years. Ensign, yielding 0.9%, is a Best Buy.

MTS Systems (MTSC)
This company has paid a quarterly dividend without interruption for the last 30 years. In the past decade, the dividend has advanced at an annualized rate of 14% and earnings per share 16%, consistent with management’s strategy of pacing the dividend with profit growth.

Dividend growth has accelerated in the past couple years, with a 25% hike announced in August on top of a 33% increase in November 2010. Management tries to keep its long-term payout ratio at roughly 40% of net earnings per share. The current payout ratio is 30%, leaving room for a generous hike in the year ahead.

A leading supplier of test systems, MTS holds a 20% share of the test market, valued at roughly $2 billion. For fiscal 2012 ending September, the consensus estimate projects 12% higher per-share profits and 10% sales growth. Looking to build on the record orders and revenue tallied in fiscal 2011, MTS opened fiscal 2012 with a $287 million backlog, up 34% from a year ago.

At less than 14 times trailing earnings, the stock trades at a discount to its five- and ten-year average P/E ratios near 18. MTS, yielding 2.2%, is a Best Buy.

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