With interest rates at embarrassingly low levels and with stocks at all-time highs, many investors have turned to key dividend-paying stocks to generate income and hopefully to achieve long-term upside. The week of August 12 brought the Merrill Lynch RIC Report, which is effectively a culmination of the firm’s top research ideas, views and advice for clients. The one common theme throughout this report was where to find yields.
Before getting into stocks and sectors, it is important to realize that roughly 25% of the bonds in developed nations had negative yields. That is effectively a safety tax, and it erodes capital through time.
The first issue to consider is that there has become a role reversal between stocks and bonds, whereby bonds were the source of price appreciation and stocks have become a better source of income. Quite simply, this is the inverse of every investing and finance class you ever took. In fact, at the end of July, it was the case that 65% of the S&P 500 members had dividend yields that exceeded the 10-year Treasury yield.
What Merrill Lynch is focused on now is a mix of high-quality bonds and dividend-paying stocks. They feel that investors should look at some stocks as sources of income, but they need to keep in mind the extra price risk and volatility of returns. In high-quality bonds, they see income but see very limited price appreciation.
It is important to understand that the so-called yield trade is not really new. In fact, utilities and some defensive stocks now trade with massive market valuation premiums. Issues to consider are that returns on stocks are more volatile through time, not all yields are created equally (do not forget that!) and defensive sectors usually are the first place investors look for yield. Financial stocks, including banks and real estate investment trusts (REITs), also may be an overlooked source of yield. Integrated oil stocks can be a steady source of income, but master limited partnerships have a higher risk profile.
Merrill Lynch has a proposed equity income portfolio for investors here. There are other stocks rated with Buy ratings that might have higher yields in the Merrill Lynch coverage universe, but these are the ones with what are deemed normalized or safer yields than might be found elsewhere. 24/7 Wall St. has taken the highest yield from each sector in that model income portfolio, and all but two have Buy ratings, and we eliminated the companies that were not based in the United States.
McDonald’s Corp. (NYSE: MCD) was the top U.S. pick in the model income portfolio’s consumer discretionary stocks. Its yield was 2.99%. Merrill Lynch has a Buy rating on McDonald’s, and its price objective of $140 compares to a current price of $119.52, and is against a consensus analyst price target of $130.29.
CenturyLink Inc. (NYSE: CTL) is the highest yield of the telecom sector at 7.23%, an average of three points higher than AT&T and Verizon. CenturyLink has a Buy rating at Merrill Lynch, and the firm’s price objective is all the way up at $42. The consensus price target is $29.23, just under the current share price of $29.96.
International Business Machines Corp. (NYSE: IBM) is the top income portfolio pick in technology and IT, with a 3.43% yield. Merrill Lynch actually has only a Neutral rating on IBM, but it has a $170 price objective. IBM’s current price of $161.95 is against a consensus price target that is lower at $153.90.