Dividend stocks are great but dividend stocks with rising earnings and low valuations are even better

by Barry Schwartz

We’re all fans of dividends now.  Record low interest rates are here to stay and as a result, many investors have jumped on the dividend bandwagon.  I don’t blame them, companies that have predictable revenue streams, great balance sheets and a history of rising dividend payments should be the cornerstone of any portfolio.  But many of these names are clearly overvalued.  North American REIT’s, pipelines, utilities, consumer discretionary stocks and even some telcos  are trading at record valuations and well above the overall market P/E ratio.  Investors should use caution buying stocks in these sectors.  Sure you’ll get the dividend but you could be in for a capital loss if the market starts to reward riskier companies.

Instead of chasing yield, it’s time to look for growth at a cheap price.  We think the winning formula is to buy companies with a dividend yield of at least 1.5%, a P/E ratio of 12 times this year’s earnings expectations or less, forward earnings growth of at least 10% for 2012 and a track record of raising dividends over time.

Three names that fit this bill are Teva Pharmaceutical, Home Capital Group and CSX Corporation.

Teva manufactures both generic and branded drugs.  It earned $4.97 a share in 2011 and is expected to earn $5.59 a share for 2012, suggesting 12% growth.  With the release of its fourth quarter results, Teva raised its dividend 25% and now has a current yield of 2.4%.  Teva has raised its dividend 13 years in a row. At its current price of $44.70, Teva is trading at 8 times its 2012 earnings per share estimate.

Home Capital is a mortgage lender and financial services company.  It earned $5.53 a share in 2011 and is expected to earn $6.42 a share in 2012, suggesting 16% growth.  Home Capital has raised its dividend 16 times over the last 8 years.  Its current yield is 1.6%.  At its recent price of $49.61, Home is trading at 7.7 times its 2012 earnings per share estimate.

CSX is a Class One railway operating in North America.  It earned $1.67 a share in 2011 and is expected to earn $1.87 a share in 2012, suggesting 12% growth.  CSX has raised its dividend seven years in a row and has a current yield of 2.2%.  Currently trading at $21.79, CSX is valued at 11.6 times its 2012 earnings per share estimate.

Disclosure: The author and/or his family members own shares in Home Capital Group and Teva Pharmaceuticals.  Clients of Baskin Financial own shares in all three companies  mentioned above.