These are the dividend stocks that will hold up in a weakening economy in 2024, says this highly rated money manager

By Philip van Doorn

A focus on companies that can generate enough free cash flow to raise dividends can help defend an investment portfolio during tough times

Do you expect the U.S. economy to slip into a recession next year? If so, you might also expect a reversal of this year's stock-market rally. Stocks of quality dividend payers that can keep raising payouts might hold up well in that scenario, according to John Bailer, deputy head of equity income at Newton Investment Management North America, a subsidiary of Bank of New York Mellon Corp.

Bailer co-manages the BNY Mellon Income Stock Fund, which is rated four stars (out of five) within Morningstar's Large Value fund category. During an interview with MarketWatch, he named three examples of quality dividend stocks held by the fund.

The Federal Reserve's change in monetary policy during 2022 led to a rapid increase in interest rates and an 18.1% decline for the S&P 500 SPX that year. (All investment returns in this article include reinvested dividends.) But the BNY Mellon Income Stock Fund's Class M shares MPISX returned 4.4% during 2022 and its Investor shares MIISX returned 4.3%. Those fund returns were after annual expenses, which come to 0.83% of assets under management for Class M and 1.08% for the Investor share class.

Here are more comparisons of total returns for the two share classes, the S&P 500 and the Russell 1000 Value Index RLV:

   Fund or index                                   2023 through Dec. 6  3 years  5 years  10 years 
   BNY Mellon Income Stock Fund Class M Shares                    5.2%      45%      66%      153% 
   BNY Mellon Income Stock Fund Investor Shares                   5.0%      44%      64%      142% 
   S&P 500                                                       18.5%      29%      84%      204% 
   Russell 1000 Value                                             5.8%      23%      48%      118% 
                                                                                   Source: FactSet 

The BNY Mellon Income Stock Fund aims for a dividend yield that is at least 50% higher than the S&P 500's dividend yield, which is currently 1.55%, according to FactSet. The Fund's portfolio dividend yield is 2.54%, according to FactSet.

The fund hasn't ridden along with this year's rally for the market-capitalization-weighted S&P 500, which has been driven by stellar returns for the "Magnificent Seven" group of companies: Apple Inc. (AAPL), Microsoft Corp. (MSFT), Alphabet Inc. (GOOGL) (GOOG), Amazon.com Inc. (AMZN), Nvidia Corp. (NVDA), Meta Platforms Inc. (META) and Tesla Inc. (TSLA). That group makes up 28% of the SPDR S&P 500 ETF Trust SPY.

But the BNY Mellon Income Stock Fund's outperformance in 2022 has helped it to beat the S&P 500's performance by a wide margin for three years. It might also be a safe harbor if an economic slowdown stops the momentum of the Magnificent Seven.

There are various signs of an economic slowdown, including a decline in U.S. job openings to their lowest level in 28 months and a decline in the Federal Reserve Bank of Atlanta's GDPNow forecast to a 1.2% annualized GDP growth rate for the U.S. in the fourth quarter, down from the previous estimate of 1.8%, for what would be a sharp decline from the official GDP growth rate of 5.2% in the third quarter.

The bond market is also sending renewed signals of an economic slowdown. Strong buying activity for 10-year U.S. Treasury notes BX:TMUBMUSD10Y indicates expectation of an economic slowdown, because the Federal Reserve would be expected to lower interest rates. Demand for bonds lowers their market values, but the buying also allows investors to lock in relatively high long-term interest rates. The 10-year Treasury yield has fallen to 4.16% from 4.88% at the end of October.

Three dividend-stock examples

The BNY Mellon Income Stock Fund held shares of 58 companies as of Oct. 31. Bailer said that in addition to paying dividends, companies in the fund need to have "high-quality balance sheets" and be positioned to avoid interest-rate shocks when bonds mature or borrowings come up for renewal.

Many of the companies the fund invests in have "debt that has been termed out over time," including some maturities as far out as 2052, Bailer said. "This is what differentiates large-cap companies from small-cap companies. Many small companies have floating-rate debt or debt coming due short term."

The fund has a value focus, tending toward stocks trading relatively low to expected earnings. That, combined with the dividend focus, leads Bailer to expect the portfolio "to provide great downside protection" in the event of an economic slowdown.

He named three examples of companies held by the fund:

Cisco Systems

Shares of Cisco Systems Inc. (CSCO) have a dividend yield of 3.27%. The stock closed at $47.70 on Wednesday and traded for 12.1 times the consensus earnings-per-share estimate of $3.95 among analysts polled by FactSet. The S&P 500 trades at a price-to-earnings ratio of 18.6, based on the weighted aggregate consensus EPS estimate for 2024.

Bailer said that Cisco "has value characteristics we like to see," including "a ton of cash" that it can deploy through share buybacks or to "to make a good acquisition."

To illustrate how effective the company is when it comes to generating cash, the consensus estimate for Cisco's free cash flow per share in 2024 is $3.77. If we divide that by Wednesday's closing share price of $47.70, we have an estimated free cash flow yield of 7.9%, leaving plenty of headroom above the current dividend yield. A company's free cash flow is its remaining cash flow after capital expenditures. This is money that can be put to work through dividend increases, expansion, acquisitions, buybacks or for other corporate purposes.

International Game Technology

International Game Technology PLC (IGT) has a varied business, providing services to governments that run state lotteries and also making slot machines and providing other gaming equipment and services.

IGT has contracts to manage lotteries in New Jersey and Indiana. The company said in its 2022 annual report that it provides lottery services to "37 of the 48 U.S. lotteries (including the District of Columbia, Puerto Rico, and U.S. Virgin Islands)."

The company also provides services to online sports-betting operators, including FanDuel, a unit of Flutter Entertainment PLC (IE:FLTR) (UK:FLTR) (PDYPY).

Its most important customer relationship is its exclusive contract with Italy's national government to run that country's lotteries. That eight-year contract runs out in 2025, making for the type of binary event that some investors shy away from. Bailer expects the contract to be renewed. During IGT's most recent quarterly earnings call, management "said they might be able to renew it in front of the contract date," Bailer said.

He added that the company is looking to spin off its slot-machine business. "That would be a catalyst" for the stock, he said. "It is trading at a discount to its lottery peers. The market is disappointed they have not done the spin or sale yet."

IGT's stock closed at $26.29 on Wednesday and traded for 12.1 times the consensus 2024 EPS estimate of $2.17.

To illustrate how inexpensively he believes IGT is trading, Bailer pointed to another way of measuring a company's stock valuation - looking at the value of the entire enterprise (the market value of its stock plus its debt minus its cash) divided by its estimated earnings before interest, taxes, depreciation and amortization. On this basis, IGT trades for 6.3 times estimated 2024 Ebitda, according to FactSet. Bailer said that in 2022, "Scientific Games sold their lottery business for 13 times Ebitda."

Everest Group

Everest Group Ltd. (EG) provides reinsurance to property and casualty insurers. The stock closed at $390.37 on Wednesday and traded for 6.4 times the consensus 2024 EPS estimate of $61.32. Looking back 10 years, the stock's average forward P/E ratio has been 7.8, according to FactSet.

"What we are excited about, for the reinsurers, is that people are very concerned about climate change," Bailer said. "That is leading to a hard market for [property and casualty] and for reinsurers." The industry is now trying to price premiums for hurricanes that occur every two to three years, he said, versus a 10-year horizon for hurricanes.

Insurers invest premiums mainly in bonds, hoping to earn profits before paying out on claims. Berkshire Hathaway Inc. (BRK.B) CEO Warren Buffett calls insurance premiums that can be invested "float" and has described how the company has grown this key part of its business over the years.

Bailer said that Everest is continuing to benefit from the rise in interest rates as older bonds mature and it invests in higher-yielding bonds at current rates. An expected bounce in reinsurance premiums - the contracts renew every January - is very well timed, he said.

He is a "big fan" of Everest right now, expecting the increasing float to enable large increases in the company's dividend.

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12-09-23 0612ET

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