3 High-Dividend Stocks to Avoid

Susan Dziubinski: Hi, I am Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar Research Services chief U.S. market strategist Dave Sekera to discuss one thing that’s on his radar this week, one new piece of Morningstar Research, and a few stock picks or pans for the week ahead. On your radar this week, Dave, are some new economic numbers, but before we dive into that, we talked last week about the chance that the economy may surprise on the upside. Based on the economic metrics that have come up since then, what’s your latest take?

Dave Sekera: Good morning, Susan. I still think there’s a higher probability that the economy surprises to the upside as compared to the downside, versus our base case forecast for this quarter. So this past week, there were a couple of different metrics that were out. First, we had new-home sales, then we had core durable orders. Both of those came out better than expected. We also had the services PMI number. Now, that did come out a little bit lower than what it had been prior, but it still indicates expansion.

And then of course, lastly, we did have a speech by Federal Reserve Chair Powell last week. Now, I still think his speech overall was a big bag of nothing. I don’t think that there was anything different in there than what he’s been talking about before, but he did highlight that growth has been coming in higher than the Fed’s expectations. And there were two areas that he specifically cited. First, “Consumer spending has been especially robust,” in his view. And then secondly, the housing sector he noted was also showing signs of picking back up.

Dziubinski: Let’s look ahead to this week now. What economic numbers will you be watching this week and what might that mean for markets?

Sekera: This week we have a couple. So we have on the economic front, pending home sales, payrolls, unemployment, the Institute of Supply Managers Purchasing Managers Index. And then on the inflationary front, we have the personal consumption expenditures. And within that, you really need to watch the PCE Price Index, that is the Fed’s favorite measure for inflation. Now, I assume that index, that inflationary measure should come out to be otherwise OK. I think if it wasn’t, Powell would’ve been more hawkish at his Jackson Hole speech.

What does that all mean for the markets? The markets just want that goldilocks. They want the economy to be just right, not too hot, not too cool. They want economic growth to be strong enough in order to keep earnings up, but not too strong that it inflates inflation.

Dziubinski: Any earnings reports on tap this week that you’re keeping an eye on?

Sekera: There’s a couple of remaining stragglers. The two I’m going to be watching this week are Salesforce CRM and CrowdStrike CRWD. Salesforce is a tech stock. It’s one that we had long thought was undervalued by the marketplace, but it’s up 55% thus far this year. That puts it into 3-star territory. It still trades at about a 15% discount to our fair value. We do rate the company with a wide economic moat. This stock, I would just note that having spoken to our analyst who covers it, he does think it does have the best balance between growth and profitability expansion. The other one, CrowdStrike, we’ve highlighted a couple of times the long-term secular tailwind that we’ve seen in the cybersecurity industry. And most of these stocks have rallied up thus far this year. Most of them are in 3-star territory, similar to CrowdStrike. It’s a 3-star-rated stock, trades at an 8% discount, and a company has a narrow economic moat.

Dziubinski: Let’s move on to some new research from Morningstar. This week we’re focusing on our updated analysis on Nvidia NVDA. Now, Nvidia of course, reported last week, another terrific quarter.

Sekera: For those of you who also enjoy some heavy metal music, they’ll get my Metallica reference. Last week, nothing else mattered other than Nvidia. Nvidia’s results were nothing other than astonishing. When I break these down, revenue came in at $13.5 billion, well above the consensus estimate of $11.1 billion. Earnings came in at $2.70 a share, well above the $2.07 that was expected by the marketplace. And then they also gave higher guidance for this next quarter of $16.0 billion versus the market forecast of $12.6 billion, which is also much higher than any of the whisper numbers that were out there.

We actually relaunched coverage on Nvidia stock. The stock is now being covered by Brian Colello. He’s the director of our technology team. We raised our fair value estimate on Nvidia now to $480 a share, but we also raised our uncertainty rating to Very High from High. And I think that’s just in recognition that with AI still in such early stages, it’s really just especially difficult right now to make long-term projections and assumptions as far as just how much that industry is going to grow over the next five years.

Dziubinski: This was a pretty big change in our fair value estimate. What in our assumptions changed?

Sekera: Let me break it down into a couple of areas. First, we raised our revenue forecast for this year to a 100% growth. It was 50% growth before. And then over the next five years, we raised our five-year forecast compound annual growth rate from revenue up to 35% from 23%. When we look at revenue, it was $27 billion last year. We’re projecting it to go to $54 billion this year, and it’s forecast now to go all the way up to $120 billion by 2028.

I think the question is how did we get there? So what we did is oftentimes we’ll use a lot of different projections and forecasts that are used by industry participants. In this case, we looked at AMD’s forecast for artificial intelligence accelerator total addressable market, and they’re looking at $150 billion in 2028. So, we’re currently assuming that Nvidia captures two thirds of the market share of that number.

We also raised our operating margin assumption. It now averages 55%. Our prior estimate was 46%. And just as a side note, historically, Nvidia’s operating margin actually averaged 25% over the past 10 years. So net-net, this boosted our earnings per share to $10.59 from $8.11 for this year. And then by 2028, our earnings are now up to $25.00 a share. That’s an increase from our prior projection of $16.30. So net-net, when I break this all down, our fair value estimate of $480 is now 45 times this year’s earnings and 19 times 2028 earnings.

Dziubinski: The stock doesn’t seem to be trading up the way it did after reporting those blowout first-quarter earnings. What do you make of that?

Sekera: Well, like always as an investor, especially long-term investors, you shouldn’t read too much into short-term trading of a stock. It’s always going to be moved by a combination of both technical and fundamental factors. Considering just how much they beat and how much they raise guidance, it does appear that the short-term momentum here might be running out of steam. In my mind, it really begs two questions. One, is this just profit-taking from investors that own the stock lower? Or is it just that the market is now getting to the point that they really can’t justify valuations any higher or realistically push up their forecast any higher than they already are? At this point, I think time will tell.

Dziubinski: It’s time to move on to the picks and pans portion of our program. Last week we talked about some dividend stocks to buy. This week we’re focusing on high-dividend stocks to avoid. Your first high-dividend stock to avoid this week is Xerox XRX.

Sekera: Xerox is currently rated 2 stars, trades at a 20% premium over our fair value, and we rate the company with no economic moat. Its dividend yield is about 7% right now, which of course is a very high dividend yield in this market. And when I look at the valuation, I think the PE multiple—and again, it depends on how you want to adjust their earnings here—is somewhere around 7 or 8 times. At this point, the stock does look cheap, but it’s cheap for a reason. And, in my view, I think it’s a value trap.

In my opinion, I think Xerox is a melting ice cube. Its main business, printing, is in a long-term secular decline. When I look at our financial model, I just note that over the past 10 years, revenue has dropped all the way down to $7 billion from $20 billion, and we do forecast that the top line will continue to deteriorate from here. And when I look at earnings, we really don’t have any real growth trend in earnings. It almost looks like the best for investors to hope for here is really just to clip that dividend and then keep your fingers crossed that the company can raise margins on the declining revenue base in order to be able to try and maintain those earnings as long as possible.

Dziubinski: Your second high-dividend stock to avoid is IBM IBM.

Sekera: IBM, in my mind, I don’t think it’s really all that much better than Xerox. It’s also a 2-star-rated stock, 15% premium, narrow economic moat. The dividend yield is about 5% right now. And again, you have to make some adjustments to earnings. Our adjusted PE ratios in that 13 to 14 times area, so higher than what you saw at Xerox but certainly lower than what you see in the marketplace today. And again, revenue’s been on a long-term decline at IBM.

Looking forward, we are forecasting about a 2% top-line growth on average over the next five years. And when we look at average annual earnings growth, it’s about 6.5% on average over the next five years. In my view, I think IBM appears like it’s just going nowhere fast, and we do see much better opportunities elsewhere.

Dziubinski: And then your last high-dividend stock to avoid is Seagate STX. Why avoid that one?

Sekera: Seagate stock is rated 2 stars and trades at a 17% premium. We rate the company with no economic moat. Its dividend yield right now is about 4.5%. Seagate makes hard disk drives and of course, as you would expect, it’s a very cyclical business, and you really shouldn’t value the company just on any one year’s earnings. Now, taking a look at the PC market, there was a huge upswing early during the pandemic as you had employees switching to working from home. But, of course, now that all that demand has been satisfied, PC demand has dropped precipitously, and we forecast PC demand isn’t going to recover until 2025.

I’d also note that within the industry, PCs are incorporating less hard disk drive memory in favor of solid-state memory. So in the meantime, Seagate has been transitioning its portfolio, it’s trying to focus more on mass capacity drives for the cloud providers. Looking at the valuation here, the stocks trading at about 15, 16 times 2025 earnings. And at that forward multiple two years into the future, I think that’s still relatively high. I’d rather invest in stocks that we think have a better growth profile, even if they pay a lower dividend.

Dziubinski: Well, thanks for your time this morning, Dave. Dave and I will be off next Monday celebrating Labor Day, but we’ll be back live on Monday, Sept. 11 at 9 a.m. Eastern, 8 a.m. Central. In the meantime, please like this video and subscribe to Morningstar’s channel. Have a great week.