4 Undervalued Dividend Stocks

Key Takeaways

• What we’ve seen is really a reversal of fortune for dividend stocks relative to the broad market in 2023.
• In 2023, we’ve seen some phenomenal returns from some stocks you would find in the growth column of the Morningstar Style Box.
• The federal-funds rate is at its highest level in, I believe, 16 years, bond yields are much higher, and investors can actually get a pretty good return now even from just like a savings account or CDs.
• It’s not just about current income or yield, and with dividend-payers, you have both the current income coming from those dividend payments but also the prospect of capital appreciation, particularly if you’re able to buy high-quality companies that are undervalued currently.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar, and welcome to Dividend Stock Deep-Dive. I’m here today with David Harrell, editor of Morningstar DividendInvestor. We’re going to unpack the performance of dividend stocks so far in 2023, and I’ll also get David’s take on the dividend prospects of four high-dividend stocks that Morningstar’s analysts think are undervalued.

Good to see you today, David.

David Harrell: Great to be back.

Dziubinski: Let’s start out with a little bit of a recap about how dividend stocks have performed this year relative to the broader market.

Harrell: Sure. So, with the usual caveat that, as investors, we shouldn’t be too concerned or worried about short-term performance, what we’ve seen is really a reversal of fortune for dividend stocks relative to the broad market in 2023. As you know, last year, pretty bad year for the U.S. equity market as a whole. The U.S. equity market was down around 18% on a total return basis, but dividend indexes and dividend-oriented portfolios, much better performance. Some of them actually eked out a slight gain in 2022. So far, in 2023, for the broad U.S. market, depending on which index you look at, we are up around 9% for the year, but dividend indexes are kind of flat for the year.

Dziubinski: What’s been driving that sort of underperformances here?

Harrell: Well, we can look at it through a couple of different lenses. One is investment style. So, in addition to being a bad year for the overall stock market last year, it was a horrible year for growth stocks. Whereas in 2023, we’ve seen some phenomenal returns from some stocks you would find in the growth column of the Morningstar Style Box. Stocks like Nvidia, Salesforce, Microsoft, Apple are all up for the year by double-digit amounts. So, I think, when we look at the growth column as a whole, it’s up around 14% for the year, whereas the value column, which is more likely to be home to dividend-payers, is lagging by about 12 percentage points. So, there’s definitely been a shift so far in 2023 where growth stocks are outperforming.

We can also look at it through a sector lens, although there’s a fair amount of overlap with sector investment style. We’re seeing sectors like technology and communication services up over 20% for the year to date, whereas some of the sectors where we’re more likely to find our dividend-payers, utilities, energy, healthcare, financial services, those sectors are all actually in the red for the year to date.

Dziubinski: Let’s talk a little bit about bond yields and dividend-paying stocks. Bond yields are certainly far more attractive today than they were 12 months ago. Why might investors be considering dividend stocks when bond yields look as good as they do?

Harrell: Sure. As you say, it’s a very different situation than we were in 12 months ago or a year-and-a-half ago where bond yields were low, and investors really couldn’t expect anything at all from a cash investment. Right before we began taping today, the Fed announced its latest rate hike, a quarter of a percentage point. I believe that was the 10th consecutive raise. So, the federal-funds rate is at its highest level in, I believe, 16 years, bond yields are much higher, and investors can actually get a pretty good return now even from just like a savings account or CDs. So, certainly, more options for investors seeking current income today than they had 12 months or 18 months ago. But as to why dividend stocks in this environment, I would say it’s not just about current income or yield and with dividend-payers, you have both the current income coming from those dividend payments but also the prospect of capital appreciation, particularly if you’re able to buy high-quality companies that are undervalued currently. I’d also point to something Warren Buffett of Berkshire Hathaway—the company famously does not pay a dividend, but in the most recent annual shareholder letter, Buffett was praising dividend stocks and how the income from those stocks had benefited Berkshire Hathaway’s investment portfolio.

Dziubinski: David, let’s pivot a little bit and talk about the dividend prospects of some high-yielding stocks that our analysts think are undervalued. So, this is their position on valuation, and you can talk a little bit about what you think of the dividend. Our first stock is Altria Group MO. Altria is, of course, one of the big tobacco companies in the United States. The company is trying to pivot its portfolio more toward tobacco and nicotine products to sort of mitigate the falloff and, of course, the big decline of cigarette sales. Now, we think the company has carved out a wide economic moat, the stock offers a forward dividend yield in excess of 7% as of today, and the stock looks about 9% undervalued according to our analysts. Talk a little bit about the dividend here.

Harrell: As you said, Morningstar analysts expect cigarette volumes to decline by about 5% a year moving forward. However, they also believe that Altria—you have a product where your customers are addicted to it. They believe Altria should be able to raise its prices in excess of that decline. So that would allow the firm to continue to increase its revenue, increase its earnings, and then therefore be able to keep the dividend and actually increase that dividend overtime.

Looking at the dividend right now, so I just said over 7%, but the payout ratio is fairly high, around 85%, I believe, last year and expected to be the same. So, when your payout ratio is that high, you don’t have a lot of room for maneuverability in case of some sort of liquidity crisis or black swan regulatory event or something like that. That said, Morningstar analysts believe Altria is very devoted to its dividend and would only cut it under the most extreme of circumstances. And they also point out that if it came to that, Altria has a 10% stake in Anheuser-Busch InBev. So, if it came to it, they could use that to provide cash to keep the dividend covered if necessary.

Dziubinski: David, Altria’s management also released a letter recently about the dividend?

Harrell: Yes, they put out a statement basically saying that, looking ahead, they were targeting dividend growth in a mid-single-digit range. They’re certainly hoping to increase the dividend, but it’s going to be a fairly small percentage on an ongoing basis.

Dziubinski: Let’s turn and talk about another undervalued high-dividend stock, and that’s Verizon VZ. We’re talking about a 6% forward dividend yield as of today for the stock. The stock is trading at more than a 30% discount to our analysts’ $57 fair value estimate. Of course, Verizon is one of the three biggest U.S. wireless carriers, and while we expect a limited subscriber growth, management has said that cash flow growth remains its top priority. So, talk a little bit about the dividend here.

Harrell: Verizon raised its dividend last year by 2%, and now it can point to 16 consecutive years of annual dividend increases, which is a great thing. However, those increases have generally been pretty small, and I believe Verizon’s five-year annualized dividend-growth rate is only 2.1%, so not a lot of dividend growth there. And the primary reason for that is, back in 2014, Verizon took on a lot of debt in order to buy out Vodafone from a joint venture that the two firms had together. So, basically, Morningstar analysts note that they’ve got a lot of debt to pay off, they’re trying to reduce that leverage, and Morningstar analysts believe that it’s going to just keep them from being able to return much cash to shareholders over the next couple of years. We’re probably not going to see a lot of near-term dividend growth there. But as you say, the yield is up, but a lot of that is simply because of the decline in the share price we’ve seen over the past year or so.

Dziubinski: Got it. Let’s talk about another stock that’s really gotten knocked down after the banking crisis, and that’s Truist Financial TFC, really undervalued. It’s one of the larger regional banks in the United States, and we think that it has carved out a narrow economic moat. First-quarter results showed that there was some earnings pressure building, but our analysts think that it’s an amount that’s going to be manageable. The stock is more than 40% undervalued as of today relative to our fair value estimate and has a forward dividend yield of about 6%. What about this one?

Harrell: Sure. We’ve seen a pretty big drop in Truist’s share price since March, and that share price drop has pushed the yield above 6%. And as you mentioned, there’s some earnings pressure there that the bank is going to have to work through and that could possibly hinder near-term dividend growth. But one thing in favor of Truist is—it, as an organization, has expressed a lot of support for the dividend in the past. Back in 2020, the CEO at the time actually said it was morally right for the bank to continue to pay its dividend to the investors who were depending on the dividend unless it reached a point where regulators would prevent them from doing so. So, that sort of attitude does not in any way guarantee a dividend, but it’s good for income-focused investors to see, and in the most recent earnings call, I believe April 20, the current CEO again reiterated the commitment of the firm to the dividend.

Dziubinski: Great. There’s one last stock we’re going to talk about that’s undervalued, high-dividend—Lloyds Banking Group LYG. Before we get into the details of that stock, though, I just want to point out that here we’re talking about the ADR of a British bank. So, let’s step back and talk a little bit about what types of things investors should be keeping in mind when investing in dividend-paying stocks from non-U.S. companies.

Harrell: One thing that’s different is that in the U.S. the norm for most dividend-paying companies, but not all, is to pay a fixed quarterly dividend. So, they have a dividend rate, they pay that out for the next four quarters and then, hopefully, you’ll get a dividend raise. Outside the U.S., it’s not as common. And actually, it’s very common that you’ll have semiannual dividend payments, where a firm will pay an interim dividend and then at the end of its fiscal year make a final dividend payment based on the results for that year. So, you don’t have the four payments a year, so it’s just twice a year, and there’s also some uncertainty about how much you’re going to receive from your shares.

A couple of other things to point out is that you’re going to have ADR fees in many cases. So, maybe a slight amount of that dividend payment is actually taken away from you as an ADR fee. And there’s also the currency angle. If they’re paying out the dividend in the British pound or euro, that has to be transferred to U.S. dollars. And the U.S. dollar has been very, very strong over the past year or so. Now, it’s come down a little since it peaked in September, but there have been cases where non-U.S. dividend-payers maintained their dividend or even raised it a little bit but U.S. investors saw the final amount they received go down because of that currency situation.

Dziubinski: Got it. Let’s talk specifically then about Lloyds. Again, it’s a pure-play U.K. bank, more than 95% of its assets are invested domestically. Now, our analysts think this is a reasonably lower-risk domestic retail and commercial bank. Narrow economic moat rating. Now the bank has guided to lower net interest income for 2023. Stock is trading more than 30% below our fair value estimate. Has over a 4% forward dividend yield. What do you think of the dividend?

Harrell: Yeah. Well, first, a few logistical things. First of all, we were talking about the interim and final dividend payment. Back in 2020, Lloyds actually announced it was going to move to a quarterly dividend payment, putting it more in line with the U.S. companies. There was still going to be a variable element where it would pay a fixed quarterly dividend for the first three quarters of the year and then its last dividend would be variable based on the fiscal results for the year. However, before it could commence that new plan, it halted its dividend altogether in 2020. Now, Lloyds probably had the financial strength to continue its dividend, but this was simply U.K. banking regulators—just put the kibosh on all dividend payments for U.K. banks. Now, Lloyds reintroduced its dividend in 2021, but they went back to this interim final payment.

Lloyds’ first payout of 2023 was actually its final dividend for fiscal-year 2022. It was more than it paid for its final dividend of 2021. And it looks like the bank is going to be able to pay out after ADR fees about $0.11 per ADR share to U.S. investors, and that translates into a yield of around 4.6% for U.S. investors, and that’s certainly more of a yield than you’re going to get from any of the big four U.S. banks. I believe three of them, Bank of America, JPMorgan Chase, and Wells Fargo, are all yielding around 3% or just slightly below that, while Citigroup is yielding 4% right now.

And I want to follow up on the Morningstar analysts’ take on the risk that you mentioned. A couple of things: First of all, Lloyds is very well capitalized. The second thing is that one difference between U.S. and U.K. banks is that the length of a mortgage in the U.K. tends to be much shorter than the U.S., where we typically have 15- or even 30-year mortgages. So, what that means is the banks are less likely to get out of market range in terms of their mortgage exposure, and when interest rates move against them, it’s going to do less damage. Now, in terms of ongoing dividend growth, management is supportive of the dividend and dividend growth, but last year in an earnings call, the CEO did say when discussing the capital allocation plans for the bank, that its institutional shareholders had expressed a strong preference for buybacks over dividends. So, it seems that maybe any incremental growth, those dollars might be devoted to buybacks as opposed to growing the dividend.

Dziubinski: David, thank you so much for your time today and your dividend insights into some of these higher-yielding dividend-paying stocks. We appreciate it.

Harrell: Thanks for having me.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch “3 Dividend Stocks for May 2023″ for more from David Harrell.