Interest rates are on the rise, and the stock market doesn’t like that.
Ever since the 2008 financial crisis, the stock market has grown accustomed to an era of near zero interest rates. But a piece of good news (record wage growth in the January Jobs Report) has threatened the longevity of currently low interest rates.
Inflation is showing up to the party sooner than it’s supposed to, and we still have tax cuts and stimulus coming. More inflation means more rate hikes, which means higher fixed income yields. That is bad, because in many ways, investing is a search for yield. In this sense, rising zero-risk yields pressure equity valuations.
All in all, stocks are repricing to an ear of higher interest rates.
I don’t think this sell-off is a big deal. I’m actually looking at a price target north of 3,000 by the end of 2018 for the S&P 500.
But I do think you invest a little bit differently in a higher interest rate environment. You place higher value on companies with big yields — both earnings yields and dividend yields. You also place higher value on companies with stable growth prospects and big moats.
From this perspective, I think big dividend yield, big earnings yield companies with huge moats and stable growth prospects will outperform in this higher interest rate environment.
Here are my three favorite dividend stocks to pick from.
Dividend Stocks to Buy: Apple Inc. (AAPL)
The whole market has been down recently, but tech giant Apple Inc. (NADSAQ:AAPL) has been an especially big loser due to poor timing. Sentiment shifted on AAPL stock right as sentiment was shifting on the whole market.
In the weeks leading up to the big market sell-off, rumors were starting to spread that Apple didn’t sell as many iPhones as investors thought they would sell. That caused AAPL stock to drop off its all time highs. Then, right before the big sell-off, Apple reported quarterly earnings that confirmed weak iPhone demand. The iPhone X “Super Cycle” thesis was scrapped, and AAPL stock dropped.
But where there is ruin, there is opportunity. Despite being the biggest company in the market and possessing a huge moat in the form of the Apple ecosystem (think iPhones, iPads, Macs, Apple Watches, Apple TVs, etc.), AAPL stock trades at just 12.4-times forward earnings (8% yield). The S&P 500 is trading at 16.5-times forward earnings (6% yield).
That means that as the 10-Year Treasury yield creeps up to 3% and perhaps higher, AAPL stock has an additional 200 basis points in valuation cushion relative to the market. That is a sizable cushion.
Moreover, thanks primarily to a ramp in the company’s Services business, Apple’s long-term earnings growth rate is roughly 12%. The market’s is 15%. That gives AAPL stock a price-to-earnings/growth (PEG) ratio of just over 1, which is more attractive than the market’s 1.1 PEG.
Lastly, Apple also has this big dividend (1.6% yield), which will likely get a big boost thanks to all the cash Apple is going to repatriate over the next year. Some of that cash will also go to buybacks, so the dividend yield will get a double tailwind over the next year.
All together, this is a stable growth, big yield, big moat company that has been butchered recently. I smell opportunity.
Dividend Stocks to Buy: AT&T Inc. (T)
Telecom giant AT&T Inc. (NYSE:T) is another really good company with a strengthening growth narrative and below-market valuation that should do well in a higher interest rate environment.
Firstly, I’ve been bullish on AT&T stock for a while now. This is a company that is starting to turn their biggest headwind (cord cutting) into a strong tailwind (over-the-top subscriber growth through DirecTV NOW), while also benefiting from a favorable macro-economic back drop (tax cuts and the repeal of net neutrality).
The roll-out of 5G this year will also help the company once again distinguish itself in terms of quality in the wireless service market, which should help wireless revenues and margins stabilize. They could even rebound.
All together, the AT&T growth narrative is about as good today as it has been over the past several years.
Secondly, despite that strengthening growth narrative, AT&T stock still features super high yields. The forward earnings yield is just above 9%. The free cash flow yield is near 8%. Dividend yield? North of 5.5%.
In other words, higher interest rates shouldn’t pressure the valuation on AT&T stock all that much because the stock already features sky-high yields where it matters. Moreover, with multiple catalysts on the horizon, I realistically see earnings, free cash flow, and the dividend heading materially higher over the next several years. That means these yields will explode higher.
Unless the stock price goes up with those operational improvements. That is what I think will happen. Given sky-high yields and multiple forthcoming catalysts, I see AT&T stock as a solid outperformer in this higher rate environment.
Dividend Stocks to Buy: Target Corporation (TGT)
While Apple and AT&T are good investments over the next 12 months, I think Target Corporation (NYSE:TGT) is a great investment in that time period.
This is a company that was absolutely on fire before the big market sell-off. Left for dead in the first half of 2017, Target began to pick up steam in the back half of the year as comparable sales trends improved, margins started to stabilize and digital growth remained red-hot. This big run led to a holiday period wherein comparable sales in every core merchandise category at Target were not only positive, but accelerated from the prior period.
The strong momentum, coupled with tax reform, led TGT to deliver a really strong guide. Investors got excited, and TGT stock was pushed up to $80. But higher rates have dragged TGT stock back down to $70.
That doesn’t make much sense to me. Inflation will actually help big box retailers like Target. If inflation does continue to pick up, that means there is robust wage growth for the first time in a decade. Higher wages leads to more spending, especially since consumers have been saving up a whole bunch over the past decade. In other words, I think the savings rate goes down as wages go up, creating a double tailwind for consumer spending. Target will naturally see a sales lift.
Moreover, TGT stock has a 7% forward earnings yield (more than double the 10-Year Treasury yield) and a 3.4% dividend yield (roughly 55 basis points above the 10-Year Treasury yield). Those are pretty good yields that give the stock a comfortable cushion before valuation is pressured by higher rates.
And then there is the whole valuation discrepancy with Walmart Inc (NYSE:WMT). As one would reasonably assume considering the two are essentially interchangeable, the valuations of TGT and WMT have mirrored each other over the past decade. In mid-2017, though, the valuation discrepancy between WMT and TGT grew to unprecedented levels thanks to WMT’s success and TGT’s troubles in the digital commerce world.
Now, TGT finally has its act together on the digital commerce front and comparable sales growth is strongly positive. But the valuation discrepancy between TGT and WMT remains far too wide. This gap will narrow, and as it does, TGT stock will head higher.
As of this writing, Luke Lango was long AAPL, T and TGT.