One of the main investing themes that defined this year was the threat of rising interest rates and inflation.
Rising interest rates are also an issue for income stocks (specifically those that pay a high dividend) because the future cash flows are “discounted” at a higher rate. So, if all else remains the same, a big dividend payer becomes less valuable as interest rates rise.
At least, that’s what many investors have been led to believe…
The truth of the matter is that income-paying stocks do tend to get beat up a bit when rates rise quickly, but this is a good illustration of the inherent irrationality of the market. The truth is that dividend payers tend to follow HIGHER interest rates over the medium term (anything longer than six to 12 weeks).
Why is that?
Growth drives both dividend payers and interest rates. Most stocks will rise in a growing economy, and inflation and interest rates increase accordingly.
Bottom line: Every time the initial shock of higher rates sends dividend payers lower, it represents a buying opportunity to profit when investors start acting more rationally.
In our view, there are a lot of dividend payers that look very good right now and should be buying opportunities on any dips. And today, we’ll reveal the top five on our watchlist for 2022.
Income Stock No. 1: Public Storage (PSA)
Around since 1972, Public Storage (NYSE:PSA) is the “largest owner and operator of self-storage facilities in the world.” Their neon orange signs are recognizable across the United States, even if the name right off the bat doesn’t ring a bell.
At the moment, 10.6% of U.S. households rent a storage unit – and they pay an average of $89.12 per month to do so. That is a huge market. And in the storage unit business, it is said that the four Ds – death, divorce, downsizing, and displacement – drive profitability. If the market stumbles in 2022, which seems possible, then a stock positioned to profit from a decline makes sense.
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Although folks going through tough times certainly aren’t the only ones in need of an extra place to store their belongings, we would add “demand” as the fifth D to the list. Demand for extra storage has increased with housing prices. This correlation isn’t new, and it means storage looks relatively good, regardless of market volatility.
The big differentiator between PSA and its competitors CubeSmart (NYSE:CUBE) and Life Storage Inc. (NYSE:LSI) is size; PSA’s market cap is about 6X the size of CUBE and LSI. Plus, it has been around for nearly 50 years and has operations in the U.S., Canada, and Europe.
Its large market cap in such a high-margin, cash-heavy business means Public Storage has that much more to spend on acquisitions and new builds. Additionally, its longevity shows that it can survive in almost any economic climate.
Although the dividend yield on PSA is good, like most REITs, most of the payment is an “ordinary” dividend subject to a higher tax rate. So, talk to your tax adviser about how to shelter that income.
Income Stock No. 2: Big 5 Sporting Goods Corp. (BGFV)
Our second stock is the El Segundo, Calif.-based sporting goods retailer Big 5 Sporting Goods Corp. (NASDAQ:BGFV). This group operates about 400 stores in a dozen Western states.
In early August 2021, the retailer issued robust second-quarter metrics. Sales came at $326.0 million, compared to $227.9 million a year ago. Net income of $36.8 million translated into earnings of $1.63 per diluted share. In 2020, these metrics had been $11.1 million, or 52 cents per diluted share. Investors were pleased to see that the gross margin went up from 31.7% to 38.9%.
BGFV has been one of the stocks to benefit from the COVID-19 pandemic. Consumer interest in outdoor activities and demand for sporting goods increased; however, unlike many other pandemic stocks, the shift back to “normal times” should not impact BGFV the same way it might affect Zoom Video Communications Inc. (NASDAQ:ZM).
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And as consumer spending rises, we like BGFV’s prospects, despite some of the short-term logistical problems that have impeded the company’s Chinese imports.
One of the most compelling aspects in favor of BGFV is the dividend yield at 4.16%, which is almost triple the average of the S&P 500. Investors are undervaluing the stock and the income right now as it competes with other highflyers.
Income Stock No. 3: Energy Transfer LP (ET)
Energy Transfer LP (NYSE:ET), as you might have guessed by its name, engages in pipeline transportation and oil transmission. Basically, it’s a company that has been performing well in the energy rebound… and should continue to do so.
In Q2 2021, the company hit $15.1 billion in revenues, a jump of 106% over the same period a year earlier. With oil prices increasing quickly, there’s every reason to believe revenues will increase as company demand picks up.
The company is undertaking a debt-reduction effort, which should increase its attractiveness. In Q2 Energy Transfer paid down $1.5 billion in outstanding debt. In 2021, that took that number to $5.2 billion in aggregate.
Companies like ET are interesting because they are relatively unknown outside of oil-focused investment circles. They have upside and rise quickly when a catalyst hits. Recent price projections suggest an average upside of 42%, but that is very likely rising as oil supply deficits worsen.
The shares that represent limited partnerships in the energy sector have somewhat fallen out of favor since 2019. However, energy product demand and a robust economic recovery have made them look much better. Volatility has been high, but a 6.14% dividend yield can go a long way in hedging that risk.
We believe the real reason Energy Transfer has such a low valuation is the company’s history of regulators citing it for violations. Another 48 criminal charges have been lodged against the company in Pennsylvania in 2021.
We don’t like lawsuits, criminal charges, or shortcuts like this, but the legal risks should only result in small fines (compared to total revenue) and a subsequent improvement in management’s operations.
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The charges have been headline-grabbers, and investors got spooked. This makes Energy Transfer, one of the largest midstream (one that’s involved in transporting, refining, or selling energy commodities) companies in the sector, a unique buying opportunity for a risk-tolerant income investor.
We should note that the dividends ET pays are considered “distributions” from the partnership, so talk to a tax adviser about how best to shelter that income stream.
Income Stock No. 4: Fidelity National Financial Inc. (FNF)
Fidelity National Financial Inc. (NYSE:FNF) holds the No. 1 position in the U.S. for title insurance and settlement services in the residential and commercial real estate markets – a red-hot real estate market has helped turn FNF stock into a big growth story through the pandemic.
And while not everyone follows the title insurance business as closely as we do, it is an excellent barometer to measure the housing market’s health. From that perspective, FNF is a unique play. It tends to be less volatile than other housing stocks and pays a 3.27% dividend.
As you might imagine, the housing market has been driving massive revenue and profit growth at FNF over the past year. But many investors see that as a reason to sell before the market starts to cool. Those concerns have pushed Fidelity National Financial’s share price back down to some attractive valuations.
We don’t think investors should try to pick the top in the housing market yet. As long as economic growth is positive and wages are rising, the sector should remain strong throughout 2022.
Additionally, we think many of these investors are neglecting to include the value of FNF’s acquisition of Guaranty Life Insurance Co. that closed on June 1, 2020. Sales of life insurance products, including annuities, have been stronger than expected and should smooth things out for Fidelity National Financial if the housing market gets a little toppy.
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Despite all this growth, income, and compounded value through acquisitions, FNF frequently trades at a discount below its real value. Anytime its dividend yield is above 3%, the shares are likely at a good value.
Income Stock No. 5: Franchise Group Inc. (FRG)
This little gem is flying way under the radar these days, despite a 4% dividend yield and solid growth. A name change in 2019 from Liberty Tax Inc. and somewhat confusing financials have kept the stock from getting a lot of the attention it deserves.
Franchise Group Inc. (NASDAQ:FRG) buys companies with locations that are either already franchised or could be franchised where a large percentage of the stores are still corporate owned. That allows FRG to sell the corporate-owned stores for large cash inflows while supporting franchisees with operational support and access to credit.
If you have ever seen a Vitamin Shoppe, Liberty Tax office, or Sylvan Learning Center in your neighborhood, then you have seen some of FRG’s largest franchises.
The trick with Franchise Group is to evaluate it on a cash-flow basis rather than earnings. In both cases, the numbers are a little choppy, but its excellent free cash flow will give you a better idea of the company’s ability to raise the dividend without the complexity of accounting for the income statement acquisitions.
John Jagerson & Wade Hansen
Editors, Trading Opportunities