Dividends With Room to Grow

In the perverse logic of Wall Street, young, rapidly expanding businesses that pay no dividends are all the rage (think Google), while solid, profitable companies that work hard to cut you a quarterly check are often ignored.

Well, here's to the working-class heroes of the stock market. Since 1980, dividend-paying members of Standard Poor's 500-stock index have, on average, gained 15% annualized. That compares with an annualized return of 13% for nonpayers. The difference, says SP analyst Howard Silverblatt, roughly equals the index's average dividend yield over the period. Looked at another way, a $10,000 investment in SP 500 dividend payers on December 31, 1979, would have been worth $375,738 at the end of November 2005. The same investment in nonpayers would have grown to $225,906.

Dividends have another big advantage: favorable tax treatment. Uncle Sam taxes qualified dividends at a maximum rate of 15%, compared with as much as 35% for ordinary income.

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How do you pick a good dividend-paying stock? Aside from utility and real estate stocks, which are known for their generous yields (annual dividend payment divided by share price), a big payout of 5% or better isn't always the way to go. Sometimes it points to a company in distress. General Motors, for example, yields nearly 9%, but the company's precarious financial position makes it highly unlikely that the dividend will be maintained at anything near its present level. Better to settle for a lower yield and focus on firms that are on solid financial footing. A good strategy is to identify companies with a long record of raising their dividends and with operations that generate more than enough cash to cover the payouts. The five reasonably priced stocks listed here are prime choices.

Family values

With the rise of the Internet, old media doesn't always get the respect it deserves. Meredith Corp. is a good example. The 104-year-old publisher of Better Homes Gardens and more than 100 other subscription magazines and special-interest newsstand publications has a long record of consistent earnings and dividend growth. Its recent acquisition of Family Circle, Parents, Child and two other titles from Gruner + Jahr boosted revenues and profits to record levels in the quarter that ended in September. Meredith's publishing business (about 75% of its $1.2 billion in revenues) will look even better over the next few years as the new titles' operating margins (operating profits divided by revenues), currently less than 5%, approach the mid-teens average of established Meredith magazines. Yet Meredith's stock, recently $51, has barely budged over the past two years. Standard Poor's analyst James Peters thinks the shares are worth $60 and rates the stock four stars, SP's second-highest grade.

Meredith magazines, such as Ladies' Home Journal and Traditional Home, have long appealed to middle-aged female homeowners. The acquisition of American Baby in 2002, combined with the recently purchased titles, extend the Des Moines company's reach to a younger audience. Siempre Mujer, a new title, targets the fast-growing Hispanic market. Meredith also owns 14 TV stations, a book-publishing arm, profitable Web sites and an 85-million-name database that is used to boost subscription sales. Meredith has paid a dividend for 58 straight years and has raised it the past 12. With an annual payout of 56 cents, the stock yields 1.1%. It trades at 18 times estimated earnings of $2.86 a share for the year ending next June.

There are some headwinds, though. Postage and paper costs are rising, and a slowdown in the housing market could hurt Meredith's many home and remodeling titles. Consumers are still spending money on their homes, says Meredith president Stephen Lacy. "But it's one of the reasons we feel good about balancing our portfolio" with the recently acquired family-oriented titles, he says.

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Bank for the masses

With the gap between short-term and long-term interest rates shrinking, banks are less able to profit from one of their favorite moneymaking activities: borrowing at cheap short-term rates and lending at higher long-term rates. As a result, investors have been indifferent to bank stocks, which have been flat over the past year. But TCF Financial is down 7% over the same period, even though it may be better positioned than others to handle the profit squeeze.

The regional bank, headquartered in Wayzata, Minn., caters primarily to small depositors, and most of its 442 branches are in supermarkets. It pushed no-monthly-fee checking and now has 1.7 million accounts. Those accounts provide TCF with an unusually cheap source of capital. It paid an average of just 1.2% on its deposits during the most recent quarter. That money is then turned into a high-quality portfolio of consumer and commercial loans. No wonder TCF's net interest margin (the difference between its borrowing and lending rates) is close to a full percentage point higher than the average for the top 50 banks. TCF also gets nearly half its revenues from service charges (including checking-account and debit-card fees), which further insulates its results from interest-rate gyrations. A steady expansion program, which added branches in Colorado and Arizona to a primarily midwestern base, should keep revenues growing. Profits have risen 14% annually over the past decade.

Large banks, which once shunned small depositors, are now competing hard for them, a factor that may worry some TCF investors. But chief executive officer William Cooper insists that big banks can't serve small customers as well as TCF can. "What makes us more competitive is the fact that we're open seven days a week and on holidays," he says. "We have a total commitment" to serving small depositors.

The stock looks cheap. At $28, it trades for 13 times estimated 2006 profits of $2.08 per share, a lower price-earnings ratio than that of other regional banks of TCF's size. A.G. Edwards analyst David Stumpf says the stock could hit $33 in a year to 18 months if the P/E gap shrinks. Meanwhile, the stock yields 3.1%. TCF has raised its dividend 14 straight years.

Discounter on sale

One thing you usually don't find discounted at Wal-Mart is its stock. Yet at $48, the shares are down from a 2004 high of $61, and they trade for just 16 times expected earnings of $3 per share for the fiscal year ending January 2007. That P/E is roughly the same as the overall market's. But over the past ten years, the P/E of the discount retailing giant has been as much as two and a half times greater than the market's. Granted, now that annual sales are approaching $300 billion, it's hard for Wal-Mart to grow as fast as it once did. And the company's labor practices and its impact on small-town retailers have attracted considerable opposition, which has hampered its expansion into some communities.

But it's far too early to write off the behemoth from Bentonville, Ark. In the quarter that ended October 31, sales rose 10%, despite Hurricanes Katrina and Rita and higher energy prices that hit Wal-Mart's low-income customer base particularly hard. And the retail giant has a plethora of opportunities to keep that growth going, including new U.S. stores (as many as 370 could open this year), international expansion (overseas stores should account for one-third of sales in five years), and further incursions into groceries and consumer electronics, categories that remain ripe for Wal-Mart's picking.

The stock isn't as much of a bargain as it was immediately after Katrina, when it fell to a low of $42. But Citigroup's Deborah Weinswig thinks it could hit $62 within a year. Wal-Mart has boosted its annual dividend, now 60 cents, for 31 straight years. The stock yields 1.2%.

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Niche collector

Ron Hoffman runs New York City-based Dover much the way Warren Buffett presides over Berkshire Hathaway -- as a collection of disparate businesses run by CEOs who are given wide discretion. But while many of Buffett's businesses tend to be household names (Dairy Queen and Fruit of the Loom), none of Dover's 50 firms is a familiar brand.

Dover was formed in 1955 to buy up small, privately owned firms that make equipment and machinery for industrial and commercial customers. Owners can cash out but continue to run their businesses and, at the same time, know that they have the resources of a major enterprise ($6 billion in annual sales) behind them. But although Dover units make everything from valves for Boeing 747 jets to refrigerated food cases, Hoffman recoils from the term conglomerate. "Conglomerates homogenize businesses," says Hoffman, who joined Dover in 1996 -- when it bought his company, Tulsa Winch -- and became CEO in 2005. "We allow the business models and cultures we buy to stay intact."

Dover has generated profit growth of 11% per year over the past decade. Under Hoffman, Dover's corporate staff (fewer than 100 of its 30,000 employees) has been more aggressive in pushing leaders of Dover's businesses to share ideas for improving efficiencies. Hoffman has also fine-tuned Dover's mix of businesses, moving into higher-growth areas such as health sciences and energy exploration. As a result, analysts see faster profit growth, on the order of 17% annually, over the next three to five years. JPMorgan analyst Stephen Tusa says Dover shares, recently $41, could be worth $48 in a year as investors, like Dover, turn away from slower-growing businesses. Dover's dividend is currently 68 cents a share (resulting in a 1.7% yield), and it is reliable: The company has increased its payout 49 straight years.

Eye for opportunity

Fast-growing companies usually prefer to plow profits back into their business rather than pay them out as dividends. But profits at LCA-Vision are growing so fast the company declared its first dividend in 2004 and increased it by 50% last year. It also initiated a one-million-share buyback program. Even so, the Cincinnati-based chain of laser vision treatment centers still holds a growing cash hoard of more than $110 million, or $5 a share. Although we prefer companies with longer dividend histories, LCA's 48-cent dividend has a lot of room to grow. The stock yields 1.0%.

LCA's 50 LasikPlus centers in the U.S. and Canada treat patients for nearsightedness, farsightedness and astigmatism. Some 60 million adults are potential patients, and only four million have been treated so far, says chief financial officer Alan Buckey. LCA added ten locations in 2005 and plans to open ten more in '06. A new center costs $1 million to $1.5 million to open, and it typically generates cash flow of $1 million within a year.

LCA shares have more than doubled in the past year, to $49. But if you subtract the $5-per-share cash stash from the stock price, LCA trades for just 23 times expected 2006 earnings of $1.94 a share. That's not bad, considering that analysts expect profits to grow nearly 50% over the next two years, even though laser treatment is an expensive elective procedure ($1,400 per eye) that consumers could forgo if strapped for cash. Still, LCA is a leader in a relatively young business with growth potential as far as the eye can see.

Data to December 12. *Fiscal year ends June 30, 2006. sup1;Fiscal year ends January 31, 2007. #Estimated. laquo;Based on estimated earnings.

Sources: Thomson First Call, Yahoo.