Co-Produced with Hidden Opportunities
Have you ever heard someone extolling the virtues of a recent purchase they have made? They’ll often say “This is the best/smartest/most clever purchase I have ever made because…”
We all love the feeling of besting someone else or beating the prevailing condition. Whether that’s snagging a car at an amazing deal or finding some item on Amazon that the listing is incorrectly typed in and you get it for 90% off.
The thrill of the smart buy can be hard to beat.
Beaten-down stocks with solid dividend potential are usually smart buys for income investors. These purchases allow you to buy more income with less capital!
Stocks drop for a wide variety of reasons, broadly classified as internal and external factors. While company internal factors include deteriorating fundamentals, business headwinds, and growing competitive pressures, external factors are at the discretion of Mr. Market. They could be geopolitical issues, fading trends, misunderstood transactions, or a broader market correction. There is no end to the number of reasons for a stock to get beaten up. As individual investors, the irrationality or the recovery is not in our control; it requires patience. Warren Buffett has famously said that the stock market rewards patience long-term.
“The stock market is a device for transferring money from the impatient to the patient” – Warren Buffett
But this is easier said than done. When stocks fall, there is pessimism, anxiety, and the desire to cut one’s losses and get out. It is pretty hard to buy with both hands when stocks are plunging.
If you know the company’s fundamentals are sound, it is easier to purchase in a downtrend when you are incentivized to sit through the chaos. The most common incentive in the market is dividends; you get paid to wait for a better price from Mr. Market. Today, we discuss two beaten-down stocks with a tremendous incentive to wait for upside – yields up to 7.2%. Without further ado, let us dive into these picks.
Pick #1 BTI, Yield 6.9%
This pandemic fueled the global consumer demand for combustible tobacco. According to a recent study, cigarette sales across the U.S. were up more than 14% from March 2020 to June 2021. This is despite leading nations fighting combustible tobacco tooth and nail through regulations, taxes, and large-scale awareness campaigns. Cigarettes are among the highest-taxed products in many countries including the U.S. Such is the moat of big tobacco in this business.
“I’ll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It’s addictive.” – Warren Buffett
British American Tobacco (BTI) is the largest tobacco company globally by revenues and the most undervalued in the peer group.
We have been pounding the table on BTI since Q3 2021. Since our initial recommendation to subscribers, BTI has been up almost 23%, but there is significant upside ahead and a hefty ~7% dividend for you to wait for those gains.
Note: BTI declares and pays its dividends in GBP. This means the dividends received by American investors will vary based on USD-GBP rates.
BTI may have just had its best year yet, with solid growth in the legacy combustible business (something its peers cannot boast of) from emerging markets and a rapidly growing new product segment comprising nicotine and vape products. BTI is the only company with the coveted FDA marketing approval for Vuse, a significant tailwind for this top-rated product in the U.S. market. Vuse already has the top market share in key markets and is rapidly gaining traction in the U.S. New products are projected to contribute to the profit growth for the first time.
BTI shares are materially undervalued due to the social image of big tobacco. Nevertheless, the company’s e-cigarettes are highly popular among the millennial and Generation Z population. Management recognized this undervaluation and hinted at buybacks in the 2021 pre-closing report. Barclays analysts believe BTI may announce a $1.36 billion share buyback program and expects the manufacturer to “progressively step it up” in the next few years.
“With its strong cash flow generation, we estimate BAT could cumulatively do a share buyback of $13.5 billion by fiscal 2025.” – Jain Gaurav, Barclays Global Staples Analyst.
BTI’s top products have tremendous product pricing power. Earlier this month, the U.S. subsidiary – Reynolds, raised its list price by 14 cents. This marks the fifth such list-price hike in less than a year. This demonstrates that the company can punch inflation in the face by using its moat-driven price increases to achieve record profitability. You will be interested to know that BTI has consistently maintained the highest gross profit margin among competitors.
WSJ analysts have an average price target of $53 for this cash-flow rich company, implying ~24% upside. As the influence of new products grows on the top line, there is even more upside ahead, and share buybacks will fuel the share price further.
BTI continues to execute successfully in growing its vape business. The category has regulatory tailwinds in leading nations. In countries like the UK and New Zealand, the use of regulated novel tobacco and nicotine products is seen as an appropriate alternative for smokers who do not quit, and their use is encouraged by public health bodies. For socially conscious investors, BTI is ranked 3rd in the ESG category within the FTSE 100. BTI produces the world’s first carbon-neutral vape brand and recently won the Sustainable Product Award in the prestigious 2021 SEAL Business Sustainability Awards. The company is committed to eliminating single-use plastics and having all packaging recyclable by 2025.
To sum up, BTI presents compelling value at today’s prices, with healthy execution and potential buybacks, investors can expect more than 25% upside in the next 12 months. Investors can sit back and collect ~7% yield from this Big Tobacco leader whose bottom line is largely immune to inflationary pressures.
Pick #2 DFP, Yield 7.2%
Preferred securities are an excellent defense in challenging market conditions. They provide dual benefits of reduced volatility and a reliable stream of income.
Flaherty & Crumrine Dynamic Preferred and Income Fund (DFP) is a preferred CEF (Closed-End Fund) operated by Flaherty & Crumrine, a leading fund manager with ~40 years of experience in preferred securities.
DFP holds a combination of preferred shares, bonds, and convertible bonds and is leveraged at approximately 33%.
Stocks in the banking and financial services sector benefit from a strong economy and higher rates since they can charge borrowers more. This is good news because DFP primarily invests in the banking and insurance sectors.
In the near-zero rate climate, this portfolio of high-quality preferred and bonds has been commanding a fairly high premium to NAV (Net Asset Value), almost as high as 15%! With rising rates on the horizon, DFP saw its premium to NAV shrink down materially to just below par, its lowest in 18 months, presenting a valuable opportunity for income investors.
Despite shrinking premium to NAV, DFP’s NAV has remained high as the headwinds from rising rates on fixed-income assets have been offset by very strong results for banks and insurance companies. This is a critical factor because, at the end of the day, a CEF’s NAV drives returns to shareholders, generating higher dividends or higher share prices.
NAV represents the value of the underlying holdings and is the accurate measure of the manager’s performance, and DFP is performing well in this metric. After the great financial crisis, the Federal Reserve began raising rates in 2016. $10,000 invested in DFP in 2017 would have generated $774 average annual income.
Today, DFP yields 7.2% and presents similar income prospects as it did back then, and the economic parameters are comparable. DFP’s distribution policy is to distribute all its net investment income (‘NII’). However, to maintain a stable monthly distribution rate and due to the variations in the fund’s income, they may retain a portion of the undistributed amount within their NAV or pay in excess of NII in the form of a return of capital (‘ROC’). Looking at the distribution since inception, we can see that DFP has maintained a relatively stable payout, with special dividends paid when the CEF outperforms.
Mr. Market continues his irrational streak across the board, this time punishing this preferred security CEF due to upcoming rate increases. Looking under the hood, we can see DFP has a relatively large exposure to “fixed-to-float” investments, at 89%. Typically, rising interest rates are negative for preferred securities, but Fixed-to-float counteracts the sensitivity to rates because when interest rates climb, the dividends climb with them. DFP’s significant exposure to FTF makes it very attractive in these times of high inflation, particularly when we are expecting multiple rate hikes in the coming years.
Flaherty & Crumrine’s DFP continues to demonstrate the ability to grow its NAV in conditions that other funds would struggle in doing so. When we factor in this ability with their monthly payouts and history of trading at a strong premium to NAV, this is a great monthly-pay, fixed-income CEF to add during these volatile times before it pops higher back to premium to NAV territory as it is used to seeing.
The retail industry is built on the principle that people shop when there is a sale. This is true for almost everything we purchase, except stocks. When stocks go down, you can get more for your money just like a sale on any of your favorite items. Instead of celebrating the bargain, there is widespread fear, uncertainty, and doubt (a.k.a. FUD) along with anxiety and panic. Almost every negative emotion that humans can experience will show up as the sell-off intensifies.
Instead of buying the sale, many investors do the opposite, they sell! Imagine if your response to seeing a jacket on the 80% off rack, was to run to the cash register and offer the cashier your identical jacket for 90% off! Silly right? Yet this is exactly what people do when they see stock prices falling. Instead of looking through the sale for things to buy, they rush to sell what they own!
Often, stocks drop due to external factors that are less connected with the company’s fundamentals. In fact, the company may actually be performing really well, but the irrational Mr. Market will miss the point amidst the noise. So will most investors. Opportunities may be right under our noses but may not be easy to identify in the emotional panic.
At HDO, we are income-oriented value investors. We buy high yields from fundamentally strong companies and load up when Mr. Market is irrational. It is easy because when a quality dividend stock drops, we pay less to purchase a more significant yield, plus we have an added incentive to wait for the misunderstanding to clear itself. This is how we grow our income.
Today, we discussed two beaten-down stocks with yields of up to 7.2%. There are many more out there if you look! In this volatile market, reliable dividends provide the unparalleled comfort you need for a happy and healthy retirement.