Conservative investors can readily find low-risk stocks. Of course, there is a tradeoff between risk and return, and low-risk securities often produce commensurately low returns. With this in mind, we screened the Value Line data base for stocks that combine below-average risk with worthwhile total return (price appreciation and dividends) potential over the long haul. First, we limited the field to equities with Above Average Safety ranks, which are stocks that, in our opinion, have less-than-normal total risk. Next, we required price appreciation potential to 2014-2016 of at least 65%. Then, we specified that the remaining equities must have a current dividend yield of at least 3.2%. From that list, we excluded any issue with projected three- to five-year average annual dividend growth of less than 6.0%.
In order to tie the growth and income criteria together, we also required an average annual total return over the next three to five years of 15%, which is favorable given the returns currently available. Finally, we eliminated all holdings with subpar prospects for market performance over the next six to 12 months (those ranked Below Average for Timeliness). This step was taken to screen out stocks that are most at risk of underperformance in the near term, in spite of their otherwise attractive investment attributes.
Given our stringent criteria, it is not surprising that our screen only produced ten names. Although small, this is an elite group of stocks that appears suitable for patient investors who seek worthwhile total returns, but are also averse to excess risk. This list should be particularly useful in today’s market, given the volatility that has been prevalent as investors deal with the uncertain prospects for economic growth.
Lorillard, Inc. (LO) is the third-largest manufacturer of cigarettes in the United States. It produces five brands: Newport, Kent, True, Maverick, and Old Gold. Under these labels, it has created 43 different types of cigarettes ranging in price, flavor, taste, and length. Newport is the flagship brand and accounted for 90% of 2010 sales. Lorillard sells to distributors, which then service chain stores and other retail channels. It has an approximate 40% share of the menthol cigarette sales in the United States.
Shares of Lorillard have had an excellent run over the past 12 months, appreciating 44% in price. Newport cigarettes are proven to have above average brand loyalty relative to peers, which we think positively influences peoples’ decisions to adopt the brand and reduces the likelihood of customers switching temporarily out of convenience. Menthol volumes continue to expand at a marginal pace despite an overall decline in cigarette consumption. Further, the company continues to wrestle market share away from competitors to add to its dominant position.
The company is attempting to break out of the Menthol category with its discount Maverick brand and higher end Newport Reds. The company is seeing solid growth in underserved markets west of the Mississippi river, but this is coming at the cost of a higher marketing spend. Lower price points ought to continue to attract cash-strapped consumers. We think the company’s strong management team and top-notch execution augur well for its success in the non-menthol space.
Currently, Lorillard is awaiting an independent peer review conducted by the FDA of whether menthol cigarettes are more harmful to humans that the non-menthol variety. Considering the proportion of LO’s revenue that comes from Menthol, any negative news from the FDA will likely result in a decline in the share price. We would be very surprised to see an outright ban of menthol cigarettes, but new information stating menthol cigarettes are somewhat more harmful than non-menthol varieties seems quite possible. The decision is not likely to be definitive either, and the issue should continue to be debated for a number of quarters yet. Therefore, the potential upside is probably not as much as the downside. Thus, more-conservative investors would likely be best served waiting for the results of the FDA’s review to capitalize on this stock’s worthwhile total return and strong 4.7% dividend yield.
Kellogg (K) is engaged in the manufacture and marketing of ready-to-eat cereal and convenience foods, such as cookies, crackers, toaster pastries, cereal bars, fruit-flavored snacks, frozen waffles, and veggie foods. Its products are sold through the grocery trade in more than 180 countries and are generally marketed under the Kellogg name. Agricultural commodities, such as corn, wheat, soy bean oil, sugar, and cocoa, are the primary raw materials used in its products.
Kellogg’s has a myriad of immensely popular brands and is well positioned in the cereal and snacks space. Many of its products have been in existence for decades and have become a small part of American culture. This should ensure revenues remain relatively stable for years to come. Further, the company has proven adept at rolling out successful new products, which adds to the stocks appeal from a growth perspective. It has a long history of dividend increases as the payout has risen in each of the past seven years. The current yield is a solid 3.7% and we expect growth to continue for the foreseeable future. Although the company may face some near term headwinds from raw material cost inflation, Value Line analyst William Ferguson believes this pressure will abate soon.
The company is set to release December quarter earnings per share on February 2nd. Investors may want to wait before jumping in to take advantage of Kellogg’s solid risk-adjusted long term total return potential and above average dividend yield.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.