David Katz

intc

mcd

While Federal Reserve Chairman Bernanke’s comments have temporarily calmed the markets’ fears of the Fed possibly ending its stimulative easing posture, interest rates have been rising in the U.S. and are likely to keep rising over the next six to 12 months. One of the many implications of this rise has been a headwind for dividend-oriented stocks, as bond yields are becoming more competitive with stock dividends.

While bond yields, which were as low as 1.6% on 10-year U.S. Treasuries, had been well below the 3% to 4% dividends (or more) offered by a number of high quality, consistently performing U.S. stocks, the landscape has changed significantly and quickly. The recent dramatic increase to 2.7% on the 10-year U.S. Treasury, and the likelihood that interest rates might reach the 3% level or higher in the not too distant future, means that safe bonds should increasingly offer a reasonable income alternative to higher yielding stocks.

Nevertheless, we continue to believe that select stocks with high yields and lower volatility have merit and should continue to provide favorable investment returns. However, we also anticipate that their outperformance in 2011 and 2012 will slow.

In this scenario, we believe that investors should focus on economically sensitive dividend stocks which have the realistic potential to increase their dividends by more than 5% annually. This rising dividend stream, taxed at still favorable rates when compared to taxable bonds, creates a niche that should continue to be part of an opportunistically prudent portfolio.

Four stocks that meet our criteria and are currently attractively priced are DuPont (DD ), General Electric (GE ), Intel (INTC ), and McDonald’s (MCD ). We don’t expect home runs from any of the four, but do expect adequate mid-term stock price appreciation and a healthy and growing dividend along the way. We also believe that the rising interest rate environment will not have a meaningful adverse effect on their businesses or stock prices.

DuPont is a prime example of this thesis. CEO Ellen Cullman has methodically retailored the company’s portfolio of businesses to improve its return on capital, by reducing its commodity exposure and increasing its contribution from science-oriented, value-added businesses. Dividends are a high priority with more than 100 years of uninterrupted payments, and the stock yields 3.3%. DuPont is currently valued at 14.3 times 2013 estimated EPS, which should grow about 7% annually over time.

General Electric is a more diverse company, with a still-large financial subsidiary, but management has finally done a good job of reducing the risk profile and relative size of that segment, while also improving its industrial businesses. Profit growth in the energy, medical and power segments will more than offset the designed shrinkage of the financial services segment, generating long-term growth around 10%. The stock pays a 3.2% dividend that will grow with earnings, and is valued at 14.3 times current year’s EPS.

In the tech sector, Intel has been a key high quality name for years, and was an early leader in rewarding its shareholders via dividends. Newly promoted CEO Brian Krzanich is actively addressing the company’s lagging effort in offerings for the dynamic tablet and smartphone markets, while extending its dominance in PCs and servers. Its strong profit and cash flow generation has enabled strong and consistent dividend growth without starving the manufacturing base that continues as the source of the company’s strength. As a result the stock’s dividend yield is 3.75%, with another dividend increase likely in August. Intel is valued at 12.65 times this year’s EPS, and earnings are expect to grow in the 10% range annually.

Lastly, McDonald’s has had its ups and downs, but has also consistently fought through its difficulties to produce solid financial returns. The company has recently turned around its comparable unit sales in the United States, an indicator that menu changes and other improvements have taken hold. Importantly, profitability has also grown, with management addressing costs as well. As U.S. employment increases, McDonald’s will benefit from higher discretionary income from more workers. The company has been strongly committed to its dividend, which has more than doubled over the last five years and now represents a 3.1% yield. While the stock is not as cheap as the others, trading at a current year price-to-earnings ratio of 17.7 times, EPS should grow around 8% annually.

The bottom line is each of these companies pays a good and increasing dividend, has solid earnings growth expectations, should not be meaningfully affected by higher interest rates and trades at reasonable or attractive valuations. In a robust equity market driven by an improving economy, these stocks may not be the leaders but should participate.

Add in their growing above-market dividend yield, total returns should be in the double digits going forward, with lower risk than the overall equity market. For an investor seeking quality, income, stability and moderate capital appreciation, these high quality companies earn their place.

At the time of publication the author held DD, GE, INTC and MCD.