Investing In Shadow Dividend Stocks

Stories about the bleak housing market have filled the news headlines for the past three years. It’s almost hard to remember back to the heydays of 2005-2006 when real estate was the hottest investment since internet IPO’s. Unfortunately now all we hear is bad news and many don’t expect a recovery for several more years.

 

One of the factors holding back a recovery in the housing markets is the tremendous “shadow inventory”. Shadow inventory in the housing market refers to the number of homeowners that would like to list their house for sale, but market conditions, financial circumstances or a host of other reasons keep them from doing so. These homes are not included in the current inventory of available homes for sale, but it is understood that this “shadow inventory” represents a large number of homes that will come onto the market if certain circumstances are met.

 

In the world of dividend investing, there is a similar parallel with what we affectionately refer to as “shadow dividend stocks”. These companies currently do not pay a dividend to investors, but they have all the criteria to make a great dividend stock.

 

These companies generate significant free cash flow, impeccable balance sheets with growing cash balances and consistent earnings growth. All of which are fundamental criteria that a good dividend investor looks for when evaluating a stock. The only thing that seems to be missing is the actual dividend.

 

For investors that need current income, this is obviously a major issue. However, many investors look to dividend stocks not just for the income, but because these stocks have consistently outperformed the overall market returns. These companies have strong cash flows and a high degree of confidence in future cash flows to consistently pay and even increase their dividend payments. Investing in stocks that meet these criteria, but don’t yet pay a dividend is an intriguing option to these investors.

 

Apple (AAPL: 258.75 -0.85%) is prime example of a shadow dividend stock. The company generated $4 billion in cash last quarter and has over $24 billion in cash. The company has been consistently growing their earnings and few doubt their ability to continue to do so given their strong product pipeline. The only problem is that Apple doesn’t pay a dividend. They’ve also given no indication that they will do so in the foreseeable future, despite the fact that Apple CEO Steve Jobs makes a living off dividend income.

 

However, for long-term investors that don’t need immediate income, Apple represents the type of cash cow that you love to have in your portfolio. Even if Apple paid out only 50% of their current cash flows, this shadow dividend stock would yield 3-4%. Cisco Systems (CSCO: 23.30 -0.38%), Google (GOOG: 486.30 +0.40%) and to a lesser extent Adobe Systems (ADBE: 28.83 +0.49%) all fit into this category.

 

Shadow dividend stocks aren’t restricted to the technology sector either:

 

Chipotle Mexican Grill (CMG: 146.45 -1.01%) has generated $87 million in free cash flow in the first half of 2010 despite opening 45 new stores this year.

 

Big Lots (BIG: 34.30 -2.00%) expects to generate $220 million in cash flow this year.

 

Celgene (CELG: 53.6701 +1.55%) has over $3 billion in cash on their balance sheet and that has grown nearly $120 million since the beginning of the year.

 

While Family Dollar Stores (FDO: 41.07 -0.53%) is a dividend aristocrat that has increased their dividend for 34 consecutive years, competitor 99¢ Stores pays no dividend despite generating $75 million in operating cash flow last quarter.

 

These stocks are all attractive because of their ability to generate strong, future cash flows. Even if they don’t currently pay a dividend, these shadow dividend stocks have the potential to reward investors in the future.

 

At the time this article was published, the author held a financial position in Apple.

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