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Most income-oriented investors select their stocks based on their dividend yields. However, it is risky to base an investing strategy solely on this criterion. An investing strategy becomes much stronger if the selected stocks simultaneously offer a high yield and trade at a cheap valuation level. In this article, we will discuss the prospects of three undervalued high-yield stocks, namely Walgreens Boots Alliance (WBA), Kinder Morgan (KMI), and American Assets Trust (AAT).

Walgreens Boots Alliance

Walgreens Boots Alliance is the largest retail pharmacy in both the U.S. and Europe. Through its flagship Walgreens business and other business ventures, the company is present in more than 9 countries, with more than 13,000 stores in the U.S., Europe, and Latin America.

Walgreens has a dominant position in its business and enjoys great economies of scale thanks to its immense network. This is a key factor behind the exceptional dividend growth record of the company. Walgreens has raised its dividend for 47 consecutive years.

Unfortunately, the company is currently facing some business headwinds. First of all, it is facing heating competition, which has resulted in thin operating margins. Profit margins in the pharmaceutical industry have become an object under scrutiny in recent years and hence Walgreens is not likely to enhance its margins anytime soon.

Moreover, Walgreens greatly benefited from the numerous vaccinations and tests it sold during the pandemic but this tailwind has been fading in recent quarters, as the pandemic has subsided. In the second quarter, the company executed only 2.4 million vaccinations, which were 80% lower than the 11.8 million vaccinations executed in the prior year’s quarter. As a result, the earnings per share of Walgreens slumped 27% over the prior year’s quarter.

Furthermore, Walgreens attempted to sell its Boots business but it failed to receive an attractive bid. Consequently, it eventually decided to keep its Boots business. The failed attempt to sell Boots does not bode well for the future growth prospects of this business.

Due to all these headwinds, the stock of Walgreens has been punished to the extreme by the market. During the last five years, the stock has shed 43% whereas the S&P has rallied 54%. This extremely rare underperformance of the healthcare giant has rendered the stock deeply undervalued from a long-term perspective.

Walgreens is currently trading at a nearly 10-year low price-to-earnings ratio of 8.1, which is much lower than the 10-year average of 14.3 of the stock. In addition, Walgreens is now offering a nearly 10-year high dividend yield of 5.3%. Given the exceptional dividend growth record of the company, its healthy payout ratio of 42% and its defensive business model, its dividend is likely to remain on the rise for many more years, albeit at a slow pace. Overall, Walgreens is exceptionally attractive for patient investors, who can maintain a long-term perspective during the ongoing downturn of the company.

Kinder Morgan

Kinder Morgan is one of the largest oil and gas companies in the U.S. It is engaged in storage and transportation of gas and oil products and owns an interest in or operates approximately 83,000 miles of pipelines and 144 terminals.

Kinder Morgan is focused primarily on natural gas, which is a much cleaner fuel than coal and fuel oil. As a result, environmental policies do not aim to reduce the consumption of natural gas. Therefore, Kinder Morgan is resilient to the secular shift from fossil fuels to clean energy sources, which has accelerated in the last three years.

Most oil and gas companies are highly cyclical due to the wide swings of the prices of oil and gas but Kinder Morgan is a bright exception to the rule. The company has a defensive business model in place, generating nearly all its cash flows from fee-based contracts and minimum-volume contracts. Kinder Morgan generates about two-thirds of its operating income from minimum-volume contracts and thus its customers pay a minimum amount every year even if they transport and store lower volumes than normal. Another one-fourth of operating income comes from fees, which are hardly affected by the cycles of commodity prices. Therefore, Kinder Morgan generates reliable cash flows even under unfavorable business conditions.

Thanks to its defensive business model, Kinder Morgan proved resilient throughout the coronavirus crisis. Most energy companies incurred a collapse in their earnings in 2020 due to the pandemic but Kinder Morgan posted just an 8% decrease in its distributable cash flow per share in that year. Even better, the company has fully recovered from the pandemic and is thriving in the current environment, as the U.S. is replacing the lost barrels from the sanctions imposed on Russia and the deep production cuts of OPEC. The increased output of the U.S. means that greater volumes of gas and oil products will go through the network of Kinder Morgan in the upcoming quarters.

Moreover, Kinder Morgan is trading at a price-to-distributable cash flow ratio of only 8.4 and is offering a 6.3% dividend yield. Thanks to the solid payout ratio of 52% and the defensive business model of the company, its dividend has a wide margin of safety.

American Assets Trust

American Assets Trust is a REIT that was formed in 2011 as a successor of American Assets, a privately held company founded in 1967. The trust is headquartered in San Diego, California, and has great experience in acquiring, improving and developing office, retail and residential properties throughout the U.S., primarily in Southern California, Northern California, Oregon, Washington and Hawaii. The office portfolio and the retail portfolio of the REIT comprise of approximately 4.0 million and 3.1 million square feet, respectively. The trust also owns more than 2,000 multifamily units.

American Assets Trust pursues growth by acquiring properties in submarkets with favorable supply and demand characteristics, including high barriers to entry. The company also redevelops many of its newly-acquired properties in order to enhance their value. Thanks to its solid business model, the REIT has grown its funds from operations (FFO) per unit in 8 of the last 9 years, at a 4.7% average annual rate.

American Assets Trust has decelerated lately due to an economic slowdown but it has beaten the analysts’ estimates for 8 consecutive quarters. Moreover, the stock is trading at a 10-year low price-to-FFO ratio of 8.0, which is much lower than the 10-year average of 19.4 of the stock. In addition, the stock is now offering a 10-year high dividend yield of 7.3%, with a healthy payout ratio of 59%.

The exceptionally cheap valuation of the REIT has resulted primarily from the adverse environment of high interest rates, which are likely to increase the interest expense of the REIT in the upcoming years. However, American Assets Trust has received investment grade ratings from the major rating agencies. Thanks to its solid business model, the REIT is likely to endure the downturn caused by high interest rates and recover strongly whenever interest rates revert to normal levels. Overall, the stock appears deeply undervalued from a long-term point of view.

Final Thoughts

The above three stocks are trading at remarkably cheap valuation levels and are offering exceptionally high dividend yields, with a material margin of safety. As a result, they are likely to offer excessive returns to the investors who can wait patiently for interest rates to revert to normal levels and the market to appreciate the virtues of these three stocks.

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