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Finding Dividend Leaders

Use this screen to suss out dividend stalwarts.

Haywood Kelly, 05/11/2010

With governments--national and local--facing huge financial obligations and runaway deficits, inflation has to be on every investor's radar screen. Governments throughout history have turned to money creation to bail themselves out of dire financial straits, and just as night follows day, money creation leads to inflation. Particularly for the investor needing income, inflation spells trouble. Bonds are rotten investments in an inflationary environment, as are high-yield common stocks if they belong to companies that lack the ability to raise prices.

But there are common stocks out there that offer a nice balance of high current yield and the ability to raise dividends over time to offset inflation. They're the focus of this issue's stock screen.

Dividend Yield > 4%

How high a yield should we look for? The U.S. market is only yielding about 2% these days, so we want to focus on stocks yielding significantly above that. But not too much higher, or else we risk ending up with a miserable set of companies that may have high current dividends, but which don't have the financial wherewithal to maintain them.

And Morningstar Rating >= 3 Stars

A dividend yield of 4% or more offers us a universe of 700-plus stocks to choose from. Our first step in narrowing this list is to throw out those our analysts think are overvalued. Even if we earn a decent income stream on an investment, we don't want to see our capital shrink because we paid too much.

The dividend yield only measures current dividends as a percent of the stock price. For prudent investors, it's important for the income stream at least to stay constant in future years, and better yet to grow. Only companies with the ability to increase dividends can help investors offset the declining purchasing power of the dollar in an inflationary environment. To make sure we focus on companies with the ability to do this, we introduce two quality screens.

And Economic Moat >= Narrow

We first look for companies with economic moat ratings of narrow or wide. To gain a wide moat rating, our analysts need to be convinced that the company has a good chance of earning outsized returns on capital for 20 years or more. Only 10% of our coverage universe is high-quality enough to merit this designation, so it's a select group. (Think Coca-Cola KO or Exxon Mobil XOM.) For a narrow moat rating, a company must stand a good chance-- in our view--of earning good returns on capital for 10 years or thereabouts. These are still great companies, even if we don't have the same degree of confidence that their competitive advantages are sustainable as we do with wide-moat firms.

And Financial Health Grade >= B-

Next, we require that the company sport a financial health grade of B or better. The financial health grade is one of the key components of Morningstar's new corporate credit ratings, and it does a good job of flagging companies with deteriorating financials. If the company has a poor financial health grade, it's likely to run into trouble maintaining, or even paying, its dividend in future years.

The screen yields about 70 stocks. Below, we highlight five of them that our analysts think are particularly attractive.

AstraZeneca AZN
AstraZeneca's leading presence in the pharma and biotech industry is built on patent- protected drugs and a developing pipeline that all add up to a wide moat. The firm's dynamic operations and an aggressive acquisition strategy create growth opportunities to offset patent losses, including the near-term expiration on cardiovascular drug Toprol.

The company boasts a healthy product portfolio led by five key drugs. These growth drivers include gastrointestinal drug Nexium, antipsychotic treatment Seroquel, cholesterol reducer Crestor, and respiratory agent Symbicort. Collectively, these drugs posted $15 billion in sales for 2008, representing half of sales. Ongoing clinical studies are advancing the indications for these products and tapping into new patient pools for continued growth. Also, the corresponding patent expirations range from 2010 to 2016, which provides ample time for pipeline products to kick in. Modified-release versions of these products may also partially extend patent protection.

Energy Transfer Partners ETP
We have long thought that Energy Transfer benefits from two savvy strategic moves. First, full-throttle investment in Barnett Shale takeaway capacity has begun to have an increasing impact on earnings, and second, entry into interstate transportation has broadened Energy Transfer's theater of operations and may widen its economic moat. In our view, Energy Transfer operates one of the best natural gas transportation systems in the industry, and when combined with strong growth prospects, generous cash distributions, and good cash-flow growth visibility, we think this is one of the most attractive master limited partnerships in our coverage.

Maxim Integrated Products MXIM
Maxim is a leading analog chipmaker that made a bold shift in strategy a few years ago by entering high-volume segments of the analog semiconductor market. Although Maxim earns lower gross margins on high-volume chips, it should remain a profitable player for years to come. Maxim has an attractive dividend policy and generates healthy free cash flow on a regular basis.

Maxim's specialty is the design and production of high-performance analog chips, which are used by a wide variety of industries. HPA design expertise is not easy to come by, so firms that have spent years developing proprietary designs and retaining experienced engineers have an advantage over new entrants. These designs do not rapidly evolve or require cutting-edge production techniques, so HPAs tend to have long product lives, stable pricing, and strong profitability. We think Maxim's HPA expertise and the favorable characteristics of the HPA industry are the source of the firm's wide economic moat.

Paychex PAYX
Switching from one payroll-processing vendor to another is a very difficult task, and customers' unwillingness to do so has allowed Paychex to build a relatively sticky client base. This inelasticity has enabled the firm to raise prices annually and expand profits. Strong scalability has also allowed the firm to be price competitive without feeling margin pressure. Paychex is the second- largest player in the payroll outsourcing market (based on revenue), and it can leverage its 550,000 clients to spread costs associated with its servicing infrastructure. The firm's strong brand also plays a significant role, because clients are hesitant to entrust their critical HR functions and payroll cash to an unproven competitor. The combination of these factors has produced margins that have been well above 30% during the past 10 years.

Southern Company SO
We think this well-positioned juggernaut from the Deep South could be an attractive investment for investors seeking dividends and capital preservation. Enviable regulatory relationships and rate structures, along with a commitment to the pure-play regulated utility model, make Southern one of our favorite regulated utilities. The company has paid a stable or increasing dividend for 242 consecutive quarters, yields 4.8% at our fair value estimate, and could raise the dividend by 4% annually.

Haywood Kelly, CFA, is vice president of equity research at Morningstar.

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