3 Undervalued Dividend Payers

Jeremy Glaser

The market's down week did little to ameliorate the underlying problem equity investors face today. Stocks remain mostly overvalued at a time when other alternatives like cash or bonds aren't looking terribly attractive either. During the past few weeks, we've explored several ways investors can stack the deck in their favor in this environment, including making sure they are only buying the best-quality names and searching for exemplary management teams. Another way to make the best of a less-than-ideal investment landscape is to seek out above-average dividend payers that can help provide a reasonable total return. There aren't a ton of values right now, but fortunately there are some solid income producers still trading at reasonable levels today.

The over 2% decline in the Morningstar US Market Index last week did little to depress the market's valuation. Of all stocks under Morningstar equity analyst coverage, the median price shows a 1% overvaluation today. There just isn't a margin of safety in the broader market to protect investors against a sell-off. That doesn't mean it is time to abandon stocks completely. For investors with long-term time horizons, equities still deserve a place in their portfolios, particularly when you look at equities compared with the prospects for bonds in a rising-rate world and for cash today. But full valuations do point to the necessity of being very selective in what you buy and keeping some powder dry for a possible correction.

Look for the Dividend Payers
Seeking out dividends is a way to eke out better returns in a market that is richly valued. When stocks are pricey, there is less room for capital appreciation because you can't profit as the market realizes it initially had underpriced a security and bids the price back up to its intrinsic value. But dividend payments keep coming even as the market gyrates up and down, helping create a much better total-return picture over the long haul.  

Of course this strategy only works if the dividend payments continue regardless of market conditions. You have to look past the current yield to see if the dividend is sustainable and preferably going to increase over time. According to Morningstar DividendInvestor editor Josh Peters, the ability to keep increasing the payment is one of the most important things to look for in a dividend payer. Not only does it help boost your yield over time, it also is a good sign that you own a high-quality company with increasing earnings. Peters illustrated the importance of this concept recently when he noted that in the portfolios he runs, he's made money on nearly 90% of the stocks that have raised their dividends since he has owned them. On other hand, he's in the red on more than 80% of the firms that have cut their payments. 

There is no established way to ensure that your dividend payer will be able to keep making distributions, but there are a few things to watch for to keep the odds in your favor. The first thing to look for is a company's ability to keep paying. This means avoiding firms that currently are paying out an unsustainable amount of earnings and may be forced to cut imminently. It also makes sense to focus on companies with economic moats. Morningstar analysts expect that these firms will be able to earn economic profits over time, and that excess cash flow can then be returned to shareholders. But that doesn't mean it will be. The other major thing investors need to keep an eye out for is a management team and a board of directors that are committed to continuing and increasing the payouts. A long history of dividend growth is a great sign that the firm is committed to returning capital to shareholders.  

The advantages of dividends are hardly a secret. During the past few years, investors faced with the low-yield environment bid up the prices of many high-yielding sectors, leaving very few values. This has unwound somewhat in the past few months, but there still aren't a huge number of values. However, a few options do exist, and we used the Morningstar  Premium Stock Screener to find them. We looked for stocks with yields higher than 3% and that have had annualized dividend growth of 3% during the past five years. Below are three names that passed. Run the screen for  yourself here.

 Clorox (CLX)    
| Economic Moat: Narrow | Uncertainty Rating: Low | Dividend Yield: 3.13%  
From the  Premium Analyst Report:    
While Clorox operates in categories where competitive pressures abound, its brand strength is undeniable, as nearly 90% of its portfolio holds the number-one or number-two spot. The brand equity inherent in its product lineup is further evidenced by the fact that since 2005, the firm has taken 66 price increases across its business, and 64 of those are still in place--a 97% success rate. These factors, combined with the fact that Clorox boasts returns on invested capital (which have averaged nearly 25% over the past five years) far in excess of our cost of capital estimate and solid cash flow generation, support our stance that the firm maintains a narrow economic moat.

 McDonald's (MCD)    
| Economic Moat: Wide | Uncertainty Rating: Low | Dividend Yield: 3.17%  
From the  Premium Analyst Report:    
McDonald's remains resilient despite an increasingly challenging environment for restaurant operators. Although it's unlikely that the firm duplicates the almost 1,500 basis points of operating margin expansion it posted during the past five years, we are optimistic that it is capable of generating superior returns on invested capital over an extended horizon. Our confidence stems from unrivaled scale advantages, an incredibly strong brand, a cohesive franchisee system, and ample international growth opportunities. Despite a few self-inflected product pipeline and value-menu management missteps during 2012 as well as industry competition that remains fierce, we don't expect McDonald's strong competitive positioning to abate anytime soon, and we believe the company possesses the widest economic moat in the restaurant category. 

 American Electric Power (AEP)    
| Economic Moat: Narrow | Uncertainty Rating: Low | Dividend Yield: 4.43%  
From the  Premium Analyst Report:    
With American Electric Power deriving nearly all of its earnings from its regulated utilities, we give AEP a narrow economic moat because of its efficient scale advantage. In exchange for AEP's service-territory monopoly at its regulated utilities, state regulators set the company's returns at a level that aims to keep customer costs low while providing adequate returns for capital providers. This implicit contract between regulators and the utilities should theoretically allow AEP to earn its cost of capital in the long run.  

All data as of Aug. 16.

Jeremy Glaser does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.