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By Christine Benz | 01-24-2011 10:03 AM

Dividend Picks for the Slow and Fast Lane

Morningstar's Josh Peters says this Midwestern utility could be attractive for more conservative dividend-seekers, while this pharma pick offers strong dividend growth potential.

Note: This is an excerpt from a previously aired webcast.

Christine Benz: Josh, I want to steer it back to you. I want to hear a couple of high-yield or companies with good dividend yields. Maybe we can talk about one that you view as kind of a safe, but steady pick, maybe something that you would own in your slower-lane portfolio. And then maybe a dividend-payer that you view as a little more aggressive, not quite as slow and steady.

Peters: It's amazing you know what passes for aggressive in my brain would probably strike everybody else almost as boring.

Benz: So you're pretty conservative.

Peters: Yes. There is a lot of merit to that. If I can find a company where I like the yield, I like the dividend growth prospects, I like the balance sheet, I like the basics of the business, I think it's got some sustainable competitive advantage--an economic moat in Morningstar speak--and it's boring, nobody ever says anything about it. I really like that, I consider that a big plus.

If you have another stock that is constantly churning out a lot of drama, for example, General Electric, which is in my dividend growth-oriented, Dividend Builder Portfolio. It's like 90% of the news flow for both of my portfolios, 34 stocks combined, is coming from just that one name. It can't stay out of the headlines for even five minutes. So, boring is definitely an advantage.

On the more conservative side, I still think that there is some value in utilities--not a whole lot. For any other yield-sensitive sector, last year was an amazing year to watch. That span of what I would consider to be good, safer, reliable, capable of growing type of yields had dropped from being 6%-7%, almost down into the 4%-5% range, and now here in the last six weeks, higher-yielding stocks have really stalled out. The market has continued to go up, but interest rates have been rising, and it seems like there is a sort of delayed response in the way people are thinking, because the big interest rate move on the 10-year was from August through November, but then things started to stall out mainly in December.

Two names that I'd like to highlight within utilities: First is Westar Energy, the largest utility in Kansas. It's fully regulated, including the generation side of the business, as well as the very steady transmission and distribution side.

We just recently took our uncertainty rating down. This helps determine in part what price I would be willing to pay for a stock. Our fair value estimate is $28. When we had a higher uncertainty rating, [and were] a little less confident, perhaps, in the long run outlook for the business and, for my purposes, for the dividend in terms of increases, then I want to pay less. As we become more confident with Westar's position, then we think that a low uncertainty rating, you can pay a little bit more, feeling like it's a more secure situation.

For any utility, it's really driven off of just a couple of key factors. I think it's relatively easy for most people to understand. One is going to be the geography. Westar, in particular, is mostly rural Kansas. They don't cover the Kansas City immediate area; Great Plains Energy has that territory. It's not a very fast growing business in terms of population growth like you might find, at least back in the old days, in a Florida or Georgia or something like that. But that's not necessarily a bad thing because the next thing that comes into play is, what does the utility need to invest? In the case of Westar, they have the opportunity to do a lot of investment into their utility plant. That means additional generation, more transmission.

I think there are bunch of states that are trying to call themselves the Saudi Arabia of Wind, up and down the middle of the country, and Kansas is one of them. But that wind power is coming from areas that aren't typically right adjacent to a metropolitan area. So you need those long-haul transmission lines to carry the power to where it's going to be used. Those in particular have a very good regulatory framework associated with them.

Then if you have this opportunity where the utility can invest and grow its asset base, then it really comes down to just what kind of return are regulators going to allow it to earn? Kansas and Westar have a pretty bitter relationship if you go back a decade. This is one of those almost Enron-era utilities where bad management took control of the business, made a lot of bad decisions, sort of neglected the business of delivering electricity. Went off and chased acquisitions in other areas, wrecked the balance sheet. If you go back a few years, see they actually had to cut their dividend twice. But with a utility, management can be very critical, and good management has turned this utility around, raised the dividend every year now for a couple of years running.

The stock's yield is close to the 5% area, which I think is very attractive, and because of these investments that they are making in their rate base, the asset base of power plants and power blinds and everything that they are allowed to earn a return over, we are looking at this being a 9%-10% type of total return story; get a 5% dividend yield or close to it where the stock is trading right now [plus] a 4%-5% dividend growth rate we think in the long term. If anything, dividend growth will probably pick up. It's been running about 3% in the last couple of years as they are investing all this money, but as this big, big book of construction projects peaks out and starts to generate a lot of cash, then the capital spending requirements will fall back a little bit, and they should be able to raise the dividend a little bit faster.

I think it's very boring. If I put the audience to sleep, my apologies, but this is really the kind of stock that I want to look for and emphasize I don't need to get a whole lot right. That doesn't mean I can put it in a drawer and forget about it, but it's one that you can have, I think, a level of comfort that it's a necessary business, it's properly capitalized, it's being run well. You watch those factors, but you watch it in the context of a longer period of time.

Burns: How could that have been boring? You brought Enron into it...dividend cuts...

Peters: It didn't used to be boring, but it came back to the universe of the boring, and I wouldn't have considered it any other way. The ticker symbol on that, by the way, is WR.

Benz: So, how about a more aggressive pick?

Peters: More aggressive for me typically is going to be more emphasizing the dividend growth part of the equation. Here, this is another name that probably wouldn't strike most people as being aggressive, but right here in Chicago's own backyard, Abbott Laboratories, ticker symbol is ABT. It's amazing that the yield right now on the stock is up around 3.7%, 3.8%. By Abbott's own history, that's a very, very high yield. That's more than double the S&P 500.

You can look back at many, many years of very solid growth for earnings, for the dividend. Last year, the dividend went up 10%. I'm looking at probably another 10% dividend increase to be announced here within the next couple of months, which would boost your yield right back over 4% on a pretty quick basis, assuming the stock price doesn't change.

What's made this name just a little bit more controversial is that they have one large drug called Humira. It's a treatment for rheumatoid arthritis and some other autoimmune disorders. It accounts for about 25% of sales, and it's growing as a percentage of the whole. It's been a very effective treatment. It seems like they keep finding new autoimmune disorders that Humira can treat.

And it's got plenty of patent protection. Being a biologic, it's in a much better position as opposed to a traditional small molecule drug like a Lipitor, where it hits a patent cliff. Revenues just fall off very rapidly once the patent expires. Humira isn't likely to face that kind of a problem anytime soon.

What it will face, in all probability, we don't know this for certain, is a competing drug that works through different mechanisms. It's called a JAK inhibitor, and it's something that Pfizer is currently developing.

Now, the Phase III trial data that we have so far on Pfizer's therapy doesn't suggest that it's any better in terms of efficacy or side effect profile. The main difference is that Humira is a once-every-two-weeks injection--and not the "you have to find your vein" but just an "anywhere on the skin" injection from what I have been told--and the JAK inhibitor will be a pill, a daily pill.

So this creates kind of an interesting situation. What is most likely to happen when this new drug hits the market? In this kind of situation, I'm really grateful to have a team of 80, 90, 100 stock analysts, specialized, and really digging into the details at the industry level, the company level, in this case, medical data to help me interpret this, and that in turn makes it a little bit more speculative for me, because I am not a doctor, but I've found their analyses very helpful. Our take is that doctors are not going to suddenly re-write millions of prescriptions for patients where an existing therapy is working just to make this relatively small move in terms of the actual taking of the medicine.

For a doctor, that's kind of risky. If you've got something that's working, you stick with it, and that's what you hope for with just about any business, is that your customers have switching costs. It's not automatically a decision where you can walk from one provider to another on the basis of price or something small that has changed about the product.

Our view is that we expect Humira to continue to grow. And right now the stock market is starting to price in not just losses of incremental market share in this market--which we think is underpenetrated as a whole, not just Humira but everybody who is playing in this space like Johnson & Johnson's Remicade, for example--that Humira is essentially going to get hammered by this new therapy. We really don't think that's realistic. I have actually read what some other analysts on the Street have had to say about Abbott, and everybody agrees it's cheap. Everybody seems to agree that Humira is still an excellent franchise, can throw off a lot of cash and that Abbott will be able to continue growing its earnings and dividends. But they say, "but there is no catalyst."

Well, if you know what the catalyst is for a particular stock, you're paying for it, and if it's something great that might be happening and everybody agrees that it's going to happen, the day the announcement comes, you probably make no money. Then people start to scratch their heads and say, "what was all that about?"

What I like in this situation is that you have the opportunity to collect a very good yield from a company that has, we believe, the capacity to continue growing this dividend at a very good rate, and it's depressed for what we think are really overblown reasons.

It's not to say this is a guarantee, but I like to think that these are the kind of opportunities that you hope for, where you can come across the stock of a good company, strong competitive advantages, great balance sheet, management with a very good record of making sure that the success of the business becomes the success for its shareholders through dividends and dividend increases and being able to buy it relatively cheaply.

Again, perhaps ... not what most people would regard as aggressive, but even in a downside scenario where Humira stops growing and the incremental market share, the growth of this market, goes to Pfizer, it's going to throw off a lot of cash and Abbott has shown that it can reinvest, redeploy internally-generated resources into a number of different businesses.

It's not like Pfizer that is just a drug company. [Abbott] has got a device business, they've got a nutritionals business. My little girl has Similac baby formula sometimes. And I like that. I really think that the market's not giving Abbott enough credit for that.

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