10 Undervalued Dividend Stocks for 2023

Key Takeaways

• Looking ahead at undervalued dividend stocks for 2023. There’s a big difference coming into this year versus last year.
• Examples of using long-term secular growth trends to find companies that are going to be leveraged to them and will perform well as a result.
• Opportunities for higher-risk investors who are looking for extra dividend yield and are able to take that extra risk in their portfolio.

David Harrell: Hi, I’m David Harrell with Morningstar Investment Management, and I’m here again with Dave Sekera, who is Morningstar’s chief U.S. market strategist.

Dave, thanks for being here and belated Happy New Year.

David Sekera: Happy New Year, as well. I think we’re all kind of happy to be past 2022.

Harrell: Right. So, after extraordinary returns for the U.S. equity market in 2019, 2020, and 2021, I believe the S&P 500 doubled on a total return basis over that, we saw large losses in U.S. equities in 2022 for the year. It was a different story, however, for dividend stocks. First off, we saw record dividend payments. I believe the S&P 500 companies paid an estimated $561 billion in dividends last year, about a 10% increase from 2021. And if you look at the total returns of dividend stocks, most dividend indexes were actually in positive territory for the year. So, we had about a 20-percentage-point differential between dividend stocks and the broad market. Why did we see that last year?

Sekera: Well, as you noted, 2021 was a pretty strong year for the equity markets. In fact, at the end of 2021 and coming into 2022, in our 2022 market outlook, we noted that we thought that the overall market was broadly overvalued coming into the year. And then, when we broke those valuations down into the Morningstar nine-box style box, we noted that a lot of that overvaluation was coming in the growth categories and those sectors that were most leveraged to growth. So, in 2022, those are the sectors that we saw that really got hit the most to the downside. The growth category in and of itself, I think, was down over 36%, whereas the value category, which is the area that we saw as being slightly undervalued at the beginning of 2022, pretty much held its value throughout the entire year. I think it was only down less than 1%. So, it’s really a composition analysis that most of those dividend-paying stocks, of course, are more established companies and typically are more in those value categories, and even more specifically, within defensive sectors. And again, those are the ones that held up last year.

Harrell: Right. So, when you’re looking at dividend portfolios and dividend indexes, it’s really what they didn’t hold in 2022. You don’t have those growth names in there where we saw the large double-digit losses through the year?

Sekera: Yeah, exactly. So, when you think about some of the sector analysis, the energy stocks, a lot of those are high-dividend stocks. Those were the ones we actually thought were the most undervalued coming into 2022. I know the Morningstar Energy Index was up over 60% last year in and of itself. Utilities, again, big dividend payers. Those were up a couple of percent as well. And then, the consumer defensive and the healthcare sectors, also areas where you see a lot of dividend-paying stocks, those were down a lot less than the broad market averages.

Harrell: Got it. So, you spoke about the headwinds that you saw going into 2022. And I think when we spoke about a year ago, you mentioned some of them are prospective higher interest rates, rising inflation, and so on. Looking ahead at 2023, where do we stand with those headwinds right now? And what are you thinking in terms of prospects for corporate earnings growth, which then, of course, would actually drive dividend increases in 2023?

Sekera: Yeah. So, at the beginning of 2022, we noted there were four main headwinds that the market was going to have to contend with, and we certainly saw those play out last year. Of those four, I’d say, two have really started to abate and are probably behind us. The two that I’m still focused on right now are the economy and the Fed. So, as far as our economic outlook this year, while we expect for the full year GDP to be slightly under 1%, we do think that there’s a good chance the economy is going to be pretty stagnant to potentially recessionary in the first half of this year before we can see it reaccelerate in the second half of the year. As far as monetary tightening policy goes, we do see in the markets, they’re pricing in one if not two more hikes by the next couple of meetings.

Now, we do think that with the economy being relatively soft in the first half of the year, we do think that inflation is coming down, we think it already peaked several months ago. We think that by the second half of this year, that’s actually going to give the Fed the room it would need to actually be able to pivot and start easing monetary policy by the end of the year. So, when I’m thinking about how the year is going to play out, I do think earnings certainly could be under pressure for the next couple of quarters just because of what we expect going on economically, and I suspect a lot of companies and dividend-paying companies may look to decide to try and retain cash. So, instead of increasing their dividends or maybe slowing down their dividend growth rates for the first part of the year and then the second part of the year, maybe we can get back to more of like a normal dividend payment stream.

Harrell: I was going to ask you thoughts on capital allocation in general in terms of dividends versus buybacks, which give companies more flexibility. They can stop buybacks. You can’t take back a dividend increase very easily without getting punished by the market. We do have this buyback excise tax now of 1%. Do you think that’s going to have any impact on how companies allocate capital going forward?

Sekera: We haven’t seen it yet. So, we’re actually coming into the earnings reporting season starting this week with the big banks and then we’ll ramp up from there. So, I’m going to be listening to a lot of those calls really to hear what management is talking about and whether or not they make any mention of changing their capital allocation policies. But at this point, I don’t think that excise tax is going to be enough that it’s going to change how companies are going to decide how to reward shareholders, whether that’s with dividends or whether it’s with the stock buybacks.

Harrell: Right. And at 1%, it’s probably not enough to really make that difference there. I want to get back to some of the sectors you were mentioning earlier, the sectors that had the strong relative performance in 2022. When we look at valuations across the board, are those sectors tend to be more fairly valued right now or slightly overvalued relative to the overall market?

Sekera: Yeah, it’s a big difference this year coming into this year versus last year as far as where we see value in the marketplace today. So, as we noted, energy, which was the most undervalued after a 60% increase, it’s actually now the sector that we see as being the most overvalued, trading at probably around a 12% premium to composite of our fair values. So, very difficult for us to find much value in that sector today. And similar with some of the other defensive categories that held their value, I’d say, at this point, we think that they’re fully valued to even being slightly overvalued at this point. So, again, hard finding good opportunities, especially in some of the dividend payers there today compared to what we saw a year ago.

Harrell: Got it. But even so, these sectors aren’t homogeneous. So, there are different valuations within them. And I guess, I was wondering you could share some of your current names that you find the most attractive on both the valuation and current yield standpoint.

Sekera: Of course. I did run a screen here, and what I did is I looked for those companies that we rated with either 4 or 5 stars, so again, companies that we do think are undervalued on a price to fair value basis. But then, I also looked for companies that had like a wide or narrow economic moat, something that I would think would tend to cause people to think that these are going to be higher-quality companies. And then, I did a rank order there of their dividend payment in order to find some of the companies that we thought were undervalued, still have upside potential, and do pay a relatively decent or healthy dividend yield.

So, some of the lower-risk names based on our Uncertainty Rating—so, again, our uncertainty rating is how closely do we think that we’ll be able to model these companies out in the future—so, those that we have either a Low or a Medium Uncertainty Rating on the first I would highlight is actually going to be Verizon. So, Verizon, again, in the communications sector, the entire sector was hit hard. It was no exception. That stock got hit pretty hard in and of itself last year. At this point, it’s rated 5 stars. We do think the company has a narrow economic moat. Trades at a 29% discount to our fair value, and it currently yields 6.2%.

Now, moving down the list in the utilities sector, one of the few names there that we see value today is going to be Dominion Energy. That’s rated 4 stars, has a wide economic moat, trades at a 21% discount to fair value, and has a 4.3% dividend yield. U.S. Bank, another wide-moat company, 4 stars, 22% discount to fair value and a 4.1% dividend yield. And then, just around this category, there’s Clorox and Kellogg. To me, they’re kind of a similar story right now. Both are rated with a wide economic moat. Both have 4 stars. They both have about a 3.3% dividend yield, and they trade at a 14% discount to our fair value. I would just note here of the two, I like Kellogg myself, because when we look at the brands in their portfolio, we think they have a really good lineup and good exposure to the emerging markets.

Harrell: And for a lot of these companies, the yields that we’re seeing right now are actually above some of their historical averages, and that’s just due to the fact the price has come down so much. So, it’s giving investors an opportunity to buy in at a higher yield rate right now than maybe what they would have had a year or two ago.

Sekera: Exactly. And there’s also some other plays in the dividend space, which I like. One of the things I always really like about investing is looking for what we consider to be long-term secular growth trends and then finding those companies that are going to be leveraged to those trends. So, for example, one right now that we are watching is Eastman Chemical. So, that’s a 5-star rated stock, narrow economic moat, trades at a 31% discount to fair value, pays a 3.5% dividend yield. And that would be a stock that I’m thinking is going to be leveraged to the transition from automobiles to electric vehicles from internal combustion engines. So, one thing that it requires is that these EVs, they take 2.5 to 3 times as many specialty chemicals in their manufacturing process. So, again, as we see that transition over the next decade, this company has some pretty good tailwinds behind it.

Another area is in the medtech space. So, Medtronic could be one that I would like to highlight there. It’s a wide economic moat, 5 stars, trades at a 30% discount and has a 3.4% dividend yield. And then, lastly, another one is a Digital Realty. It’s actually one of the very few REITs that we give an economic moat to. So, it has 4 stars, a narrow economic moat. It’s at 23% discount to fair value and pays a 4.8% dividend yield, and that company provides specialized space for data centers in the technology sector.

Harrell: Great. And I’d say, Medtronic is an example of one of those firms I know, over the past five years, its average yield has been in the 2% range, so up above 3% definitely, a better opportunity for income-focused investors right now.

Sekera: Yeah. And then, lastly, I’d like to highlight a couple, which I would say are probably more for higher-risk investors who are looking for that extra dividend yield, but at the same point in time, are able to take that extra risk in their portfolio. The first one here that I’d mention is Equitrans. Now, it is the only company that I’ve noted on this list that has below-investment-grade rating. So, again, it is going to be a little bit riskier of a situation. It pays well over an 8% dividend yield, though, and it trades at half of our fair value. So, again, I do think that provides a very large and a wide margin of safety for investors today. Rated 5 stars. So, again, I think it’s for more high-risk investors, but I do think that one is worth taking a look.

And then, lastly, Intel. I don’t think a lot of people would necessarily think of Intel as being a high dividend payer. But with as much as that stock has come down, it is. So, it’s currently rated 4 stars, has a narrow economic moat, trades at a 35% discount to our fair value, and pays a 5% dividend yield. Now, this would be the one, though, that I would probably have some of the most caution as far as the potential for a dividend cut. I would say that if there was a dividend cut, though, I think that the company only would do that in the case that they want to use those cash proceeds to reinvest back into the business with additional capital expenditures, which of course would then help build the company over time and be able to raise its intrinsic value. But again, if you’re really relying on that dividend, that would be one that I would caution a little bit more.

Harrell: So, some of the higher-yielding stocks, obviously, a little more risk there just in terms of variability of earnings or potential for the dividend reductions. Well, Dave, thanks for sharing your insight. It’s been great having you here as always. I’m David Harrell for Morningstar Investment Management. Thanks for watching, and we’ll see you again next month.

Watch “3 Top Growth Stocks to Buy and Hold in 2023″ with Susan Dziubinski.