Generating Buy Ideas with Columbia Dividend Income

By Alan Rambaldini | Stock Analyst

When selecting managers to include in our Ultimate Stock-Pickers' Investment Manager Roster, we tend to favor not only managers who have achieved great long-term investment performance, but also managers who share our value investing philosophy. Within that framework, however, we've been willing to allow for a much wider degree of latitude. For instance, some managers might focus more on small-cap stocks, while others may focus on large caps, domestic stocks, international stocks, etc. Of the managers we currently track, the team at  Columbia Dividend Income  (LBSAX) believes that superior performance comes from the return provided by dividends. Much like we did with our recent article on  The Jensen Fund (JENSX), we took a look at Columbia's investment approach and cross-referenced it with Morningstar's own stock research to generate some investable ideas.

Columbia Dividend Income Investment Approach
Judging by the name, it's obvious that the fund focuses on dividend-paying stocks. What is not obvious is that the focal point is not necessarily on yield, but on the free cash flow that can be returned to shareholders either by increasing dividends or repurchasing shares. To determine a specific company's ability to increase the cash it returns to shareholders in the future, the fund looks not only for a historical record of dividend growth, but also for balance sheet strength and free cash flow quality. Their approach has some merit, given the historical outperformance (over the last 30 years) of dividend-paying stocks over those that have not paid a dividend. We believe this record of outperformance can likely be attributed to the fact that paying dividends forces the management of a company to be disciplined with its capital, which bodes well for long-term shareholder value creation.

While Columbia Dividend Income can't boast a 30-year track record because it adopted its current philosophy only five years ago, the fund has beaten its benchmark, the S&P 500 Index (SPX), by more than 3.5 percentage points annually (on average) during that time frame. Better yet, this outperformance has come in both good and bad markets, with the fund performing well over the course of the 2003-07 bull market, as well as during last year's market debacle. While year-to-date results have been less inspiring for the fund, as much of the recent rally in the markets has been focused on lower-quality and smaller-cap equities, Columbia Dividend Income's high-return/low-risk performance has resulted in a 5-star rating for the fund from Morningstar. (Note: The Morningstar Rating for funds is distinct from the Morningstar Rating for stocks, as the former is based on funds' risk-adjusted past performance.)

Screening for Potential Stock Ideas
To come up with investment ideas that we believe the team at Columbia Dividend Income could be considering today, we decided to set up a screen focused on dividend-paying stocks. While the fund doesn't publish specific criteria for minimum dividend yield or growth, we were able to analyze the current portfolio using Morningstar Direct. Sifting through the data, we came to the conclusion that the team favors dividend yields between 1% and 7%, and that more than half the current holdings had historical growth rates for their dividends of at least 10% annualized over the past five years. This helped us to establish the parameters for our screen.

Because we also wanted to feel comfortable about the sustainability of the dividend paid on any particular stock generated by the screen, and we wanted there to be some room available for a company to increase its dividend to shareholders as well, we screened for firms that had a payout ratio below 50% of their earnings. Our assumption was that with a payout ratio below 50%, a company would still have half of its earnings available for reinvestment, with the rest potentially directed toward shares repurchases or dividend increases.

Given that Columbia Dividend Income also limits itself to a universe of 1,000 large-cap stocks, we decided to mimic this approach by limiting our screen to companies with a market capitalization of greater than $3 billion. And to make things even simpler, we also screened out companies that Morningstar does not cover, as well as those that aren't traded on a domestic exchange. The end result of the screen was 22 companies operating across a broad spectrum of industries--from mining firms to utilities to financial services.

Applying Morningstar's Methodology
Lacking information on specific valuation criterion that the team at Columbia Dividend Income might employ when buying and selling securities, and not wanting to get caught paying too hefty a price for the dividend-paying stocks that were generated by our screen, we employed our own Morningstar Rating for stocks to narrow the list down even further. By excluding companies that are rated 3 stars or lower, which implies that our analysts consider the company to be at least fairly valued (to potentially overvalued), we ensure that we're looking only at companies trading at a discount to our own fair value estimate. The idea, after all, is to find stock ideas that might be investable today.

Finally, wanting to potentially reduce the possibility of getting caught by an unforeseen dividend cut, we decided to look only at companies where the fair value uncertainty rating was below very high. Although it would be ideal to focus only on firms with low or medium uncertainty bands around our fair value estimate (which basically implies that our analysts are more confident in their judgment about the future prospects of a firm than those with higher uncertainty ratings), we know of many instances where firms with high uncertainty bands are still capable of supporting their dividends (even through times as difficult as we're going through right now).

We still think it would be wise, however, to avoid very high and extreme rated firms, which tend to have some level of financial duress associated with them, increasing the likelihood that their dividend (if they even pay one, that is) could be cut in the near to medium term. That's not to say a dividend cut won't can't happen to a firm that is rated high or lower, which is why we always stress the importance of digging deeper into a company's financials and current business conditions before deciding to put your own money on the line.

Six Potential Ideas, One Top Purchase
With these steps employed we were able to whittle the list down to the following six stocks:

Top Ideas from Screen Based on Columbia Dividend Income Holdings
	Star Rating	Fair Value Uncertainty	Size of Moat	Current Price ($)	Current Dividend Yield	5-Year Dividend Growth	3-Year Expected Return
STMicroelectronics NV (STM)		High	Narrow	6.23	6.8%	58%	49%
ConocoPhillips (COP)		Medium	Narrow	44.74	4.2%	18%	36%
Vulcan Materials (VMC)		Medium	Wide	41.48	4.6%	15%	32%
Devon Energy (DVN)		High	Narrow	62.01	1.0%	45%	32%
Ingersoll-Rand (IR)		High	None	20.40	1.4%	15%	29%
Tyco International		Medium	Narrow	25.74	3.6%	27%	19%
Data as of 05-14-09.

Out of these six names, Columbia Dividend Income currently holds just one:  ConocoPhillips (COP). This puts the fund in fairly good company, as (based on our latest holdings data) 11 of our Ultimate Stock-Pickers hold ConocoPhillips in their portfolios. The stock was also one of the top purchases during the period we surveyed, with seven managers either building or adding to existing positions in the name--an issue we highlighted in a recent article on the Ultimate Stock-Pickers' top purchases and sales.

Given the generous amount of support that ConocoPhillips has garnered from the managers on our list, we decided to ask Allen Good, the Morningstar analyst who covers the firm, for his take on the business and why he believes that it can sustain its dividend over the long run, and this is what he had to say:

"ConocoPhillips is the smallest of the three U.S.-based major integrated oil and gas companies. Compared with its larger peers,  Exxon (XOM) and  Chevron (CVX), ConocoPhillips differs in several regards. Operationally, natural gas is a larger portion of (the firm's) total production and downstream operations are more reliant on the U.S. (markets). ConocoPhillips (also) pursued an acquisition strategy in recent years as commodity prices soared, while its peers remained on the sidelines. (Significantly) lower commodity prices have left the company in a much weaker financial position (as a result). In response the company has increased debt, reduced capital expenditures, and discontinued share repurchases. While (ConocoPhillips) ceased growing the dividend several quarters ago, a dividend cut is unlikely. Even if operations continue to suffer with low oil and gas prices, the company would likely continue to increase debt to fund its capital program and maintain the dividend."

Although not the most rousing of endorsements, we take comfort in the fact that while the current prices of oil and natural gas are likely to prevent investors from benefiting from a dividend increase in the near future, a purchase of ConocoPhillips at its current 5-star price should provide investors with a three-year expected return of at least 35% (based on our current fair value estimate) solely through capital appreciation--plus a current dividend yield of 4%. That said, we'd also encourage investors to take a close look at the other 5-star names on this list, even if Columbia Dividend Income is not currently building a position in any of these companies, because these firms also offer the potential for capital appreciation along with higher-than-average dividend yields. For more information about our opinion on these five stocks, as well as the 2,000 other companies we cover, please see our full list of Stock Analyst Reports on Morningstar.com.

Disclosure: Alan Rambaldini doesn't own shares in any of the companies mentioned above.