Top 10 Ultimate Stock-Pickers' Dividend Stocks

As many of you already know, when sifting through the holdings, purchases, and sales of the top managers included in our Investment Manager Roster, the main goal of the Ultimate Stock-Pickers Team is to uncover and highlight investment ideas that are trading at what our analysts consider to be attractive valuations. In that regard, we're basically agnostic to stock classifications like growth or value, preferring to focus on whether or not a company's shares are trading at a deep enough discount to our fair value estimate to warrant purchasing. While we will always be drawn to value managers, given the impact that investors such as Benjamin Graham and Warren Buffett have had on our own investment research, we believe that we should always be willing to look outside of the value investing toolbox--especially if it helps us come to stronger conclusions about our own research, as well as the stocks we might be looking to buy or sell.

It is in that spirit that we decided to take a deeper look at the collection of dividend-paying stocks held by our Ultimate Stock-Pickers, with the hope being that we could find widely-held stocks that are not only trading at reasonable valuations, but which offer attractive and sustainable dividends for investors. Not everyone pays close attention to dividends, and some investors see dividends as a sign of poor growth prospects. But dividends can actually help investors earn superior total returns. Professor Jeremy Siegel, in his 2005 book, The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New, identified dividends as one of the key drivers of long-term equity outperformance. While companies that pay dividends may not grow as fast as successful non-dividend payers, the income they generate--in addition to the signals that dividends send about financial strength, business stability and capital discipline--have been extremely valuable for long-term investors.

Our own equity-income specialist, Josh Peters, equities strategist and editor of the monthly Morningstar DividendInvestor newsletter, couldn't agree more. His philosophy with regards to dividends is fairly straightforward: "I am just as concerned with what happens to a company's earnings and cash flows as with how large those earnings are in the first place. Pay me a dividend, and I know I'm getting something from my investment I never need to give back. Pay me a dividend, and I have the flexibility to help fund my lifestyle in retirement or reinvest my income for additional wealth compounding. Withhold dividends, and I will be only too happy to withhold my capital." (For those who are interested, you can check out a free trial copy of Josh's monthly newsletter by signing up here).

Focus on Free Cash Flow and Long Time Horizons
Looking through the commentary of the managers on our list of Ultimate Stock-Pickers that focus more heavily on dividend-paying stocks-- Amana Trust Income (AMANX),  Columbia Dividend Income ,  Oakmark Equity & Income (OAKBX), and  Parnassus Equity Income (PRBLX)--we found many similarities with our own investment philosophy. For instance, Columbia's valuation process starts not with the size of the dividend, but with the free cash flow available to support future dividends. Here at Morningstar we focus on a company's ability to improve or sustain the level of free cash flow it generates. This not only helps us determine the width of the moat ratings we assign to each individual firm, but also plays a critical role in valuing the shares of the companies we cover. Free cash flow, not reported earnings, is what counts.

The funds that focus more on dividend-paying stocks also tend stick to a fairly long-term time horizon when investing. This makes sense, because in all likelihood the price appreciation (or depreciation) that can occur in any given year would, in most cases, outstrip the dividend that would be received from a stock yielding just 2% annually (which, incidentally, has been the average annual dividend yield for the S&P 500 Index (SPX) over both the last ten and twenty year time frames). Of particular note was Amana Trust Income's commitment to this type of buy-and-hold strategy, with the turnover rate for the fund only 6% over the last year.

Top Dividend Paying Stocks of Our Ultimate Stock-Pickers
While it would be relatively easy to just look at the highest yielding stocks held by our 26 top managers, we found that most of those securities were actually held by fewer than two managers. It also didn't help that some of the highest yielding stocks on the list were coming from companies that could potentially lack the ability to sustain the dividend they were paying longer term. As such, we decided to narrow down the list to securities that were held by at least five of our Ultimate Stock Pickers, where the annual yield was greater than that of the S&P 500, in the hopes of finding firms where the dividend might prove to be more sustainable. We've not only included these stocks in the table below but have collected commentary from our analysts reflecting their current thinking on several of these names.

Top 10 Dividend-Yielding Stocks Among Widely Held Securities of Ultimate Stock-Pickers

Stock Price and Morningstar Rating data as of 01-21-10

The list, itself, is dominated by large firms with relatively stable businesses, which might not strike most people as a terribly exciting place to look for investing ideas, but as Columbia Dividend Income has often noted "during periods of market volatility, dividend-paying stocks have historically fluctuated less than stocks that pay no dividends." After the events of the last year and a half, we think that most investors would probably view a move towards more stability in their portfolios as a move in the right direction.

With the market rally during the last three quarters of 2009 pushing the value of most stocks up, it has become harder and harder to find securities trading at prices that our analysts consider attractive. For some perspective, as of the market close on January 21, 2010, there were only 30 securities rated 5-stars out of Morningstar's coverage universe of more than 1,700 stocks. Looking at the list of top 10 dividend yielding stocks, though, there are a few opportunities worth considering further, including the following 4- and 5-Star rated stocks:

 AT&T (T)
Through the first nine months of 2009, AT&T paid out a bit more than half of its free cash flow in dividend payments, which would seem to provide an ample cushion. But management expected capital spending to hit $17-$18 billion during the year, implying a substantial increase in spending during the fourth quarter of 2009. If capital spending was at the lower end of this range, the dividend would have reached 60% of free cash flow for the year. Analyst Mike Hodel believes the dividend is still well supported, but he expects the firm will use its excess cash to reduce debt over the next year rather than sharply increase returns to shareholders (in the form of dividends or share repurchases).

 Exelon (EXC)
Analyst Travis Miller believes that Exelon is in an enviable position as the largest nuclear power plant operator in the United States, and that the firm's ability to produce low-cost, carbon-free electricity should produce substantial and growing shareholder value for many years, regardless of what path power prices take. He thinks the company's biggest challenge is what to do with its cash flow. Travis gives management credit for increasing the dividend and buying back stock as commodity prices rose during 2007 and 2008, but notes that Exelon has also had a habit of unsuccessfully pursuing acquisitions, which could potentially divert cash flow from being return to shareholders.

 Pfizer (PFE)
Analyst Damien Conover believes that Pfizer's size establishes the largest economy of scale in the pharmaceutical industry. In a business where drug development needs a lot of shots on goal to be successful, Pfizer has the financial resources and the established research power to support the development of additional new drugs. That said, the lapsing of patent protection for many of its top drugs over the next few years creates some challenges for the firm. Pfizer also took on more than $22 billion in debt to finance the Wyeth acquisition (which closed in the fourth quarter of 2009). Damien believes that the firm should be able to whittle down this debt over the next few years, though, especially since it will hold more than $10 billion in cash on its balance sheet following the acquisition. Following a 50% dividend cut in January of last year (aimed at helping to fund the Wyeth acquisition), he expects Pfizer to significantly increase its dividend over the next several years.

 Sysco (SYY)
Through this difficult economic environment, Sysco's volumes have suffered, particularly in the restaurant sector. But analyst Erin Swanson believes the firm's expansive distribution network will allow it to remain the dominant North American food distributor, generating strong cash flows. She also believes that Sysco's dividend is sustainable. Free cash flow averaged 2.5% of sales over the past five years, and she expects the firm to generate a similar level of cash flows over the next five years. Further, Sysco shouldn't have any issues servicing future debt maturities (which amount to less than $10 million in each of the next two years and about $200 million annually through fiscal 2014). As a result, she believes Sysco has the flexibility to return excess cash to shareholders in the form of dividends and share repurchases while still reinvesting in the business.

Disclosure: Brett Horn does not own shares in any of the securities mentioned above.