10 Solid Ultimate Stock-Pickers' Dividend Stocks

By Drew Woodbury | Stock Analyst

As you may recall from one of our previous articles, The Ultimate Stock-Pickers Team tends to be 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 regardless of how the stock might be classified. While we'll always be drawn to value managers, given the impact investors like Benjamin Graham and Warren Buffett have had on our own investment research, we also believe in looking outside of the value investing toolbox--especially if doing so helps us to come to stronger conclusions about our own research, as well as stocks we might interested in buying or selling. One exercise that we undertake from time to time involves taking a much deeper look at the dividend-paying stocks held by our Ultimate Stock-Pickers, with the goal being to find some widely held stocks that are not only trading at reasonable valuations, but also offer attractive and sustainable dividends for investors.

Not everyone pays close attention to dividends, but for those that do the suspension of  BP PLC's (BP) dividend this summer may have raised questions about the stability of dividends. While BP's dividend elimination was due to a catastrophic event that would be nearly impossible to predict, it underscores the notion that no dividend is completely safe. During the meltdown of the credit and equity markets a year and a half ago, there were a number of firms with long histories as steady dividend players, most notably large banks and financial institutions, that cut their dividends due to liquidity concerns or simply to be more conservative with their capital base. While many nonfinancial companies made it through the crisis with their dividends intact, the subsequent downturn in the economy has started to put pressure on firms that three or four years ago would not have had the sustainability of their dividend questioned.

While there are myriad ways to screen for solid dividend payers, we think that looking at the holdings of our Ultimate Stock-Pickers, and separating the widely held firms that have wide economic moats and low to medium uncertainty from the rest of the pack, could offer up some interesting opportunities for investors. Companies with wide economic moats tend to reside in profitable industries and have long-term structural advantages that allow them to keep competitors at bay for longer periods of time, generate more predictable earnings and cash flows, and have returns on capital that exceed their cost of capital. A low uncertainty rating on a firm means that our analysts believe they can estimate future cash flows with a greater degree of confidence than companies with higher uncertainty ratings.

That said, dividends (much like share repurchases) are at the discretion of management. While dividends are often believed to impose an extra level of discipline on management, with consistent and growing dividends sending positive signals to long-term investors about the stability and financial strength of a company, there is no guarantee that firms paying dividends today will be able to sustain or grow that payout over the longer term. As such, it is important to look not only at the yield a stock is generating today, but at the ability and the commitment of a firm to generate that level of income for shareholders over the long run. But even then, there's no guarantee that today's dividend-paying stock will still be paying dividends tomorrow. After all, BP was committed to paying its dividend, and certainly had the ability (even with the ongoing costs of cleaning up the Gulf oil spill), but public pressure forced the company to suspend the dividend (at least, that is, until management has a clearer picture of the long-term financial impact that the Deepwater Horizon incident will have on the firm).

Top 10 Widely Held Dividend-Paying Stocks with Low/Medium Uncertainty

Stock Price and Morningstar Rating data as of 07-01-2010.

Believing that the 10 stocks produced by our screen of the holdings of our Ultimate Stock Pickers warrant further consideration, we collected some commentary from our analysts reflecting their current thinking on these holdings, including their thoughts on the dividend prospects for these firms.

 Wal-Mart (WMT)

While the stock is currently trading just above our Consider Buying price, it is worth keeping on the radar due to its strong business model and dividend prospects. Morningstar Associate Director Joel Bloomer believes Wal-Mart benefits from a wide economic moat that protects future profitability. He thinks the company, with more than $400 billion in annual revenue, dominates the U.S. retail landscape and is growing quickly internationally. While Wal-Mart has benefited more than its peers from consumers trading down during the recession, the company should, in his view, benefit from what it expected to be a mild economic recovery, as well as an international growth strategy that is still in its early stages. Joel believes Wal-Mart's conservative capital structure and steady cash flow leaves ample room for the firm to consistently grow its dividend.

 Johnson & Johnson (JNJ)

Morningstar analyst Damien Conover is impressed with Johnson & Johnson, believing that the firm stands alone as a leader across several major health-care industries. He feels the company's diverse revenue base, robust research pipeline, and ability to generate exceptional cash flows provides Johnson & Johnson with a wide economic moat around its business. While many of the firm's competitors are approaching a major patent cliff, Johnson & Johnson has successfully surmounted this hurdle and is on the verge of returning to growth with several new potential blockbusters. With cash flows from operations of about $16 billion, the firm is in a sound financial position. Johnson & Johnson is in the process of buying back shares and is close to completing its 2007 share-repurchase program of $10 billion. On the dividend front, the firm has been increasing its dividend about 10% annually over the past four years. Damien believes the company will also use its enormous cash flows to fund small acquisitions to augment its own internal development efforts.

 Microsoft (MSFT)

While Microsoft's dividend yield is among the lowest of the companies produced by our screen, the stock is currently trading at a price that is very close to our Consider Buying price. While Associate Director Toan Tran predicts that cloud computing will bring about a disruptive change that will challenge Microsoft's core Windows and Office franchises, he believes the firm has the opportunity to build another wide moat with its Windows Azure cloud platform. Microsoft has $40 billion in cash at the end of the first quarter of 2010 and is one of the few firms to earn a AAA Morningstar Credit Rating. Toan believes the firm is one of just a handful of companies with the technical and financial resources to invest heavily in cloud computing. Its excellent financial position should allow the firm to continue to meet and grow its dividend obligations. The company has also repurchased massive amounts of stock in recent years, and diluted shares outstanding have decreased by 17.5% over the last five years.

 Procter & Gamble (PG)

With its shares trading below our Consider Buying price, Morningstar analyst Lauren DeSanto believes investors should consider looking at this consumer goods giant. Even with the economy struggling and consumers watching their wallets, Procter & Gamble has been focused on driving profitable market share growth in its categories and markets, as well as stepping up efforts to improve productivity. CEO Robert McDonald, who assumed the helm in mid-2009, continues to stress P&G's execution with retailers and customers, with the aim of guiding the firm to operate like a smaller, more nimble company. Lauren believes the firm is on the right track and these initiatives should augment increased investments the firm is making in its brands and an improved new product pipeline. She also feels P&G is soundly committed to serving shareholders well, as evidenced by its 9.5% compound annual dividend growth rate over the last 54 years and solid AA Morningstar Credit Rating.

 Coca-Cola (KO)

Morningstar analyst Phil Gorham believes Coke's extensive direct distribution network enables the firm to deliver its products to consumers all over the globe and is the main source of the firm's wide moat. Despite the challenges raised by declining consumption of carbonated beverages in more mature markets like North America, Phil thinks the firm's global reach will present it with long-term opportunities that will ultimately outweigh any declines in local markets. Coke's most recent strategic decision has been to acquire its North American bottling operations from  Coca-Cola Enterprises (CCE) in an effort to gain a larger slice of the profits of this business. While the timing of the deal and the nature of the execution have caused us to raise an eyebrow, the deal does make strategic sense and Phil believes Coke paid a fair price. He also feels the dividend is relatively secure but could be cut in the unlikely event of a liquidity crisis if the firm needed to boost its financial flexibility.

 Pfizer (PFE)

Much like Johnson & Johnson, Morningstar analyst Damien Conover believes Pfizer has a strong business model and is attractively priced. The firm's large size confers significant competitive advantages in developing new drugs. This unmatched heft, combined with a broad portfolio of patent-protected drugs, has helped Pfizer build a wide economic moat around its business. Damien expects cost-cutting to moderate the company's upcoming patent cliff. In fact, he estimates Pfizer will reach most of its planned annual cost savings of $6 billion by 2012, which is equivalent to the annual profits of Lipitor. Pfizer also holds the second-best market share position in emerging markets, which should allow it to tap into the rapid growth expected to come from these nations. The company's dividend was cut by 50% in January 2009 to help fund its acquisition of Wyeth. Despite this move, Pfizer still has the highest current dividend yield of the 10 stocks on our list. Damien expects the firm will significantly increase its dividend over the next several years.

 Novartis (NVS)

Damien also likes Novartis, which he feels has created a wide economic moat with the support of patents, a powerful distribution network, economies of scale, and diverse operations. In contrast to many of its peers, Novartis faces a relatively light load of patent losses over the next five years. The major exception to this is the loss in 2012 of hypertension drug Diovan, which will represent more than 10% of the company's total sales this year. Despite this, Damien points out that Novartis has an industry-leading late-stage pipeline of drugs, which should propel long-term growth. As an added bonus, and in contrast to most of the other large pharmaceutical names, Novartis gives investors favorable exposure to the generics industry through its Sandoz division (and at a much cheaper valuation compared to pure-play generic firms). Damien expects the company will use its robust cash flows to pay down debt as well as increase its dividend.

 PepsiCo (PEP)

Morningstar analyst Phil Gorham notes that Pepsi, like Coke, derives its wide economic moat from its economies of scale and a direct store distribution network that gives the firm a competitive advantage through its direct relationship with retailers and ability to influence in-store displays. While the firm may play second fiddle to Coke in the cola category, the firm dominates the snack food category, with a group of brands that hold leading or second-place positions across several different categories. This allows Pepsi to further solidify its ability to earn excess returns. Much like Coke, the firm has recently moved to acquire its bottlers. Phil believes that Pepsi's bottler consolidation, which was actually announced well in advance of Coke's decision to acquire its North American bottling operations from Coca-Cola Enterprises, will be a disruptive event for the industry. He feels that the flexibility Pepsi will gain in its market routes will be a long-term competitive advantage for the firm. Like Coke, the dividend appears to be stable but could be cut in the event of a crisis.

 3M (MMM)

Over its long history, 3M has invented some of the world's greatest products. Morningstar analyst Adam Fleck believes the firm's innovative culture, bottom-line focus, and low-cost manufacturing have allowed it to carve a wide economic moat around its business. He thinks that 3M's wide diversification across multiple end markets and geographies and quick order cycle will likely lead to sharp top-line improvement once economic conditions rebound. Meanwhile, the firm remains highly profitable with only modest capital intensity, allowing 3M to post returns on invested capital north of 20% on average during the last 10 years. One potential concern for dividend investors is that the company has increased its financial leverage over the last five years, adding nearly $4 billion worth of long-term debt. Adam notes that 3M's net debt/capital ratio is still manageable, at 14%, with the company earning a Morningstar AA Credit Rating. 3M has traditionally put a priority on rewarding shareholders by repurchasing a substantial amount of shares and paying a healthy dividend, and Adam doesn't foresee any cash-flow issues that would prevent it from pursuing either activity over the long run.

 Comcast 

Besides being the largest domestic cable provider, Comcast is also a significant provider of Internet and telephone services. Our analyst Michael Hodel believes Comcast's competitive advantages stem from the fact that no other company can match its ability to offer multiple services over one connection within the territories it serves. While he's not enthralled with the firm's move to acquire NBC Universal from  General Electric (GE), believing the combination of content creation and distribution will create little value for Comcast in the longer term, he notes that the core cable business will still dominate the firm, producing around three fourths of cash flow. Mike believes that Comcast's capital structure is the most sound of any cable company that Morningstar follows. The firm has mostly used cash to repay debt since late 2008, putting it in great shape heading into the NBCU deal. While Comcast will take on more leverage when the deal closes, Mike expects the firm's financial position will remain strong.

Disclosure: Drew Woodbury owns shares or bullish option positions in the following securities mentioned above: BP PLC, Johnson & Johnson, and Procter & Gamble.