Top 10 Dividend-Yielding Stocks of Our Top Managers

By Greggory Warren, CFA | Senior Stock Analyst

About a year ago, the Ultimate Stock-Pickers Team put together an article that highlighted some of the better yielding stocks held by our top managers coming into 2010. With investors continuing to plow money into fixed income funds at a record pace, and equity valuations starting to look a bit stretched after close to two years of market gains, we thought it would be a good time to look at dividend paying stocks again--especially those held by more than a handful of our Ultimate Stock-Pickers.

Not everyone pays close attention to dividends, and some investors see dividends as a sign of poor growth prospects, but in the long run dividends can actually help investors earn superior total returns. In his 2005 book, "The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New," renowned market commentator Professor Jeremy Siegel identified dividends as one of the key drivers of long-term equity outperformance. While companies paying dividends may not grow as fast as successful non-divided payers, his research showed that 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 regard 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."

While Josh believes as we do that the market has gotten a bit stretched, he still sees opportunities for yield in excess of the 2.3% currently being offered by the S&P 500 Index (SPX). In fact, he notes that it is "not uncommon to find three, four, five, six percent even these days, and that provides an investor with the opportunity to get a lot more income for their dollar, which in turn, takes some of the pressure off of looking solely at price appreciation to drive your total returns." (For those who are interested, you can check out a free trial copy of Josh's monthly newsletter by signing up here).

Sustainable Free Cash Flows Support Dividends
It is also encouraging to note that the Ultimate Stock Pickers that tend to focus on more heavily on dividend-paying stocks-- Amana Trust Income (AMANX),  Columbia Dividend Income (LBSAX),  Oakmark Equity & Income (OAKBX), and  Parnassus Equity Income (PRBLX)--haven't lost their discipline in the face of a stronger performing market. That said, both Amana Trust Income and Columbia Dividend Income trailed the market by less than 100 basis points during 2010 (versus the more than 350 basis points that Oakmark Equity & Income and Parnassus Equity Income fell short of the return of the S&P 500 during the year). In their most recent quarterly commentary, the managers at Columbia Dividend Income noted the following about how they are responding to market conditions:

"With a challenging and uncertain environment ahead, we continue to believe that high quality dividend-paying companies should perform relatively well. Their shares are still reasonably priced compared to other asset classes, and many are currently yielding more than corporate bonds. We continue to look for companies with solid balance sheets that generate strong and sustainable free cash flow from operations."

Many of the fund's more meaningful purchases during the latter half of 2010 involved securities with much higher yields than the S&P 500, like Mattel (MAT),  DPL Incorporated , and Gallagher (AJG). According to the managers at Columbia Dividend Income, the fund's valuation process starts not with the size of the dividend but with the free cash flow that each firm they look at has available to support future dividends. This is not too dissimilar to the focus our analysts here at Morningstar place on a company's ability to improve or sustain the level of free cash flow that it generates. It helps determine the width of the moat ratings we assign to individual firms, and plays a critical role in valuing the shares of the companies that our analysts cover.

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, with some of the highest yielders on the list potentially lacking the ability to sustain the dividend that they are currently were paying. As such, we narrowed the list of highest yielding stocks down to securities held by at least five of our Ultimate Stock Pickers, and where the annual yield was greater than that of the S&P 500 (currently at 2.3%). We've not only included these stocks in the table below but have collected commentary from our analysts that reflects their current thinking on those names that we feel are more approachable right now (on a price to fair value basis).

Top 10 Dividend Yielding Stocks of Our Ultimate Stock-Pickers

Of these ten names, four of them-- Pfizer (PFE),  Philip Morris (PM),  Diageo (DEO), and  Sysco (SYY)--were on last year's list, which is not too surprising given their long-standing status as solid dividend paying stocks. Philip Morris and Diageo also have the distinction of being "sin stocks," which are stocks of companies that derive a significant portion of their revenue from socially questionable products, like cigarettes (Philip Morris) or alcohol (Diageo), and have traditionally had to pay higher dividends in order to attract and retain investors.

What's also interesting about the list is the fact that it is so heavily weighted towards Health Care and Consumer Goods and Services. We think that the Health Care bent is more a direct result of pharmaceutical firms being pressured by a raft of drug patent expirations over the near term. That said, just about every Health Care name on the list is yielding above 4%, which is much higher than we would expect from this traditionally defensive sector. As for the Consumer Goods and Services names that aren't sin-related, we believe that the yields are slightly elevated due to the impact that the downturn in the economy has had on their business models.

 Eli Lilly (LLY) 
Our analyst Damien Conover believes that Eli Lilly faces one of the most daunting 10-year outlooks in its peer group, which goes a long way towards explaining why its yield is so high. He feels that flat top-line growth over the next decade (due to the loss of several high-margin drugs) is likely to put significant pressure on the firm's earnings. Even in this dire state, though, Damien believes that the company offers a compelling valuation on the basis of his projected cash flows (which should support the current dividend) and the potential for upside from its pipeline. In particular, he thinks that Lilly's drug solanezumab could shift the paradigm in treating Alzheimer's, believing that positive data from the drug's Phase III trials (expected in 2012) could dramatically reshape the firm's prospects. Damien also expects the company to rapidly advance several Phase II candidates into Phase III development before the upcoming patent cliff, mitigating its effect. With several of Lilly's earlier-stage drugs targeting cancer--a therapeutic area that holds the potential for rapid development and quick regulatory approval--there is the potential, in his view, for the firm's outlook to improve drastically.

 Pfizer (PFE) 
Much like the rest of the pharmaceutical industry, Pfizer is facing its own slough of patent expirations, which helps explain the stock's 4%-plus dividend yield. With more than a third of Pfizer's current sales coming from products losing patent protection over the next four years, Damien believes that the company faces a negative growth rate through 2012. That said, he feels that the company's valuation is compelling, even with a poor growth outlook. Damien thinks that several underappreciated factors, such as expansion into emerging markets, will play well into the firm's long-term growth potential. With emerging markets demanding health-care products at an accelerating pace, sales of Pfizer's several blockbuster drugs could increase dramatically over the next five to ten years. The fear of counterfeit generic drugs is creating longer exclusivity periods and shelf lives for branded drugs in emerging markets, offsetting the general disregard for patent protection. Considering the cheaper marketing costs and the already sunk costs of development, the incremental returns on investment from this geographical expansion should be stellar, in his view. Damien also notes that cost-cutting efforts associated with the Wyeth merger could exceed his expectations, giving Pfizer the opportunity to generate more profit for each dollar of sales that it collects, and allowing it to increase the dividend payout ratio over the next couple of years.

 Merck (MRK) 
Merck will also not be immune to the patent expiration cliff, losing protection on drugs representing about one fourth of the company's total sales over the next three years. Damien believes that this near-term headwind has depressed market valuation for Merck's shares, providing another great opportunity for long-term investors in the pharmaceuticals industry. He feels that restructuring efforts Merck initiated after the Schering Plough acquisition should reduce costs and improve margins over the long term, helping to offset the patent expirations of high-margin products. Damien also believes that the addition of four new blockbusters--Simponi (arthritis), Saphris (antipsychotic), TRA (heart disease), and Bridion (anesthesia)--that came along as part of the Schering Plough deal, and which should launch between 2009 and 2011, should return the company's earnings to growth following the 2012 patent loss on Singulair. He also thinks that Merck's recently introduced bottom-up sales and marketing approach gives its salesforce the autonomy to tailor sales calls and should better service doctors and reduce operating costs, all of which should allow the firm to generate the cash flows it will need to support its dividend longer term.

 Abbott Laboratories (ABT) 
Unlike many of its peers, Abbott faces only a few patent losses over the next five years, which Damien believes will leave the firm well-positioned to ride a strong tailwind of demand for its products. Taking advantage of the decision by many drug firms to leave primary-care indications like cardiovascular disease, Abbott has responded by becoming a leader in the field with several new drugs to treat heart disease. He believes that the less competitive environment should bode well for Abbott, which has been very adept at finding niche markets to exploit. Damien expects continued strong demand for the company's leading drug, Humira. With drug penetration in rheumatoid arthritis reaching only 20% and even less in psoriasis and Crohn's disease, he thinks that Humira could grow at double-digit rates for the next four years. Damien also notes that Abbott's strong competitive position in nutritionals and diagnostics reduces the volatility of its earnings and creates additional avenues of growth. While Abbott has been adept at deploying cash flows from its businesses toward acquisitions and partnerships, aimed at replenishing its pipeline of next-generation of products, he feels that it should still be able to continue raising its dividend at a double-digit annual rate over the next several years.

 Sysco (SYY)
Morningstar analyst Erin Swanson believes that the market has excessively penalized Sysco as near-term results have softened as consumers eat more meals at home instead of at Sysco's primary customers (restaurants). She thinks that investors are too focused on the short-term, ands suggests that they take a longer term view of the firm's prospects, believing that management's focus on expanding Sysco's distribution platform, improving its supply-chain efficiency, and increasing its salesforce productivity will not only drive growth but prevent the firm's competitive position from eroding. Erin believes that there is still plenty of potential for Sysco to expand its market share, despite what is already a fairly dominant market position (17% share in the United States and Canada) in a highly fragmented industry. She feels that the firm should be able to expand its presence by targeting underpenetrated segments (like larger chain restaurants) and by focusing its marketing associates to grow existing business segments (such as travel and leisure). Erin expects that management's focus on driving additional share gains, as well as its commitment to returning excess cash to shareholders in the form of dividends and share repurchases, makes Sysco a worthwhile investment alternative for income and growth investors alike.

 Johnson & Johnson (JNJ) 
While many of its competitors are approaching a major patent cliff, Morningstar analyst Damien Conover notes that Johnson & Johnson has successfully passed this hurdle and is on the verge of returning to growth with several new potential blockbusters. The well-positioned company has survived the loss of patent protection on antipsychotic Risperdal and neuroscience drug Topamax by bringing forward a robust set of replacement drugs. Within this group of new drugs, rivaroxaban for cardiovascular disease and bapineuzumab for Alzheimer's offer the potential to revolutionize treatment, and Damien pegs the probability of approval for the drugs at 80% and 50%, respectively. He feels that Johnson & Johnson's medical devices and consumer health products greatly reduce the company's earnings volatility and offer investors an opportunity to own a health-care conglomerate (as opposed to a pure-play pharmaceuticals firm). Damien expects the company to deploy its enormous cash flow from operations for small acquisitions to augment internal development efforts, and notes that while he expects to see continued increases in the dividend that there is likely to be some deceleration in growth of the dividend over the next couple of years as the company weathers near-term generic competition.

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Disclosure: Greggory Warren owns shares in the following securities mentioned above: Amana Trust Income, Johnson & Johnson, and Kraft Foods.