Top 10 Dividend-Yielding Stocks of Our Top Managers

By Jaime Peters, CFA, CPA | Senior Stock Analyst

Earlier this year, the Ultimate Stock-Pickers team put together an article highlighting some of the better-yielding stocks that our top managers held coming into 2011. Since that time, unrest in the Middle East, natural (and not so natural) disasters in the Asia-Pacific region, an ongoing European debt crisis, a falling U.S. housing market, a pathetic showing for domestic job creation, and the impending end of QE2 have all had an impact on the markets. While the S&P 500 Index (SPX) had held up well through much of this turmoil, rising 6% during the first quarter (and another 3% in April), it has given back almost all of those gains during the last six weeks, with the benchmark up less than 2% for the year at the end of last week. The roller coaster of market returns that we have seen so far this year has many investors yearning for returns that cannot be taken away so readily--that is to say, dividends.

So it should not come as too much of a surprise that industries that have historically been popular because of their higher-yielding stocks have performed well in 2011. The PHLX Utility Sector Index, for example, which is comprised of geographically diverse U.S. public utility stocks, is up 4% since the start of the year on the continued strength of regulated utilities. Meanwhile, the Dow Jones REIT Indexes, which capture the performance of real estate investment trusts, are both up around 4% in 2011, despite all of the uncertainty that has surrounded the real estate markets this year. Also worth noting it's the fact that the four fund managers in our Investment Manager Roster that specialize in generating income for their investors-- Amana Trust Income (AMANX),  Columbia Dividend Income (LBSAX),  Oakmark Equity & Income (OAKBX), and  Parnassus Equity Income (PRBLX)--were either beating or very close to beating the S&P 500 at the end of last week.

And yet individual investors continue to plow an overwhelming amount of money into fixed-income funds, which continue to offer little in the way of yield, in response to the ongoing volatility in the markets. As of the end of May, net inflows into taxable bond funds were nearly $80 billion for the year, versus less than $25 billion going into U.S. stock funds and less than $20 billion flowing into international stock funds. While not completely enthusiastic about the equity markets, Josh Peters, the editor of Morningstar's DividendInvestor, continues to believe that the case for high-yielding stocks remains strong. In his view, "we're getting only a 2% yield from the Standard & Poor's 500 Index, which remains very low in historic terms. Investors are coming to crave a lot more income than most profitable corporations seem prepared to provide. But even in an environment that is starved for yield, there are plenty of higher-yielding stocks to choose from. It is true that the threat of higher interest rates down the road poses an intermediate-term risk, yet the growth of income that only dividends can provide gives high-yield investing tremendous long-term appeal on a total-return basis."

With these thoughts in mind, we decided it would be a good time to take another look at the dividend-paying stocks held by our Ultimate Stock-Pickers. While it would have been relatively easy to just look at the highest-yielding securities that our 26 top managers held at the end of the most recent period, we found that many of these securities were held by fewer than two managers, with some of the highest-yielding firms potentially lacking the ability to sustain the dividend they're currently paying. As such, we narrowed the list of highest-yielding stocks to include only securities held by at least five of our Ultimate Stock-Pickers, where the annual yield was greater than that of the S&P 500. Looking at the top 10 highest-yielding stocks produced by this screen, we discovered one genuine opportunity and a few companies where a strong current yield cannot be matched with growth longer term. We've not only included these stocks in the table below, but have also collected commentary from our analysts reflecting their current thinking on all 10 of these names.

Top 10 Dividend-Yielding Stocks of Our Ultimate Stock-Pickers

Stock Price and Morningstar Rating data as of 06-10-11.

Looking back to our previous article, the last five months have brought few changes to the list of top 10 dividend-paying stocks held by our Ultimate Stock-Pickers. In fact, just four names-- Diageo (DEO),  Kraft Foods (KFT),  Sysco (SYY), and  Johnson & Johnson (JNJ)--have fallen off, mostly due to the fact that the yield cutoff for the list has increased from 3.5% to 3.8%. It should be noted, though, that our Ultimate Stock-Pickers had a real winner in Diageo, as the alcohol manufacturer's stock price increased from $74 at the end of last year to $83 last Friday--an 11% gain versus a market that is up less than 2% year to date. All seven of the Ultimate Stock-Pickers that held Diageo at the beginning of the year continue to hold the name--as does Josh Peters in his DividendInvestor portfolio--but the increase in the stock price since the start of 2011 has led to a decline in the yield to 2.4% from 4.0%  (despite an increase in the firm's semiannual dividend). Meanwhile,  Vodafone (VOD),  Nestle (NSRGY), GlaxoSmithKline (GSK), and  Total (TOT) have been elevated onto the list, primarily due to the addition of  Oakmark (OAKMX) and  Oppenheimer Global (OPPAX) to the Investment Manager Roster, as well as some new-money purchases during the period.

 Vodafone (VOD) 
While the stock has been pretty much flat for the year, Vodafone did recently increase its variable semi-annual dividend over what it paid out a year ago. The stock yields 6.1% on a local currency basis, catapulting Vodafone to the top of our list of top 10 dividend-yielding stocks. Morningstar analyst Allan Nichols notes that the firm's core European operations generate solid free cash flow to fund its dividend and acquisitions, while its emerging market businesses provide it with some growth opportunities. He is pleased with Vodafone's more recent capital allocations decisions, which have included using the proceeds from divestitures to fund share buybacks (providing the firm with the flexibility it will need to meet its goal of increasing its dividend by at least 7.0% every year through fiscal 2013). Trading at a slight discount to our fair value estimate, Vodafone's attractive dividend yield has gleaned the attention of six of our Ultimate Stock-Pickers, with  FPA Crescent (FPACX) committing more than 3.0% of its stock portfolio to the wireless phone service provider.

 Nestle (NSRGY) 
Despite only a modest increase in its stock price this year, Nestle jumped out on our screen this time around after a fairly decent dividend increase by the Swiss firm (as well as the inclusion of Oppenheimer Global on the Investment Manager Roster). Nestle's annual dividend payment increased more than 15% to CHF1.85 per share earlier this year, leaving it with a yield of around 3.5% (on a local currency basis). Even though the shares are fairly valued right now, our analyst, Phil Gorham, believes that Nestle is an appropriate core holding for investors wishing to own broad exposure to the consumer staples industry. Like most packaged goods firms, Nestle is facing pressure from higher commodity costs. As a result, the company may be forced to further increase prices later this year, just at a time when austerity measures in Europe will begin to bite hard. While Nestle's first-quarter results were encouraging, Gorham feels that the litmus test of its pricing power is still to come in the second half of the year.

 Eli Lilly (LLY) 
The highest yielding of the pharmaceutical names that continue to dominate our list, Eli Lilly was also our top-yielding stock six months ago. A small drop in its yield--to 5.3% from 5.6% --as a result of a small increase in its stock price--to $37 from $35--has left the drug maker in third place on our list of top 10 dividend-yielding stocks. While six of our Ultimate Stock-Pickers own the stock, we are a bit less optimistic about its future, as evidence suggests to us that Eli Lilly's wide economic moat is starting to deteriorate. Morningstar analyst Damien Conover points out that the firm is facing one of the steepest patent cliffs in the industry, which means that Eli Lilly's top-line growth during the next decade is likely to be nonexistent as pipeline products barely offset revenue declines from its patent losses. With the firm's pipeline full of lower-margin drugs, Conover expects Eli Lilly's bottom line to decline slightly during the next decade. With a dividend payout of 45% there is little (if any) room for dividend growth, which means that while the stock may be a good dividend play currently, its dividend buying power will deteriorate during the next ten years (much like its economic moat).

 GlaxoSmithKline (GSK) 
GlaxoSmithKline made our top-10 list this time around not only due to the inclusion of the Oakmark fund on our Investment Manager Roster, but also a new-money purchase by Fairholme Capital Management. At the end of the most recent period, six of our Ultimate Stock-Pickers held positions in the pharmaceutical firm. The company pays a variable quarterly dividend, with GlaxoSmithKline's most recent dividend of $0.53 per share 14.3% higher than last year's May dividend of $0.46 per share. Our analyst Damien Conover believes that the stock is slightly undervalued right now, and that its future prospects are fairly sound. After weathering a massive storm of generic competition during the last 10 years, GlaxoSmithKline is emerging as a stronger company, in his view, with a focus on product areas that don't face the traditional patent cliff and offer strong long-term growth potential. While the firm still faces the risk of a generic version of Advair in the near term, GlaxoSmithKline's pipeline has re-emerged with a strong lineup of late-stage drugs, along with several drugs focused on orphan indications that carry strong pricing power and typically a more supportive regulatory environment.

 Total (TOT) 
Total was the last new addition to our list of  the top 10 dividend-yielding stocks, making the cut by virtue of our adding Oppenheimer Global to the Investment Manager Roster, which brought the number of Ultimate Stock-Pickers holding the stock at the end of the last period to five. Morningstar analyst Catharina Milostan believes that the French oil giant Total is keeping its sights on long-term goals by remaining committed to long-term projects as it navigates the tough near-term waters of low gas prices and the impact of a still-weak European economy on its downstream operations. The company has a healthy pipeline of new oil and gas fields and upstream expansion projects that could help propel future growth. With a current yield of 5.8% (on a local currency basis), managers like  Amana Trust Growth (AMAGX), FPA Crescent, Oppenheimer Global,  Mutual Shares (TESIX), and  TweedyBrowne Value (TWEBX) are, in our view, being more than fairly compensated as they wait for Total's next stage of growth to commence.

 Bristol-Myers Squibb (BMY) 
The third of six health-care companies to make the list, Bristol-Myers Squibb is yet another pharmaceutical firm facing a series of patent losses. According to analyst Damien Conover, the first wave will come in 2012 and 2013 for its cardiovascular drugs, with a second wave of anti-infective drugs coming between 2014 and 2015. While the firm's strong pipeline has the capability of replacing the lost revenue, in Conover's opinion, Bristol-Myers Squibb is unlikely to show much growth during the next decade.  This does not bode well for dividend growth, especially with a payout ratio that already exceeds 60%. Consequently, Bristol is yet another example of what we are seeing across the major drug companies, where the buying power of the dividend is likely to erode over time, even though the current yield is attractive. Interestingly enough, we had one Ultimate Stock-Picker-- Columbia Value & Restructuring --that threw in the towel on Bristol-Myers Squibb during the quarter, while Fairholme Capital Management was putting new money to work in the name.

 Merck (MRK)  
Merck's current 4.3% dividend yield continues the high-dividend, low-growth health-care company theme that has been so evident on our list of top-10 dividend-yielding stocks this year. However, with only one major patent loss left during the next five years, analyst Damien Conover notes that Merck has already dealt with the pain that most of its peers are facing. Thanks to the Schering acquisition, the drug company now has a strong lineup of new products, and is also investing heavily in research and development, which may hurt earnings and dividend growth in the near term but offers stronger growth potential longer term. Consequently, Conover expects Merck's bottom line to buck industry trends and actually grow during the next five years. That said, the company's dividend has not grown in seven years. This probably explains why only one of our income-driven managers--Columbia Dividend Income--currently holds the name. More interesting is the fact that one of our Ultimate Stock-Pickers--  Aston/Montag & Caldwell Growth (MCGIX)--completely eliminated Merck from its portfolio during the quarter, while Mutual Shares was actually putting new money to work in the name.

 Pfizer (PFE) 
After cutting its dividend in half in 2009, Pfizer's dividend is once again growing and currently yields 4.0%. Unfortunately, according to our analyst Damien Conover, more than a third of Pfizer's current sales are coming from drugs that are set to lose their patent protection during the next four years, which leads him to believe that the company's top-line growth will be flat through at least the end of 2013. That said, Conover does believe that Pfizer has a hidden source of potential revenue growth, as emerging markets are demanding health-care products at an accelerating pace. The firm already holds the second-best market share position in emerging markets, and with inexpensive marketing costs and an already sunk cost of product development, Conover believes that the incremental returns from emerging markets should be excellent. He also feels that ongoing cost-cutting efforts should help moderate the upcoming patent cliff at Pfizer, with the firm reaching most of its planned annual cost savings of $6 billion by 2012, roughly equating to the annual profits of Lipitor. All of this should add up to longer-term earnings growth for the drug manufacturer, allowing Pfizer to potentially increase it dividend even further as time goes on.

 Abbott Laboratories (ABT) 
As the only 5-star name on our list of top-10 dividend-yielding stocks, we feel Abbott Labs is a holding at which investors should take a much deeper look. Not only did seven of our Ultimate Stock-Pickers hold the name at the end of the most recent period, but Josh Peters also held the stock in his DividendInvestor portfolio. Abbott Labs is the only wide-moat health-care firm on the list and, unlike most of its peers, faces relatively minor patent losses during the next five years. Yielding 3.8%, Abbott Labs increased its quarterly dividend by 9% to $0.48 per share in April. Morningstar analyst Damien Conover expects continued strong demand for the company's top drug, Humira, and a strong competitive position in nutritionals and diagnostic to contribute to strong earnings growth during the next couple of years, which should translate into attractive dividend growth as well. With the company's shares currently trading at a discount to his fair value estimate, Conover believes there is a wide enough margin of safety in the stock right now for long-term investors to take a serious look at the name.

 Philip Morris International (PM) 
A high dividend yield of 3.8% is likely a necessity for this sinful stock to attract retail investors. According to Morningstar analyst Phil Gorham, Philip Morris has considerable competitive advantages--scale, immense brand strength, and an addictive product--that combine to give the firm industry-leading operating margins and returns on invested capital. Philip Morris has a strong presence in emerging markets, which offer favorable mix opportunities because smokers are trading up to premium brands, and no operations in the United States, which has been bereft with litigation and taxation issues over the years. That said, the company does report in U.S. dollars, so when the dollar strengthens against the other major currencies, Philip Morris' earnings power weakens, and the stock often falls. While that is not the case right now, the firm remains one of Gorham's favorite consumer packaged goods companies. He believes Philip Morris is likely to generate sustainable earnings and dividend growth longer term.

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Disclosure: Jaime Peters own shares in the following securities mentioned above: Sysco. It should also be noted that Morningstar's Institutional Equity Research Service offers research and analyst access to institutional asset managers. Through this service, Morningstar may have a business relationship with fund companies discussed in this report. Our business relationships in no way influence the funds or stocks discussed here.