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

By Brett Horn | Associate Director of Equity Research

Investors face some difficult choices in today's markets. The recovery in the U.S. economy seems to have stalled, and talk of a double-dip recession is in the air. Meanwhile across the pond, Europe faces the specter of widespread government defaults.  In this light, and given the recent downturn in the markets, equities look like a fairly risky option. But given the rush toward safety and fixed income investments over the past few years, yields on fixed income securities are incredibly low. The yield on 10-year treasuries is less than 2%, while opting for a 30-year note yields investors little more than 3% per year on their investment.

This sort of environment makes stocks with good dividend yields a potentially attractive option for investors. A healthy and safe dividend yield offers some solace in the midst of market volatility, and relative to fixed income, patient dividend investors could potentially get the benefit of both higher yields and the prospect of long-term capital appreciation. Investors following this type of strategy would have generated relatively pleasing results so far this year. While the S&P 500 Index is down around 7% on a total return basis in 2011, the PHLX Utility Sector Index, which is composed of a geographically diverse collection of U.S. public utility stocks, is up around 3% since the start of the year (on the continued strength of regulated utilities). Meanwhile, the Dow Jones REIT Index, which captures the performance of real estate investment trusts, is down around 2% so far in 2011, despite all of the uncertainty that continues to surround the domestic real estate markets.

With this backdrop in mind, we decided to take a much deeper look at the dividend-paying stocks that our Ultimate Stock-Pickers were holding at the end of the most recent period. While we could just have just focused on the four fund managers on our list-- Amana Trust Income (AMANX),  Columbia Dividend Income (LBSAX),  Oakmark Equity & Income (OAKBX), and  Parnassus Equity Income (PRBLX)--that specialize in income investing, especially as they are all beating the market this year, we decided that we'd get a stronger representation by sifting through the holdings of all of our managers. That said, we have narrowed down our screen to include only securities that were held by at least five of our Ultimate Stock-Pickers at the end of the most recent period, and where the annual yield was greater than that of the S&P 500.

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

  Star Rating Moat Size Current Price (USD) Price/Fair Value Dividend Yield (%) # Funds Holding Vodafone (VOD) 3 Narrow 25.77 0.92 5.4 7 Eli Lilly (LLY) 4 Wide 36.13 0.86 5.3 6 GlxoSmthKln (GSK) 4 Wide 41.07 0.84 5.2 5 Merck (MRK) 4 Wide 31.84 0.69 4.6 5 Pfizer (PFE) 5 Wide 18.28 0.68 4.1 10 CncoPhllps (COP) 5 Narrow 64.23 0.76 3.8 8 Sysco (SYY) 4 Wide 26.70 0.74 3.8 6 Philip Morris (PM) 3 Wide 65.90 1.01 3.7 6 Intel (INTC) 4 Wide 19.70 0.86 3.7 9 Abbott Labs (ABT) 5 Wide 50.43 0.74 3.6 8

Stock Price and Morningstar Rating data as of 09-09-11.

Looking through the list of top 10 dividend-yielding stocks held by our top managers, a few things stand out. First is that the list is dominated by wide-moat companies, with eight out of the 10 stocks on the list carrying a wide moat rating. We're not surprised to see our managers veering toward moaty stocks, but given that Morningstar assigns a wide moat rating to only about 10% of the stocks that we cover, the fact that 80% of this list is rated wide moat implies that our managers are not just looking for current yield, but are also focusing on companies profitable enough to maintain their dividends through difficult periods, as well as increase their dividend payout at a healthy clip over the long run.

Second is the complete absence of financials, which historically have been an area of focus for dividend investors. Their disappearance suggests that the relationship may have been impacted by the financial crisis, which spurred widespread dividend cuts in the sector. While our managers continue to be more heavily invested in financials (which accounted for 22% of the aggregate holdings of our Ultimate Stock-Pickers at the end of the most recent period), the rationale seems to stem from the belief that they are undervalued, not because they are stable sources of dividend income. With hindsight, investors would have done well to steer clear of the sector this year, as increasing concerns around financials have caused it to dramatically underperform the market. Year to date, the Financial Select Sector SPDR (XLF), a good proxy for the financial services industry, is underperforming the S&P 500 by around 15 percentage points.

And finally, the place that financials may have held on this list prior to the financial crisis seems to have been taken over by health-care stocks, and more specifically, pharmaceutical companies. In fact, five of the top 10 dividend-yielding stocks of our Ultimate Stock-Pickers at the end of the most recent period were pharmaceutical companies. With concerns about health-care reform now squarely in the rearview mirror, the relatively stable free cash flow of these companies and their relative independence from the economic cycle are apparently catching the eyes of our top managers. Believing that these five names warranted 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.

 Eli Lilly (LLY)
Morningstar analyst Damien Conover believes that Eli Lilly faces one of the steepest patent cliffs in the pharmaceutical industry between 2011 and 2013, with more than 40% of its current sales encountering generic competition. He does note that Lilly is taking aggressive action to best position itself. The 2008 acquisition of ImClone for $6.5 billion showcases Lilly's anxious condition. While he believes that the company overpaid for ImClone, the acquisition reinforced Lilly's stance to rebuild its battered product portfolio. Conover also notes that Lilly's internal pipeline should help to mitigate its patent losses over the next decade. The company has traditionally spent about 20% of its sales on financing the development of new drugs, much higher than the midteens industry average. Conover thinks that Lilly will likely increase this spending to 25% of sales over the next few years. He expects the firm to fund this additional spending through cost savings, noting that Lilly (in late 2009) announced plans to reduce its cost structure by $1 billion annually by the end of 2011, primarily through job cuts. Conover believes the company can generate almost $4 billion in free cash flow annually over the next few years. With the dividend requiring only a little more than a $2 billion annual outlay at the current level, the company should be able to maintain the healthy yield the stock currently offers, although there is little reason to hope for an increase in the foreseeable future, until the company can work past its issues.

 GlaxoSmithKline (GSK)
Like Eli Lilly, GlaxoSmithKline faces patent expirations on some of its drugs, most notably the respiratory drug Advair, its largest revenue generator, and the antiviral drug Valtrex. Morningstar analyst Damien Conover believes Glaxo is in a much better position, though, than many of its peers. He notes that Glaxo's size ranks it in the top tier of the pharmaceutical industry, and that this enormous bulk creates economies of scale in developing new drugs. In the highly uncertain race to drug development, the company's vast resources have created multiple opportunities for new blockbuster drugs. Glaxo's deep pockets have funded close to 20 major drugs in Phase III development. Further, the company has compiled more than 100 early-stage compounds in its pipeline. Recently approved lupus drug Benlysta should go on to blockbuster status as well. The magnitude of the company's reach is further evidenced by drugs that span all major therapeutic classes, as well as vaccines and consumer goods. While Glaxo carries a similar yield to Eli Lilly and has much better growth prospects, its dividend relative to its free cash flow is a bit higher, and the two stocks trade at similar discounts to our fair value estimate. Still, for investors focused squarely on dividends, Glaxo looks like the better option, as it should have more room to increase its dividend in the coming years.

 Merck (MRK)
The obvious recurring theme in these company discussions is patent losses, and Merck is no exception. Facing increased competition, patent losses, and a pipeline of late-stage drugs with poor chances of approval, our analyst Damien Conover thinks Merck greatly improved its long-term outlook by acquiring Schering-Plough in late 2009. Without Schering, Merck's long-term prospects were muddled--despite the recent successes that the firm has had launching several new blockbusters. Conover believes that the addition of Schering leaves Merck favorably positioned for long-term growth. On top of that, Merck's new products have helped to offset recent patent losses. Launched during the last few years, Januvia for diabetes, Isentress for HIV, and the Gardasil vaccine against human papillomavirus represent new blockbusters. All three drugs enjoyed monopoly positions at the time of their launch. That said, current and expected competition from other big drug firms is likely to create a drag on these drugs' growth over the next couple of years. With the stock carrying a 4.6% dividend yield, Merck comes in a little lower than the two previous names we discussed, but the company looks like a solid bet for dividend-focused investors, and Conover believes the stock is materially undervalued.

 Pfizer (PFE)
The expected loss of exclusivity of Lipitor in 2011 will shake Pfizer's foundation, according to Conover. That said, Conover believes that Pfizer's operations can withstand the blitz of new generic competition, and that the company's late 2009 acquisition of Wyeth should help insulate it from any one particular patent loss. Following the merger, Lipitor represented just 16% of total sales, setting up a much more manageable loss. Further, he expects billions of dollars of cost cuts, which should buoy earnings growth in the face of major patent losses. Finally, Pfizer's size establishes the largest economies of scale in the pharmaceutical industry. In a business where drug development needs a lot of shots on goal to ultimately be successful, Pfizer has the financial resources and established research power to support the development of more new drugs than its peers. Its strength is evidenced by the 100-plus drugs in its pipeline and more than 100 discovery projects. Although it carries one of the lowest dividend yields on this list, Pfizer is also one of only two 5-star rated stocks in the group. For those investors looking for both a healthy dividend yield and long-term capital appreciation prospects, Pfizer might just be the most attractive name on the list.

 Abbott Laboratories (ABT)
Although the company has other operations, Abbott's pharmaceutical business is its main engine. Our analyst Damien Conover believes that existing drugs and new pipeline products should propel long-term growth at Abbott, as the firm's pharmaceutical division contains a diverse set of growing blockbusters across many therapy groups. Autoimmune agent Humira, HIV/AIDS drug Kaletra, and cardiovascular treatments Tricor and Trilipix lead the group with more than $8 billion in annual sales (equivalent to 27% of Abbott's total sales). Humira continues to be the workhorse of the group, with 19% growth in 2010, as new indications helped propel the drug. The company's active research and development efforts have created the next generation of drugs, including cardiovascular drug Trilipix, which has blockbuster potential. Outside of the pharmaceutical group, Abbott runs top-tier diagnostic and nutritional segments that generate over 25% of total sales, helping to insulate the company from patent losses in the drug group. Complementing its other businesses, the firm's recently expanded vascular line is poised for rapid growth. Favorable clinical data on the company's new drug-coated stent Xience versus entrenched Boston Scientific (BSX) stent Taxus has resulted in fast market uptake. Abbott carries the lowest dividend yield on the list, but is also one of the two 5-star rated stocks on the list. So, like Pfizer, it might be best suited for investors looking for both dividend yield and capital appreciation prospects.

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