Top Dividend Stocks of Our Ultimate Stock-Pickers

By Greggory Warren, CFA | Senior Stock Analyst

Stock markets can be fickle things at times. After running up more than 12% during the first quarter of 2012, the U.S. markets (as exemplified by the S&P 500 Index) declined 1% in April, dropped another 6% during May, and then fell 3% on the first trading day of June. Since then the trend has been more positive than negative, with the benchmark index rising 5% over the last two weeks of trading. This type of volatility does nothing to calm investors, who have been in risk-aversion mode for much of the last three years. According to data provided by Morningstar Direct, investors have pulled more than $14 billion out of actively managed U.S stock funds since the start of the second quarter, putting them on pace to exceed the nearly $22 billion that flowed out of these type of funds during the first quarter (with more than half that total taking place in the month of March). While this may look less dire when compared with the more than $45 billion that flowed out of actively managed U.S stock funds in both the third and fourth quarters of 2011, it should be noted that outflows in the second quarter of last year reached $22 billion. And that was before the concerns that had emerged around the European debt crisis, as well as the political wrangling over the debt ceiling here in the United States, had a major impact on global stock markets last year. While concerns over the European debt crisis have never really gone away, fears have arisen once again this year, as Spain and Italy seem determined to go down the same road to insolvency that Greece has been on since the second quarter of 2010. With the economic recovery in the U.S. seeming to have stalled of late, China seeing signs of slowing growth in its own economy, and the European Union on the brink of falling apart (even with the positive results that were reported in the Greek elections over the weekend), it is getting harder and harder to see a clear path for stronger market returns in the back half of 2012.

It should come as no surprise then to note that the majority of investor inflows this year have been focused on taxable bond funds (based on data provided to us by Morningstar Direct), which investors consider to be "safer" investments, despite the fact that yields remain at historic lows. While the flows through the first two months of the second quarter approached $37 billion ($22 billion in April and $15 billion in May), they were down from the pace that was seen during the first quarter, when the monthly run rate for taxable bond inflows was around $32 billion. That said, the industry is still on pace to see at least $200 billion in net inflows in 2012, making it the fourth straight year of flows of this magnitude into the category. We continue to be confounded by this trend, especially with the yield on 10-year U.S. Treasuries below 1.75%, and the 30-year bond yielding less than 3.0%. At this point, even the S&P 500 Index, which is currently yielding a little over 2.0%, could be viewed as being somewhat more attractive, given that bond prices are going to fall once interest rates start to rise. Finding stocks that are yielding more than the benchmark index, but that operate in stable industries, where there is less uncertainty surrounding their future cash flows, is bound to offer even more downside protection for investors. This probably explains why inflows into actively managed equity-income funds remain at an all-time high even though outflows from actively managed U.S. stock funds overall continue unabated. That said, these funds only have a median 12-month yield (after expenses) of 2.0%, which is not too different from the yield offered by the S&P 500 Index, making individual stocks with good dividend yields a more attractive option for investors. After all, a healthy and safe dividend yield can offer some solace in the midst of market volatility and, relative to fixed income, potentially produce both higher yields and long-term capital appreciation for investors.

Few of Our Ultimate Stock-Pickers Focus Solely on Dividends

With this backdrop in mind, we decided to take a closer look at the dividend-paying stocks our Ultimate Stock-Pickers were holding at the end of the most recent period. As it stands now, only four of the mutual fund managers on our list of top managers-- Amana Trust Income (AMANX),  Columbia Dividend Income (LBSAX),  Oakmark Equity & Income (OAKBX), and  Parnassus Equity Income (PRBLX)--focus on income investing. Of these, the latter two run slightly more concentrated stock portfolios, with Oakmark Equity & Income holding 53 stocks at the end of the first quarter, and Parnassus Equity Income running a portfolio with just 43 holdings. Both funds had around 40% of their stock portfolios invested in their top 10 holdings at the end of the most recent period, compared with 26% for Amana Trust Income and 29% for Columbia Dividend Income. That said, Oakmark Equity & Income appears to focus less on dividend yield than it does on finding firms trading at significant discounts to their true business value, which explains why less than half of its stock holdings (based on the percentage that each stock makes up of the total portfolio) actually yield more than S&P 500 Index right now. This compares to Amana Trust Income and Columbia Dividend Income, both of which have more than 85% of their stock holdings composed of securities yielding more than the benchmark index, and Parnassus Equity Income, where stocks with yields greater than the S&P 500 Index accounted for around 60% of the total equity holdings at the fund.

Looking more closely at the top 10 holdings of each of these funds, Columbia Dividend Income has the most stocks in its top 10 holdings with yields above the benchmark index. Of the nine stocks that had yields in excess of the S&P 500 Index,  AT&T (T),  Verizon (VZ),  Merck (MRK),  Bristol-Myers Squibb (BMY),  Pfizer (PFE), and  Philip Morris International (PM) were all yielding more than 3.0% at the end of last week. Morningstar fund analyst David Kathman notes that managers Dick Dahlberg, Scott Davis, and Mike Barclay like to focus on dividend-paying large-cap stocks, but are not necessarily going for the fattest yield. The managers view consistently growing dividends as a sign of discipline, financial health, and profitability, and once they find a stock they like, the managers tend to hang on to it for a while, such that the annual turnover of their fund has been as low as 20% the past several years. Each of the three other funds held only a handful of stocks in their top 10 holdings that had yields higher than the S&P 500 Index. That said, the four funds did produce at least four names-- ExxonMobil (XOM),  Intel (INTC),  Microsoft (MSFT), and Philip Morris International--that were held in common by two or more of the managers. Of these names, Microsoft remains the most widely held among our top managers, with 16 of our 26 Ultimate Stock-Pickers holding a position in the software giant at the end of the first quarter.

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

 

  Star Rating Moat Size Current Price (USD) Price/ Fair Value T4Q DVD Yield (%) Uncertainty Rating # Funds Holding Vdfn (VOD)* 4 Narrow 27.54 0.89 5.2 Medium 5 Glaxo (GSK)* 3 Wide 45.07 0.92 5.1 Medium 6 CncPhllps (COP) 3 Narrow 55.46 0.96 4.8 Medium 6 Eli Lilly (LLY) 3 Wide 41.99 1.05 4.7 Medium 5 Novartis (NVS)* 5 Wide 53.68 0.78 4.6 Low 8 Merck (MRK) 4 Wide 38.94 0.85 4.2 Medium 6 Unilever * 3 Narrow 32.18 0.92 3.9 Medium 7 Pfizer (PFE) 4 Wide 22.61 0.84 3.7 Medium 8 Sysco (SYY) 4 Wide 29.14 0.81 3.6 Medium 7 J&J (JNJ) 4 Wide 66.01 0.86 3.5 Low 12

Stock Price and Morningstar Rating data as of 06/15/12.
*Dividends for American Depository Receipts (ADRs) can be impacted by changes in currency exchange rates. Our calculations also adjust for special dividends.

While useful information can be gleaned from the top holdings of these four fund managers that specialize in income investing, we feel that we get a much better representation of higher-conviction dividend-paying stocks when sifting through the holdings of all of our Ultimate Stock-Pickers. In order to hone in on the higher-quality names held with a greater degree of conviction by our top managers, we've narrowed our screen down to include only stocks held by at least five of our Ultimate Stock-Pickers, with yields greater than the S&P 500 Index, representing firms with wide or narrow economic moats, and where our stock analysts have an uncertainty rating of either low or medium on their fair value estimate. We think that by focusing on wide- and narrow-moat firms, we should be able to hone in on firms with competitive advantages that can allow them to generate the cash flows they'll need to maintain their dividends longer term. And considering only those firms with low or medium uncertainty ratings means that we are only looking at firms where our analysts have a greater degree of conviction behind their fair value estimates. It should also be noted that our dividend yield calculations are based on regular dividends that have been declared over the last year, and do not include the impact of any special (or supplemental) dividends paid during that time.

Much as we've noted in previous periods, our list of the top 10 dividend-yielding stocks held by our top managers continues to be dominated by health-care stocks, with drug manufacturers accounting for six out of the 10 names listed above. With health-care reform less certain now than it has been in previous periods, the relatively stable free cash flows generated by these firms, which tends not to be impacted as much by economic cycles as other dividend producing stocks (with the exception of utilities), makes them somewhat more attractive to our managers. While there is still some risk to the earnings power of the drug companies, as many are facing patent expirations in the near term, it is unlikely, in the view of our analysts, to result in dividend cuts for the names listed above (although that does not mean that dividend growth won't be stalled as these firms work through a major patent cliff). Believing that the top 10 dividend-yielding stocks held by our top managers warranted more consideration, we've collected commentary from our analysts reflecting their current thinking on the names, as well as thoughts on the dividend prospects for each firm in the near to medium term.

 Vodafone (VOD)

Morningstar analyst Allan Nichols remains pleased with Vodafone's streamlined holdings and its increased focus on shareholder returns. He feels that the firm's disposal of minority positions over the past two years was well-timed in that Vodafone was not only able to receive better prices than are currently available for these assets, but was able to buy back stock, pay a special dividend, and reduce its debt to a level below the European average (which is important, as some of its competitors are now under pressure due to the weight of their balance sheets). The firm was aided in these efforts by the $10 billion special dividend that Verizon Wireless paid in January of the year (of which Vodafone's share was $4.5 billion). Nichols notes that the firm's core European operations generate solid free cash flow to fund its dividend, share repurchases, and acquisitions, while the company's emerging-market operations provide it with some growth opportunities. While Vodafone has committed to increase its dividend 7% annually through fiscal 2013, Nichols notes that absent a dividend commitment from Verizon Wireless (in which Vodafone maintains a 45% stake), it is likely that Vodafone will reduce (and possibly halt) dividend increases beyond that point in time, as it will then be paying out virtually all of its directly generated free cash flow to cover its own dividend. Nichols does, however, remain confident that Vodafone will maintain its dividend in any year that free cash flow is insufficient to cover the projected dividend and distributions from Verizon Wireless fail to make up the difference.

 GlaxoSmithKline (GSK)

While GlaxoSmithKline faces potentially new generic competition to some of its drugs, most notably the respiratory drug Advair, its largest revenue generator, Morningstar analyst Damien Conover believes the firm is in a much better position than many of its peers. He sees management pursuing growth in other areas and believes that initiatives in areas like emerging markets, consumer health, vaccines, and biologics will help to position the company for long-term growth. While he does not envision any large acquisitions in GlaxoSmithKline's future, given the firm's relatively large debt position, Conover sees the potential for the company to make several smaller tuck-in acquisitions in order to increase its exposure to emerging markets. His research indicates the company's product pipeline has improved, though, featuring a lineup of products that includes several drugs focused on orphan indications, which have strong pricing power. And while the threat to GlaxoSmithKline's Advair asthma drug from generic alternatives is a reality, manufacturing challenges and the complexities around generic respiratory drugs may delay and limit the competitive threat. Generally, Conover believes that the company's broad strength across its operations should support slight growth in its dividend over the next few years.

 ConocoPhillips (COP)

Faced with a tightening resource market, ConocoPhillips made significant acquisitions over the past decade to boost reserves and increase production. The ensuing fall in commodity prices made those acquisitions appear poorly timed, though, according to Morningstar analyst Allen Good, who notes that management did change course last year by selling off assets and reducing investment, while moving forward this year with a spin-off of its downstream assets into a separate company,  Phillips 66 (PSX). After the spin-off of its downstream assets, ConocoPhillips ranks as the largest U.S.-based independent E&P company. Despite its somewhat lower growth profile, Good notes that the firm plans to differentiate itself by focusing on shareholder returns, with the expectation being that it will return 20%-25% of cash flow from operations to shareholders each year, primarily though dividends. ConocoPhillips emerged from the spin-off of its downstream assets with a dividend yielding 4.8%, which is unrivaled by any other independent E&P firm. Good does note, though, that given the nature of ConocoPhillips' business, which is heavily influenced by commodity prices, that additional debt issuance could be required to not only support the firm's capital spending efforts, but its dividend as well, in periods when commodity prices fall significantly.

 Eli Lilly (LLY)

Morningstar analyst Damien Conover believes that Eli Lilly faces one of the steepest patent cliffs in the pharmaceutical industry, with more than 40% of its current sales mix encountering generic competition over the next couple of years. While he believes that the drug manufacturer will be able to post flattish top-line growth during the next decade, as the firm's strong late-stage pipeline helps to  offset its  patent losses, this next generation of drugs will be less profitable, leading to a slight decline in margins and earnings power. As such, Conover believes that investors in Eli Lilly, while less likely to see dividend cuts over the near to medium term, are probably not going to see much in the way of dividend increases. That said, significant upside potential does exist for the firm if its pipeline products report strong clinical data. In particular, positive Phase III data on solanezumab could be a game changer not only for the treatment of Alzheimer's, but also for Lilly's prospects. The company has also been serious about improving its bottom line, which should allow it to generate more than $4 billion in annual cash flows from operations during the next several years, allowing Lilly to more than adequately fund its annual dividend and capital expenditures of $2 billion and $1 billion, respectively.

 Novartis (NVS)

Novartis is in front of all of the tailwinds moving the pharmaceutical industry during the next decade, according to Morningstar analyst Damien Conover. He notes that the firm's strategy of targeting unmet medical needs with its drug pipeline should yield several drugs with strong pricing power, and ranks Novartis' pipeline as the best in the industry. Conover expects the company's Sandoz generic division to benefit from patent losses on major blockbuster drugs, as well as the potential for generic biologics, and he feels that Novartis' strong exposure to the fast-growing emerging markets should help propel growth. That said, Conover does note that manufacturing issues in the company's consumer division, as well as an increasingly competitive generics industry, will likely weigh on Novartis' near-term prospects. With regard to the firm's capital structure, Conover notes that the firm still looks a little heavy on the debt side, with a $19 billion net debt position at the end of the first quarter, but that this inflated leverage position still looks highly manageable in comparison with most firms. Over the next several years, he expects the company to use its robust cash flows to pay down debt quickly. By 2013, Conover believes that Novartis will begin to aggressively buy back shares, increase its dividend at a much quicker rate, and start looking for some midsized acquisitions.

 Merck (MRK)

The recurring theme among the drug manufacturers is patent losses, and Merck is no exception. Morningstar analyst Damien Conover notes that despite the Singulair patent loss in 2012, Merck is relatively well-positioned for steady growth during the next five years. Partly based on the Schering-Plough acquisition, Conover sees Merck backing away from its patent cliff with a strong lineup of new products including Victrelis (hepatitis C), Bridion (anesthesia), Saphris (schizophrenia), Simponi (immunology diseases), and Dulera (asthma). He also notes that recently launched drugs Januvia (diabetes) and Isentress (HIV) have already developed into blockbusters and should continue to post steady gains. That said, Conover believes that Merck's pipeline does face one challenge, which is that most of these new drugs will enter markets crowded by good generic drugs. As such, he feels that efforts aimed at cost-cutting will be essential for keeping Merck's free cash flows strong, with the firm's most recent round of cuts eliminating more than $4 billion in annual costs by 2015. Believing that Merck's free cash flows from operations will average close to $12 billion per annum over the next four years, Conover does not expect the company to have any trouble funding its annual dividend of approximately $5 billion along with annual capital expenditures of $2 billion.

 Unilever /(UL)

While Unilever is the third-largest packaged foods firm in the world, operating margins have suffered over the past several years as the company has failed to present a clear global strategy and inefficiently ramped up its product base and overhead. Our analyst Erin Lash believes that Unilever has made significant strides of late to improve the efficiency of its business, though, and that the diversified consumer products firm has just begun to scratch the surface on its potential. By focusing on opportunities in developing and emerging markets years earlier than its peers, Lash notes that Unilever has been able to realize some of the benefits of being a first-mover, generating half its sales from these key growth markets. While the packaged goods firm will face challenges this year, as austerity measures in Europe, a fragile recovery in economies in North America, and evidence of slowing growth in several emerging and developing markets combine to impact consumer demand, she feels that Unilever should still be able to raise its dividend at a midsingle-digit rate annually over the next five years, while also repurchasing about 2% of shares outstanding each year. Lash has also not ruled out the potential for a separation of the firm into its two parts--household/personal care and packaged foods--which they feel would be value-enhancing for Unilever's shareholders.

 Pfizer(PFE)

With several major patent losses (including the loss of exclusivity of Lipitor last year) slowing Pfizer's sales momentum, Morningstar analyst Damien Conover still expects flat revenue growth at the firm over the next several years, believing that the company's 2009 acquisition of Wyeth will help insulate it against any one particular patent loss. Conover also feels that several underappreciated factors, such as expansion into emerging markets and aggressive cost-cutting, should contribute to the firm's long-term potential. Emerging markets are demanding health-care products at an accelerating pace, which could allow sales of Pfizer's blockbuster drugs to increase dramatically, and Pfizer is significantly cutting its cost base as a result of the Wyeth acquisition, less marketing support for drugs losing patent protection, and a structural realignment to reduce R&D spending. Conover also notes that Pfizer's pipeline is developing into one of the best in the industry, setting the foundation for strong long-term growth. Even though the firm's current quarterly dividend of $0.22 per share produces a dividend yield of 3.7%, Conover see the potential for a significant increase in the dividend over the next several years, noting that Pfizer cut its dividend by 50% in 2009 to help fund its purchase of Wyeth.

 Sysco(SYY)

Morningstar analyst Erin Lash believes that concerns about sluggish restaurant traffic and food cost inflation have been overdone and are unjustly weighing on Sysco's shares. She notes that while the firm does derive about two thirds of sales from the restaurant sector, it has expanded into other profitable niche segments, such as health care, education, and lodging. Lash also points out that Sysco's continued emphasis on stringent cost management has allowed it to realize returns that are about 3 times the level of its peers. While operating margins only amount to about 5% of annual revenue, Sysco has been able to generate returns on invested capital (including goodwill) of about 18% on average over the last five years. Lash believes that Sysco's expansive distribution network will enable it to remain the dominant player in the North American foodservice distribution space, generating strong cash flows and outsized returns for shareholders longer term. She feels that the firm's capital structure is appropriate and manageable, and expects the firm to continue to use free cash flows to fund appropriately priced acquisitions, noting that around 70% of Sysco's available market remains highly fragmented. She does, however, believe that the firm can still raise its annual dividend at a high-single-digit rate over the next five years.

 Johnson & Johnson (JNJ)

In contrast to the patent cliff facing the rest of the drug industry, Morningstar analyst Damien Conover notes that Johnson & Johnson has largely passed this hurdle following the loss of patent protection on antipsychotic Risperdal and neuroscience drug Topamax. With only near-term patent losses on anti-infective Levaquin and neuroscience drug Concerta to contend with, he expects Johnson & Johnson's new potential blockbusters to return the company to steady long-term growth. Within this group of new drugs, Conover notes that Xarelto for cardiovascular disease, bapineuzumab for Alzheimer's, and telaprevir for hepatitis C offer the potential to revolutionize treatment. He is also encouraged by the firm's revitalized medical-devices business, which is benefiting from Johnson & Johnson's acquisition of the growing orthopedic company Synthes. With both its drug and device segments poised for steady growth longer term, Conover believes that Johnson & Johnson's dividend payments could see steady increases over the next five years as earnings rise at the health-care firm. That said, he does note that some of the near-term challenges that the company currently faces, especially in its consumer division, could lead to a deceleration in the high-single-digit rate of growth that was seen in the dividend over the past five years.

Disclosure: Greggory Warren owns shares in the following securities mentioned above: Amana Trust Income. 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.

Note: This article has been corrected since original publication. Please click here for details.