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

By Greggory Warren | Senior Stock Analyst

With the U.S. stock market on pace to close out the year with its highest annual return since 2003 (when the S&P 500 TR Index was up 29% for the year), it has gotten increasingly difficult to find reasonably priced stocks. As of the middle of last week, Morningstar's stock coverage universe was trading at 1.01 times our analysts' estimates of fair value (see the Market Fair Value based on Morningstar's Fair Value Estimates for Individual Stocks graph for more details), offering no real margin of safety for investors. And yet, even with the runup in stock prices this past year, the S&P 500 has been enjoying one of the fastest periods of dividend growth on record. According to Josh Peters, director of Equity-Income Strategy and editor of Morningstar's DividendInvestor newsletter, and author of "The Ultimate Dividend Playbook: Income, Insight, and Independence for Today's Investor," per-share dividends have risen at a double-digit year-over-year rate in each of the 10 quarters through the third quarter of 2013 (when using the trailing-12-months dividend rate of the S&P 500 as a yardstick). Although the initial phase of this advance could be best characterized as a recovery from the dividend-cutting spree that took place following the 2008-09 financial crisis, Peters notes that the TTM dividend rate has surpassed its third-quarter 2008 peak by 19%.

Even as we move beyond the initial phase of the U.S. economic recovery, he highlights the fact that dividends are still rising quickly and growing faster than per-share earnings. One recent example of this was  Franklin Resources (BEN), which despite posting a 13% increase in diluted earnings per share for all of fiscal 2013 (which ended in September) raised its quarterly dividend to $0.12 per share, representing a 20% increase over the dividend that was paid in the prior quarter and a 24% increase over the quarterly dividend paid in the year-ago period. Despite this type of growth in per-share dividends, the yield on the S&P 500 has remained fairly steady at around 2% for much of the last few years as the market has risen more than 50% off the lows seen at the end of September 2011. That said, Peters still thinks that the S&P 500's dividend payout ratio has made interesting progress, noting that since the third quarter of 2011, it has moved from an all-time low of 29% to 36% on a GAAP-earnings basis (and from 27% to 34% when looking at adjusted EPS). Excluding results in and around recessionary periods over the last decade or so, this is the highest payout ratio for the S&P 500 since 1999. It is, however, well below the 53% median annual payout ratio that was seen for the S&P 500 between 1946 and 1994 (when the median dividend yield for the market was nearly twice as high as it is today). Peters goes on to note that if the S&P were paying out 53% of TTM GAAP earnings today, the entire index would yield about 3% on a trailing basis; still below historical levels, but reflecting a more-than 40% improvement in total dividend payments from today's levels.

With that in mind, we decided to take a closer look at the holdings of our Ultimate Stock-Pickers to see if we could not only identify the highest-yielding stocks in their portfolios, but also find holdings where they have been putting more money to work. As you may recall, part of our overall process with the Ultimate Stock-Pickers concept involves compiling a list of more than 500 different dividend-paying stocks each time that we run the data for our top managers. We then use this list to home in on those stocks that we think not only have competitive advantages that should allow them to generate the cash flows that they'll need to maintain their dividends longer term, but also be able to do so with far less uncertainty. We accomplish this by screening for holdings that are widely held (by five or more of our top managers), are yielding more than the S&P 500 (currently yielding about 2%), represent firms with wide or narrow economic moats, and have uncertainty ratings of either low or medium.

Once this is done, we create two tables, one reflecting the top 10 dividend-yielding stocks of our Ultimate Stock-Pickers, and the other representing stocks that are paying dividends in excess of the S&P 500 that are also widely held by our top managers. In our view, finding stocks that are yielding more than the benchmark index, but which operate in stable industries, where there is less uncertainty surrounding their future cash flows, should offer some downside protection for investors (a growing concern these days). We would also note that our dividend yield calculations in each of these tables are based on regular dividends that have been declared over the last 12 months, and do not include the impact of any special (or supplemental) dividends that may have been paid out (or declared) during that time.

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

  Star Rating Size of Moat Current Price (USD) Price/ Fair Value T4Q DVD Yield (%) # Funds Holding # Funds Buying GlxoSmthKln GSK 3 Wide 51.29 0.92 4.6 5 - Vodafone VOD 3 Narrow 37.45 1.07 4.2 5 2 Philip Morris PM 3 Wide 85.32 0.92 4.1 9 4 Lilly LLY 3 Wide 49.23 0.9 4 6 2 ConocoPhil COP 3 Narrow 69.48 1.01 3.9 6 1 Intel INTC 3 Wide 24.47 0.98 3.7 9 2 Merck MRK 3 Wide 48.32 0.93 3.6 7 2 Unilever* UN 4 Wide 38.37 0.85 3.5 8 1 Cenovus CVE 5 Narrow 28.09 0.69 3.4 5 - McDonald's MCD 4 Wide 94.1 0.9 3.3 6 3

Stock Price and Morningstar Rating data as of 12-12-13. *Dividends for American Depository Receipts (ADRs) can be affected by changes in currency exchange rates. Our calculations also adjust for special dividends.

Unlike previous periods, when Health Care firms dominated the list of the top 10 dividend-yielding stocks held by our top managers, the list looks to be a bit more balanced this time around. There are three names from the Health Care sector ( GlaxoSmithKline (GSK),  Eli Lilly (LLY), and  Merck (MRK)); two names from the Consumer Defensive sector ( Philip Morris (PM) and  Unilever /(UL)); two names from the Energy sector ( ConocoPhillips (COP) and  Cenovus Energy (CVE)); and one name each representing the Consumer Cyclical, Communication Services, and Technology sectors. Although there are relatively few stocks on the list (not to mention our entire coverage universe) trading at meaningful discounts to our analysts' fair value estimates, two names--Philip Morris and  McDonald's (MCD) --stand out from the rest, as they are not only trading at around a 10% discount right now to their Morningstar fair value estimates, but each of them had three or more of our top managers buying up shares during the most recent period.

Philip Morris was not only purchased by four of our Ultimate Stock-Pickers--it was one of the highest-conviction purchases made by our top managers during the most recent period. Four of the nine Ultimate Stock-Pickers that held the stock at the start of the third quarter were buying shares between the end of June and the end of October. Unfortunately, none of these four managers provided us with much insight into their purchase activity. We did, however, get some insight from Peters, who holds Philip Morris in both the Dividend Builder and Dividend Harvest portfolios, and has been actively buying shares of the company's common stock more recently. In his "This Week in Dividends" commentary during the third week of November, Peters noted the following about Philip Morris, which he considers a buy:

When I see a company with a wide economic moat, an ability to grow earnings even under adverse conditions, a healthy balance sheet and a dividend yield topping 4%, all I need to consider the stock a buy is a long-term EPS and dividend growth outlook of 6%. (That growth rate is what I expect to drive long-term capital appreciation and, with a 4% yield, annual total returns averaging 10%.) Anything above 6% annual growth is gravy, and in most years Philip Morris International PM--currently the only stock held in both our Builder and Harvest portfolios--pours on the gravy with a very large ladle.

 

Clearly, this is not how most investors view the market. Presenting at the Morgan Stanley Global Consumer Conference on Wednesday, Philip Morris disappointed investors with its initial guidance for earnings per share growth in 2014. Continued economic weakness in Europe and additional turbulence in a couple of key markets including Russia and the Philippines is taking a toll on international cigarette volumes. Philip Morris also plans to accelerate development of several next-generation tobacco products, which involves higher costs in the short run. All told, the company sees EPS advancing 6% to 8% next year. Though that's certainly nothing to be ashamed of, it fell short of consensus analyst expectations for 2014 as well as Philip Morris' own long-term, currency-neutral target of 10%-12% annual EPS growth. The shares, which had been rising nicely since our purchase for the Harvest on Oct. 14, slid 2.4% on Wednesday (Nov. 20( and a further 3.0% on Thursday (Nov. 21).

 

I can't help but regard this as a significant overreaction by the market--one worth taking advantage of by investors who are willing to own tobacco stocks and haven't yet added Philip Morris to their portfolios. There is bound to be some lumpiness in the operating performance of any business, even economically defensive ones. Still, I admire Philip Morris' willingness to continue investing for future growth, even if doing so might hurt short-term profitability. Additionally, management reiterated its long-term growth outlook, which if it persists much beyond the next five years would make the stock look very cheap at current prices.

While there are definitely some stigmas attached to owning tobacco-related stocks, Morningstar analyst Tom Mullarkey makes a compelling case for Philip Morris, noting that the firm is a cash-generating machine that has returned more than $45 billion to shareholders in the form of dividend payments and common stock repurchases since being spun off from  Altria (MO) in March 2008. He goes on to point out that the company's wide economic moat, which is fortified by a bevy of powerful brands, a global manufacturing and distribution system, and an addictive product set, should allow the firm to continue to generate industry-leading operating margins and returns on invested capital for some time to come. Mullarkey notes that company competes in 180 countries, controlling about 29% of the global market for tobacco products (when excluding the U.S. and China), and owns the international rights to Marlboro, the iconic global cigarette brand. While he recognizes the fact that excise tax increases, additional regulation, and/or reduced consumer demand could negatively affect cigarette volumes in the future, he thinks that the competitive advantages that the firm possesses will continue to keep it head and shoulders above the competition.

As for McDonald's, the firm was a new-money purchase for the managers at  Hartford Capital Appreciation (ITHAX); a meaningful addition for Bill Nygren and Kevin Grant at  Oakmark (OAKMX), which increased its stake in the fast-food giant by about one third during the period; and a somewhat smaller addition for the managers of the  Columbia Dividend Income (LBSAX) fund. Also of note was the fact that the managers of the investment portfolio at  Alleghany eliminated its stake in McDonald's during the third quarter, a period when the stock lost 4% of its value (in comparison with a 4% increase in the S&P 500). Much of this activity seems to have stemmed from the firm's release of second-quarter earnings, which were once again weighed down by a challenging consumer spending picture and a shrinking informal eating out market. Unfortunately, none of the four managers buying shares provided us with insight into their trading activity during the most recent period, so we have to look to more recent comments from Morningstar analyst R.J. Hottovy, who believes that McDonald's will eventually work its way through what has been an increasingly challenging operating environment for restaurant operators.

Having attended the company's 2013 analyst day last month, Hottovy now has a better appreciation for the actions that management plans to take to better counter the cyclical and competitive headwinds that it has been facing, while also laying the foundation for more consistent long-term growth. Although he notes that the company set the bar low for next year--expecting "muted top-line growth and ongoing cost pressures" in 2014--he thought that there was a palatable sense of excitement across the company about its longer-term product innovation pipeline, enhanced value platforms, individualized customer engagement tactics, and modernization plans. While Hottovy does acknowledge that it will take time to reposition McDonald's to better compete in a rapidly evolving restaurant environment, he thinks that the firm's wide economic moat rating remains fully intact, and expects management to be able to enhance its brand reach while still maintaining industry-leading margins. Despite the fact that 2014 is expected to be an investment year for the firm, with McDonald's likely to spend $3 billion on store openings, reimaging its brand, and technology investments, it is unlikely, in Hottovy's view, to affect the dividend. In fact, he notes that management balanced its discussions about growth and capacity initiatives at the analyst day meeting with talk about returning value to shareholders, highlighting the firm's plan to return somewhere between $4.5 billion and $5.5 billion to shareholders during 2013.

Widely Held Dividend-Paying Stocks of Our Ultimate Stock-Pickers

  Star Rating Size of Moat Current Price (USD) Price/ Fair Value T4Q DVD Yield (%) # Funds Holding # Funds Buying Microsoft MSFT 3 Wide 37.22 0.98 2.7 16 5 Wells Fargo WFC 3 Narrow 43.5 0.95 2.5 14 4 Wal-Mart WMT 3 Wide 78.5 0.98 2.4 13 5 J&J JNJ 3 Wide 91.16 1.01 2.8 12 1 UPS UPS 2 Wide 100.95 1.1 2.5 12 3 P&G PG 3 Wide 82.3 0.95 2.8 11 3 3M MMM 2 Wide 126.58 1.05 2 10 1 Philip Morris PM 3 Wide 85.32 0.92 4.1 9 4 Intel INTC 3 Wide 24.47 0.98 3.7 9 2 Cisco CSCO 4 Narrow 20.51 0.79 3.2 9 2

Stock Price and Morningstar Rating data as of 12-12-13. *Dividends for American Depository Receipts (ADRs) can be affected by changes in currency exchange rates. Our calculations also adjust for special dividends.

Looking more closely at the top 10 widely held securities that meet our criteria for dividend paying stocks, we find a larger commitment to Technology and Consumer Defensive stocks than to any other sector of the market.  Microsoft (MSFT) has been a perennial top 10 conviction holding for our Ultimate Stock-Pickers over the past five years, and continued to see additional buying activity during the most recent period, with the managers at  FPA Crescent (FPACX) increasing their stake by close to 30%. Meanwhile,  Intel (INTC) saw a little less buying activity, with just two of our top managers dedicating additional capital to the name, and  Cisco (CSCO) generated a similar level of interest. Of note with Cisco, though, was the fact that we saw some selling by a few of our top managers during the period, no doubt in response to some of the weaker growth the firm has been generating recently.

In the wake of the company's analyst day this week, Morningstar analyst Grady Burkett has noted that he no longer thinks that Cisco's competitive advantages will last as long as he previously believed they would, with the ongoing commodification of data networking equipment and increasing customer concentration leading him to reduce his economic moat rating on the firm from Wide to Narrow. That said, Burkett still expects the company's stock to outperform the broader market over the next 12-18 months, as his $26 per share fair value estimate already incorporates very low growth expectations. He sees a firm that is currently out-executing its traditional competitors, with no evidence of a material deterioration of market share in Cisco’s core businesses over the past year, and believes that management is investing appropriately given the long-run challenges that it faces. Burkett also thinks that the board’s capital allocation policy of returning 50% of free cash flow to investors represents a good balance for the firm, and expects Cisco to raise its dividend within the next four months.

As for the Consumer Defensive names, we've already talked extensively about Philip Morris, which was purchased by four of our top managers during the most recent period, leaving us to delve more deeply into  Wal-Mart (WMT) and  Procter & Gamble (PG). Much like Microsoft, Wal-Mart has been a perennial top 10 conviction holding for our Ultimate Stock-Pickers over the last five years, and continued to see additional buying activity during the most recent period, with the managers at Hartford Capital Appreciation making a new-money purchase in the name, and the managers of the investment portfolio at Alleghany making a significant addition to what had been a relatively small stake in the retail giant. While the company's dividend yield of remains above that for the broader index, our analysts note that the firm has the ability to increase its dividend payout ratio, but seems to be more focused on returning cash to shareholders through stock repurchases these days. As for Procter & Gamble, the firm is another perennial top 10 conviction for our Ultimate Stock-Pickers, who continue to show interest in adding to the name. Morningstar analyst Erin Lash expects the dividend to remain a priority for the firm (which has paid a dividend to its shareholders consistently for more than 120 years), and is currently forecasting mid- to high-single-digit annual dividend increases during the next 10 years.

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Disclosure: Greggory Warren own shares of the following securities mentioned above: Philip Morris International, Altria Group, and Procter & Gamble. 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.