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

By Greggory Warren | Senior Stock Analyst

The U.S. equity markets were exceptionally strong during 2013, with the S&P 500 TR Index rising more than 32% to an all-time high (and the benchmark posting its biggest annual gain since the late 1990s). That said, some of the more defensive categories in the index, which have traditionally been the source of higher dividend yields for investors, had a noticeable lag in their performance. The Utilities sector, for example, which has traditionally been the highest yielding sector in the S&P 500, generated a total return of about 13% last year, as investors pushed up the value of less defensive sectors, like Financial Services, Industrials, and Consumer Cyclicals. While not as dire as the underperformance of the Utilities sector, Consumer Defensive stocks also fell short of the performance of the market as a whole, with the sector posting a 26% gain for the year. Even so, the rise in the value of the stock market as a whole has left price/earnings ratios at much higher levels, leaving relatively few bargains out there for investors.

The positive from a dividend perspective, though, has been the fact that dividends continue to rise, in many cases growing faster than per-share earnings. As Josh Peters, director of Equity-Income Strategy, editor of Morningstar's DividendInvestor newsletter, and author of "The Ultimate Dividend Playbook: Income, Insight, and Independence for Today's Investor," pointed out near the end of last year, per-share dividends have risen at a double-digit year-over-year rate in each of the previous 10 quarters through the end of the third quarter of 2013 (when using the trailing-12-months dividend rate of the S&P 500 as a yardstick). Despite this type of growth in per-share dividends, though, the yield on the benchmark index has remained fairly steady at about 2% for much of the past few years, even with the market rising more than 60% off the lows reached at the end of September 2011. The current yield on the S&P 500 is 1.9%.

As of the end of last week, Morningstar's stock coverage universe trading was trading at 1.02 times our analysts' estimates of fair value (for more details, see the Market Fair Value based on Morningstar's Fair Value Estimates for Individual Stocks graph), offering no real margin of safety for investors. In this kind of environment, Peters notes that it is better to buy higher-quality names trading at fair value rather than pursue outlier bargains, stating the following in a recent interview on Morningstar.com:

There are really very few bargains that come to mind right now. But when you're in a market where you don't see a lot of high-quality stocks that are cheap, that essentially sets up a choice. You can buy other things that still look cheap, even though they're not as high quality, or you can pay fair prices for higher-quality names. I very, very strongly encourage people to do the latter.

 

Don't sacrifice your standards in terms of fundamental quality of the business. [Look for] narrow and wide economic moat ratings, good solid dividends that are backed by cash flow on a balance sheet that doesn't have a whole lot of debt, and management teams that are going to support that dividend and actively look to create shareholder value as opposed to just padding their own pay packets. Be willing to pay perhaps a fair price, not over value, but a fair price for that business rather than looking for the outlier bargain even if it happens to pay a dividend because, usually if the stock looks wildly mispriced, the market's picking up on the fact that something is going wrong, and you don't want to be the last person in to what might turn out to be a value trap.

This echoed the thinking of a lot of our Ultimate Stock-Pickers, who as we noted in our last article have focused much of their buying activity of late on higher quality businesses trading at relative discounts to the market, which has often led them to firms with economic moats. With that in mind, we decided to take a closer look at the holdings of our top managers to see if we could not only identify some of the highest-yielding stocks in their portfolios but find holdings where they've been putting more money to work. As you may recall, part of our Ultimate Stock-Pickers process 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 hone 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 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, represent firms with wide or narrow economic moats, and have uncertainty ratings of either low or medium. Then, 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 (which seems to be a growing concern these days). We note that our dividend yield calculations in each of these tables is based on regular dividends that have been declared over the past 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

Company Name Star Rating Size of Moat Current Price (USD) Price/ FVE T4Q DVD Yield (%) Uncertainty Rating # Funds Holding # Funds Buying Philip Mrrs PM 4 Wide 79.23 0.88 4.6 Medium 8 3 Vodafne VOD 3 Narrow 37.2 1.03 4.2 Medium 7 3 ConPhil COP 4 Narrow 66.32 0.88 4.1 Medium 6 - Mattel MAT 4 Narrow 37.07 0.88 3.9 Medium 5 2 Intel INTC 3 Wide 24.57 0.98 3.7 Medium 9 3 Unilever UL 4 Wide 39.24 0.87 3.7 Medium 7 3 Novartis NVS* 3 Wide 81.66 1.02 3.4 Low 8 1 Eli Lilly LLY 3 Wide 58.34 0.99 3.4 Medium 6 4 Cisco CSCO 4 Narrow 21.52 0.83 3.3 Medium 9 3 McDnld's MCD 4 Wide 97.37 0.93 3.2 Low 6 2

Stock Price and Morningstar Rating data as of 03-13-14. *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 the list of the top 10 dividend-yielding stocks held by our top managers was dominated by Health Care stocks, the list has become more balanced over the past few quarters--no doubt improved by the purchase of  Philip Morris International ((PM)) and  Unilever ((UL)), and the sale of stocks like  GlaxoSmithKline ((GSK)) and  Pfizer ((PFE)), as well as differences in the rate of dividend growth among these holdings of our Ultimate Stock-Pickers. There are currently only two Health Care names ( Novartis ((NVS)) and  Eli Lilly ((LLY))) on the list, with five other sectors--Consumer Defensive, Consumer Cyclical, Technology, Energy, and Communication Services--now being represented. While relatively few stocks on the list (not to mention in our entire coverage universe) are trading at meaningful discounts to our analysts' fair value estimates, three names--Philip Morris, Unilever, and Cisco--stand out from the rest. They are not only trading at more than a 10% discount to their Morningstar fair value estimates, but each had three or more of our top managers buying up shares during the most recent period.

Philip Morris was not only purchased by three of our Ultimate Stock-Pickers during the most recent period--it has been one of the highest-conviction purchases of our top managers over the past several quarters. That said, Ronald Canarkis, the manager of  Aston/Montag & Caldwell Growth ((MCGIX)), eliminated his fund's stake in the tobacco firm in January, having noted the following in his quarterly commentary to shareholders at the end of the fourth quarter of 2013:

 We trimmed Philip Morris after the company issued 2014 guidance below expectations due to increased investment behind the company's reduced risk product platform and ongoing uncertainty surrounding pricing in Japan and the Philippines.

Morningstar analyst Tom Mullarkey remains upbeat about the firm, even after Philip Morris posted weak results for the year in early February, noting the following in his earnings note:

 During 2013, Philip Morris International experienced the sting of weakening currencies, the persistent nemesis of the illicit trade, and higher excise taxes in some regions. As a result adjusted EPS grew just 3.4% to $5.40 (excluding currency changes, EPS would have grown 10% to $5.74). During 2014, the weakening emerging market currencies will likely continue to provide a stiff headwind to Philip Morris' financial results. Consequently, the company now expects to experience an unfavorable currency impact of $0.71 per share in 2014, and to earn roughly $5.02-$5.12. This is materially lower than our prior estimate of $5.56. In light of this muted outlook we plan on lowering our fair value estimate to $90 from $93, after reassessing our near-term assumptions for the currency headwinds. Longer term, we believe that the company’s emerging-market exposure and premium brand portfolio should enable the company to increase revenue 5%-6% per year and to increase EPS by 9%. Even with our lower fair value estimate, we believe that the shares are attractively priced and investors can purchase this wide-moat company with a measurable margin of safety.

With the shares currently trading at a 12% discount to Mullarkey's fair value estimate, and the yield on the stock at more than 4% right now, investors should realize a 15% total return over the next year if Philip Morris reaches our fair value estimate.

As for Unilever, we noted earlier in the cycle that two different managers-- FMI Large Cap ((FMIHX)) and  Markel ((MKL))--were putting new money to work in the name, while another-- FPA Crescent ((FPACX))--had made a meaningful increase in its holdings of the packaged goods firm. As was the case then, we've heard relatively little from these managers about their purchases, making it difficult to assess the rationale behind the purchases. That said, we know that Pat English and his team at FMI Large Cap tend to look for strong, durable businesses that are trading at reasonable valuations when putting money to work in their portfolio. While they've traditionally preferred to buy stocks trading at steep discounts to fair value and sell them into strength, current market conditions have made that much more difficult. Valuation ultimately drives their decisions, though, so it was not too surprising to see them stepping into Unilever, which is currently trading at 87% of our analyst's fair value estimate, which when combined with the stock's nearly 4% yield implies a similar return to what investors could have with Philip Morris (assuming that Unilever reaches our analyst's fair value estimate over the course of the next year).

Cisco is another name that has sparked some interest from our top managers over the past several years, part of that grouping of old technology names--including  IBM ((IBM)),  Microsoft ((MSFT)),  Oracle ((ORCL)), and even  Google ((GOOG))--that worked their way into the top holdings of our Ultimate Stock-Pickers in the aftermath of the 2008-09 financial crisis. This time, we saw a meaningful purchase from  Yacktman ((YACKX)), and some additional purchases from  Diamond Hill Large Cap ((DHLAX)) and  Vanguard Primecap ((VPMCX)), offset by a substantial sale at  Hartford Capital Appreciation ((ITHAX)). The transaction at Hartford, while meaningful, is part of an ongoing shift in the management of the fund, as longtime manager Saul Pannell (of subadvisor Wellington Management) moves closer to retirement and Kent Stahl, who oversees Hartford Capital Appreciation II (), a multimanager fund that relies on picks from several Wellington managers (including Pannell), puts his imprint on the fund. However, the stock is trading at the steepest discount to our analyst's fair value estimate which, when combined with its current yield, could lead to a 20% total return over the next year (should Cisco's stock price reach our fair value estimate of $26 per share).

Another name that stood out during the most recent period was  Vodafone Group ((VOD)), much less so for valuation reasons than for the special dividend that investors were set to receive once the European telecom firm sold off its stake in Verizon Wireless (completed at the end of February). Despite distributing about 71% of the proceeds from the deal to shareholders, Morningstar analyst Allan Nichols thinks that Vodafone retains a stronger balance sheet and an increased focus on the operations that it still controls. He notes that the firm generates significant free cash flow, which it is using to increase dividends, make acquisitions, and reinvest back into the business. At 103% of his fair value estimate, though, it is hard to get too excited about the stock, which is currently yielding about 4% (after excluding the impact of the special dividend).

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

Company Name Star Rating Size of Moat Current Price (USD) Price/ FVE T4Q DVD Yield (%) Uncertainty Rating # Funds Holding # Funds Buying Micrsft MSFT 3 Wide 37.89 0.97 2.8 Medium 16 3 WllsFgo WFC 3 Narrow 47.85 1 2.5 Medium 14 4 Wal-Mt WMT 4 Wide 74.93 0.94 2.6 Low 12 4 UPS UPS 3 Wide 97.1 1.06 2.6 Medium 12 3 J&J JNJ 3 Wide 93 0.99 2.8 Low 12 1 P&G PG 4 Wide 79.19 0.89 3 Low 11 5 3M MMM 3 Wide 130.81 1.04 2.1 Low 10 1 Pepsi PEP 4 Wide 81.8 0.93 2.8 Low 9 5 Cisco CSCO 4 Narrow 21.52 0.83 3.3 Medium 9 3 ExnMbl XOM 3 Wide 93.64 0.97 2.7 Low 9 4

Stock Price and Morningstar Rating data as of 03-13-14.

Looking more closely at the top 10 widely held securities that meet our criteria for dividend-paying stocks, we find a larger commitment to Consumer Defensive and Technology stocks than to any other sector of the market. Microsoft 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. While the managers at Hartford Capital Appreciation were the biggest buyers of the name during the period, increasing their stake more than eightfold, we have to wonder (as we did with Cisco) how much of this was related to the ongoing transfer of management responsibilities within the fund. While  Wells Fargo ((WFC)),  Wal-Mart ((WMT)),  Procter & Gamble ((PG)),  PepsiCo ((PEP)), and  Exxon Mobil ((XOM)), all stood out because four or more of our top managers were buying shares during the period, only PepsiCo crossed the threshold into more meaningful buying activity.

The snack food giant garnered increased interest from five of our Ultimate Stock-Pickers during the most recent period, with both Yacktman and  Jensen Quality Growth ((JENSX)) making significant additions to their holdings. While neither fund manager offered up information about these transactions, they coincide with increased interest in the firm on the part of activist investor Nelson Peltz, which Ronald Canarkis at Aston/Montag & Caldwell Growth noted as a reason for investing in the firm back in the third quarter. Morningstar analyst Tom Mullarkey continues to believe that PepsiCo's strong endorsement of its "Power of One" strategy--which the company's board reiterated in a recent response to Peltz's written request to the board that the firm be split into two separate businesses--makes it less likely that the activist investor will get his way. He thinks it's more likely that the snack food giant will move to acquire wide-moat rated  Mondelez International (), which was spun off from narrow-moat rated  Kraft Foods () in 2012. This would add several well-known brands, such as Oreo, Cadbury, Nabisco, Trident, and Tang, to PepsiCo's portfolio. That said, with the stock trading at only a 7% discount to his fair value estimate, and yielding less than 3%, the total return potential is less than what we were seeing from other names on the two lists.

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