The Ultimate Stock-Pickers’ Top 10 Dividend Stocks

By Greggory Warren | Senior Stock Analyst

Despite stumbling a bit in July, the U.S. equity markets (as represented by the S&P 500 TR Index) rebounded in August, leaving them up 9% on a year-to-date basis at the end of last week. The markets as a whole continue to look modestly overvalued, though, with Morningstar's stock coverage universe trading at 1.03 times our analysts' estimates of fair value coming into this week. As we've noted in past articles, the case can be made for stock market gains from this point forward. During the past decade or so, our universe of covered stocks has continued to increase in two separate calendar years after the S&P 500 rose more than 25% during the preceding year (as it did during 2014). In 2010, the market increased 15% after gaining more than 26% the preceding year, with Morningstar's stock coverage universe peaking at about 1.10 times our analyst's fair value estimates during 2009. It could be argued that the 2010 gain was nothing more than the S&P 500 climbing out from the depths of its decline during the 2008-09 bear market, but we saw the same thing happen during 2004. Coming off of a nearly 29% gain in 2003, the market increased almost 11% that year, with Morningstar's stock coverage universe approaching 1.15 times our analysts' fair value estimates near the end of 2004.

Based on these two examples, we started out 2014 believing that a 7%-12% gain in the value of the S&P 500 this year was within of the realm of possibilities. Even with the gains we've seen so far this year in the U.S. equity markets, the possibility remains that stocks could move higher if we assume a peak of 1.10-1.15 times our analysts' fair value estimates in the near term. That said, the road ahead may be a bit more difficult given the more recent increase in geopolitical risks--from the crisis in Ukraine to the growing threat posed by the ISIS terrorist organization--as well as the expected removal of liquidity as the Federal Reserve winds down its bond-purchasing program (the expectation is that the government's multiyear effort to shore up the U.S. economy will end next month).

While the general view is that rising interest rates are a negative for stocks--and for dividend-paying stocks in particular--our Utilities team recently collected some interesting statistics on the impact that rising and falling interest rates have on stocks. Looking back over the past 20 years, our analysts found that (as of the end of June 2014) utilities have consistently produced 8%-9% annual total returns during two-year holding periods regardless of how interest rates moved. During those periods when interest rates fell--our analysts note that there have been 18 periods in the past 20 years when average monthly interest rates have fallen more than 40% during a two-year span--the average annualized return for utilities was 10.9% (compared with 7.7% for the S&P 500), with absolute returns being negative in only two periods. The sector actually produced better absolute two-year returns when interest rates were rising--our analysts noted that during the 10 periods in the past 20 years when average monthly interest rates rose more than 30% during a two-year span, the average annualized return for utilities was 11.8% (compared with 21.9% for the S&P 500), with absolute returns being positive in every period.

The key takeaway from this research is that while the sector's relative performance varies, utilities have consistently produced positive absolute returns regardless of whether interest rates were rising or falling. While there is no guarantee that this trend will continue, our Utilities team thinks that investors would be well served to maintain their exposure to the sector, focusing on high-quality names like  ITC Holdings ,  Edison International (EIX),  Atmos Energy (ATO),  Dominion (D), and  Public Service Enterprise Group (PEG). They also think that there is a unique mixture of value and quality in  Southern Company (SO),  Exelon (EXC), and  Calpine , believing that the three would make a compelling stand-alone portfolio, given their diverse characteristics.

Our Ultimate Stock-Pickers have never been big investors in utilities, with the sector accounting for 0.6% of their aggregate holdings at the end of June 2014 (compared with 3.1% for the S&P 500). No single utilities stock was held by more than one of our top managers, most of whom do not even hold a stock from the sector in their portfolios. Of the four Ultimate Stock-Pickers that focus more heavily on income investing-- Amana Trust Income (AMANX),  Columbia Dividend Income (LBSAX),  Oakmark Equity & Income (OAKBX), and  Parnassus Equity Income (PRBLX)--the managers at Columbia have made the largest commitment to utilities stocks, with holdings in  American Electric Power (AEP),  Sempra Energy (SRE),  NextEra Energy (NEE), Dominion,  CMS Energy (CMS),  Northeast Utilities (NU),  Wisconsin Energy (WEC), and  Duke Energy (DUK) at the end of the second quarter. That said, these four income-oriented managers are not the only source for dividend-paying stocks among our Ultimate Stock-Pickers. In fact, we believe that we get a much better representation of higher-conviction dividend-paying stocks when sifting through the holdings of all of our top managers.

In order to hone in on the highest-quality names that are held with a greater degree of conviction by our top managers, we put together a list of more than 500 different dividend-paying stocks each time that we run the data for our Ultimate Stock-Pickers. We then focus on firms that we believe not only have competitive advantages that should allow them to generate the cash flows 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. 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 (which seems to be a growing concern these days). We 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

Company Name Ticker Star Rating Size of Moat Current Price (USD) Price/ FVE T4Q DVD Yield (%) Uncertainty Rating # Funds Holding # Funds Buying Vodafone* VOD 3 Narrow 33.03 0.89 5.5 Medium 6 4 Philip Morris PM 4 Wide 84.02 0.93 4.5 Low 7 1 ConocoPhillips COP 3 Narrow 78.45 1.05 3.6 Medium 6 - McDonald's MCD 3 Wide 93.34 0.95 3.5 Medium 5 1 Pfizer PFE 3 Wide 29.43 0.98 3.5 Medium 5 1 Unilever* UL 3 Wide 43.75 0.95 3.5 Medium 9 1 GE GE 3 Wide 25.87 0.89 3.4 Medium 5 1 Sanofi* SNY 4 Wide 56.43 0.88 3.3 Medium 5 3 Roche* RHHBY 3 Wide 36.7 1.05 3 Low 5 - Eli Lilly LLY 3 Wide 65.27 1.11 3 Medium 5 3

*Dividends for American Depository Receipts can be affected by changes in currency exchange rates. Our calculations also adjust for special dividends. Stock price and Morningstar Rating data as of 09-12-14.

There have been some changes in the list of top 10 dividend-yielding stocks of our Ultimate Stock-Pickers since our last report, with  Mattel (MAT),  Intel (INTC),  Novartis (NVS), and  Cisco (CSCO) making way for  Pfizer (PFE),  General Electric (GE),  Sanofi (SNY), and Roche (RHHBY), but the yields remain fairly comparable, even though the market has risen some 7% during the past six months. The list itself also remains fairly balanced, even with Health Care stocks--Pfizer, Sanofi, Roche, and  Eli Lilly (LLY)--accounting for four of the 10 top dividend-yielding stocks, and four other sectors continuing to be represented--Communication Services, Consumer Defensive, Energy, and Consumer Cyclical. We noted the heavier buying activity of shares of  Vodafone (VOD), Sanofi, and Eli Lilly, none of which made out list of top 10 high-conviction purchases; although Sanofi made our list of top 25 purchases (Eli Lilly did not fall too far off of the expanded list of high-conviction purchases). Vodafone would have stood out more had we not seen outright sales by two of our top managers--Amana Trust Income and  Dodge & Cox Stock (DODGX)--neither of which offered up commentary about the transactions.

Looking more closely at the top 10 widely held securities that meet our criteria for dividend-paying stocks (which has traditionally had very little overlap with our list of our Ultimate Stock-Pickers' top 10 dividend-yielding stocks), we see a much larger commitment to Consumer Defensive names-- Wal-Mart (WMT),  Procter & Gamble (PG),  PepsiCo (PEP), and  Unilever (UL)--that have traditionally offered higher yields than other stocks and have tended to maintain greater levels of price stability during down markets. Old school Technology stocks like  Microsoft (MSFT) and Cisco continue to be widely held as well, with Microsoft in particular being a perennial top 10 high-conviction holdings for our Ultimate Stock-Pickers during the last five-plus years. As for Health Care names, we see  Johnson & Johnson (JNJ) and Novartis making the list, with  Wells Fargo (WFC) representing the Financial Services sector and  United Parcel Service (UPS) making a showing for the Industrials sector. While Microsoft, Wal-Mart, Procter & Gamble, and PepsiCo all stood out because four or more of our top managers were buying shares during the most recent period, only PepsiCo crossed the threshold into more meaningful buying activity--something that we highlighted in our last article.

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

Company Name Ticker Star Rating Size of Moat Current Price (USD) Price/ FVE T4Q DVD Yield (%) Uncertainty Rating # Funds Holding # Funds Buying Microsoft MSFT 3 Wide 46.7 1.02 2.4 Medium 16 4 Wells Fargo WFC 3 Narrow 51.71 1.03 2.5 Medium 15 3 J&J JNJ 2 Wide 104.6 1.06 2.6 Low 12 1 Wal-Mart WMT 3 Wide 75.77 0.95 2.5 Low 12 4 P&G PG 4 Wide 83.26 0.9 3 Low 11 4 PepsiCo PEP 3 Wide 90.87 1.02 2.7 Low 11 4 UPS UPS 3 Wide 98.05 1.03 2.7 Medium 10 1 Unilever* UL 3 Wide 43.75 0.95 3.5 Medium 9 1 Cisco CSCO 3 Narrow 25.16 0.97 2.9 Medium 9 1 Novartis* NVS 3 Wide 93.76 1.03 2.9 Low 9 2

*Dividends for American Depository Receipts can be affected by changes in currency exchange rates. Our calculations also adjust for special dividends. Stock price and Morningstar Rating data as of 09-12-14.

To add an interesting twist to our normal coverage of our Ultimate Stock-Pickers' top dividend-paying stocks, we looked to Josh Peters--director of Equity-Income Strategy at Morningstar, responsible for our monthly DividendInvestor newsletter, and the author of "The Ultimate Dividend Playbook: Income, Insight, and Independence for Today's Investor"--for additional insight into these names. In the last two editions of Morningstar DividendInvestor, Peters has taken a deeper look at some of his core holdings, believing that it is important for investors to "know what you own and why you own it." In particular, he has delved deeper into names he considers to be core holdings, along with those designated as supporting players. Peters considers his core holdings to be stocks that not only meet his basic investment criteria, but ones where the businesses that they represent inspire an unusually strong level of confidence in the safety and growth of future dividend payments; supporting players fall somewhere below this level of confidence. He notes that this separation of his current holdings into two camps is based more on qualitative factors than quantitative ones, with no bright line existing to separate his core holdings from the supporting players.

Cross-referencing Peters' holdings against our two lists of Ultimate Stock-Pickers' top dividend-paying stocks, we were able to pull the following comments from him about a handful of our top managers' holdings, ranking them by their current dividend yield (from highest to lowest):

Philip Morris International

Ticker: PM

Current Yield: 4.5%

Price/Fair Value: 0.93

Status: Core Holding

Likes: As the dominant cigarette maker almost everywhere except the U.S. and China, Philip Morris owns seven of the world's top 15 brands and garners premium prices. Global scale adds to profit margins (as do the industry characteristics discussed earlier for Altria).

Concerns: Global cigarette consumption is tipping into decline. Plain packaging rules could threaten the pricing power of premium brands. The company has been slow to offer alternative tobacco products, and now heavy spending weighs on profits. Currency is frequently a headwind--a particularly fierce one at the moment--as 100% of profits are earned outside the U.S.

McDonald's

Ticker: MCD

Current Yield: 3.5%

Price/Fair Value: 0.95

Status: Supporting Player

Likes: The balance sheet is clean (the company hasn't yet succumbed to financial engineering), free cash flow remains strong, and the cost advantages that arise from McDonald's massive size are fairly secure. So is a dividend yield that is now well above average.

Concerns: The firm faces a difficult year of rebuilding trust in China after a food safety scare, but management seems clueless on how to revitalize sales in the U.S. The proliferation of fast-casual concepts like Chipotle CMG has fragmented the market and could be shrinking McDonalds' wide economic moat. Predictable mediocrity isn't the selling point it once was.

Unilever

Ticker: UL

Current Yield: 3.5%

Price/Fair Value: 0.95

Status: Supporting Player

Likes: Vast emerging-markets exposure suggests Unilever can sustain peer-leading volume growth for years, if not decades, to come. Recent acquisitions and divestitures have tightened management's focus and shifted mix in favor of more profitable personal care lines. This strategy has produced balanced volume growth, pricing gains, and profitability enhancements despite considerable macro headwinds.

Concerns: The organization still struggles somewhat with legacy of decentralized operations, hampering efforts to leverage its global scale. Currency and emerging-economy volatility have a major impact on results, recently contributing to an elevated payout ratio (70%) that will limit near-term dividend growth.

General Electric

Ticker: GE

Current Yield: 3.4%

Price/Fair Value: 0.89

Status: Core Holding

Likes: GE's energy, transportation, and health care infrastructure businesses are basic building blocks of the global economy. Its manufacturing prowess is world-class, while add-on services create sticky customers and recurring, recession-resistant revenue. GE Capital, whose troubles forced a dividend cut in 2009, is shrinking back to a core that leverages the opportunities offered by the industrial units. Despite the dividend cut forced by the traumas of early 2009, a strong commitment to big dividends lives on, illustrated by six increases issued since mid-2010.

Concerns: The shrinking financial unit is a near-term structural headwind for earnings growth, and a weak global economy is a cyclical one. Acquisitions create risks of overpayment and/or integration challenges.

Procter & Gamble

Ticker: PG

Current Yield: 3.0%

Price/Fair Value: 0.90

Status: Supporting Player

Likes: Fifty-eight consecutive years of dividend growth is no accident, as P&G has long been the world's dominant supplier of household products. Recent restructuring has freed up resources for internal reinvestment; now management plans to shed 90-100 of its current brands (though only 10% of sales and 5% of profits) to devote more attention to 70-80 core lines.

Concerns: The company hasn't yet hit its stride with a balance between volume gains and price increases; P&G wants some market share back, but not at any cost. Currency has hurt dollar-denominated results and boosted the payout ratio (now 58%, well above historical norms) to a level that will probably restrain dividend growth to the 7% of the past three years.

United Parcel Service

Ticker: UPS

Current Yield: 2.7%

Price/Fair Value: 1.03

Status: Core Holding

Likes: The breadth of its global package delivery network and leading volume produce outstanding returns on investment and free cash flow--especially for such a capital-intensive business. It's well positioned to capitalize on growth in global trade and Internet retailing. Dividends are now a key lever for shareholder returns, not least because UPS retirees own a lot of the stock.

Concerns: Decidedly cyclical with a high proportion of fixed costs; recurring earnings per share fell 44% between 2007 and 2009 (though the dividend held steady and soon rose again). Fresh economic turmoil wouldn't mix well with the stock's premium valuation.

Johnson & Johnson

Ticker: JNJ

Current Yield: 2.6%

Price/Fair Value: 1.06

Status: Core Holding

Likes: The firm's enormous size, geographical diversity, product diversity (pharmaceuticals, medical devices, consumer products), and unquestioned financial strength all join to create one of the safest dividends in the world. Research efforts have lately become more productive, especially in drugs. Growth has slowed over the past decade, but the dividend yield has shifted up to compensate and few patents will expire near-term.

Concerns: Product quality issues a few years back raised concerns about internal discipline. The medical device unit has stagnated. Health-care spending is under pressure around the world, offsetting some of the tailwind from aging populations.

Wells Fargo   

Ticker: WFC

Current Yield: 2.5%

Price/Fair Value: 1.03

Status: Core Holding

Likes: Wells is huge yet surprisingly simple, as if the classic 3-6-3 banking model has been blown up to gargantuan proportions (borrow at 3%, lend at 6%, golf at 3:00). The organization is particularly effective at gathering low-cost deposits and selling multiple financial products to customers. It's also a prudent underwriter of loans, and its exposure to complex and frequently costly investment banking activities is limited. The dividend has come roaring back from the early 2009 cut to reach a new peak this year.

Concerns: The dividend payout ratio will likely remain limited by regulatory scrutiny. This may mean a higher proportion of buybacks, possibly at value-destroying stock prices. Heft rules out domestic acquisitions, so there's some risk that growth may be pursued abroad. Today's environment of ultralow short-term interest rates hurts profitability, but it may last a while longer.

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Disclosure: Greggory Warren own shares of the following securities mentioned above: Philip Morris International 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.