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3 Cheap Dividend Payers From Our Ultimate Stock Pickers

Our roster of top managers is finding value in these higher-yielding stocks.

By Burkett Huey | Associate Equity Analyst

Most of our

have never been mistaken for dividend investors. That said, a handful of them--

Warren Buffett at

As you may recall from our previous dividend-themed articles, when we screen for top dividend-paying stocks among the holdings of our Ultimate Stock-Pickers we try to home in on the highest-quality names that are currently held with conviction by our top managers. We do this by taking an initial list of the dividend-paying stocks held in the portfolios of our Ultimate Stock-Pickers and then narrow it down by concentrating on firms that we believe have competitive advantages, which, in our view, should allow them to generate the excess returns they'll need to maintain their dividends longer term.

We also look for firms where there is less analyst uncertainty regarding the company's future cash flows. We accomplish all of the above goals by screening for holdings that are widely held (by five or more of our top managers), are yielding more than the S&P 500, were granted a wide or narrow economic moat from our analysts, and have uncertainty ratings of either low or medium.

Once our filtering process is complete, we create two different tables--one that reflects the top 10 stocks with the highest dividend yields, and a second table which represents the stocks that are widely held by our top managers and pay dividends in excess of the S&P 500. In our view, finding high yielding stocks that operate in more stable industries where there is less uncertainty surrounding their future cash flows should offer some downside protection for investors.

With markets currently at all-time highs and interest rates remaining at lower-than-normal levels, many investors are left searching for yield wherever they can find it. We should note, though, that the dividend yield calculations in each of these two tables are based on regular dividends that have been declared during 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.

Comparing this quarter's top dividend yielding stocks to last quarter's, we notice that wide-moat

One continuing trend is that the dividend-seeking Ultimate Stock-Pickers continue to invest in high-quality companies that fit well within Morningstar's moat framework, as all but one of the top 10 dividend yielding stocks have been granted a wide moat by Morningstar's analysts, with Kimberly-Clark being the narrow-moat exception.

Turning to sector allocation, the focus continues to be on the consumer defensive sector, which represents 60% of our top 10 dividend yielding stocks, and the healthcare sector, which accounts for 30% of the same list. Industrials continues to be represented in last spot by

Although interest rates have started to rise, the price of money has been persistently lower in this economic cycle than it has been in the past, so income-seeking investors may struggle to find safe, income-producing bonds that can produce sufficient return. Given this environment, some income-seeking investors have looked to dividend-producing equities in search of yield. Although many of the Ultimate Stock-Pickers are worried about rising valuations and interest rates, the over 9.5% year-to-date total return on the S&P 500 index shows that in aggregate, investors continue to shrug off such concerns and are still allocating new money to equities.

Consequently, several sectors that have traditionally been associated with yield and safety--like utilities and consumer defensive--continue to be bid up in the process. Searching for yield in this type of environment can be fraught with risks, including everything from price risk eroding total return or the risk that a firm cannot meet its commitment to its dividend. In an effort to offset some of these risks, we eliminate stocks with higher uncertainty ratings during our screening process.

Morningstar's analysis has found several stocks that look attractive at current valuations, as we see that three of our top 10 dividend-yielding names are trading below 95% of our analysts' fair value estimates, and there are three additional names trading at 90% or below our analysts' fair value estimates.

With that in mind, we expect to focus on the names that provide both a solid yield and a more favorable price to fair value ratio.

Looking more closely at the list of top 10 widely held securities that met our criteria for dividend-paying stocks this time around, there was some overlap with our list of top 10 dividend-yielding stocks, as wide-moat

With valuation and safety being a top concern for investors, especially with markets again at all-time highs, we continue to believe that the best way for investors to generate capital is to invest in quality businesses trading at a reasonable discount to their intrinsic value. As such, we focus on names whose business prospects have a lower uncertainty, along with defensible economic moats, and that are currently the most undervalued relative to their intrinsic value. We think these names are more likely to offer investors both the yield they are looking for and are currently trading at prices that provide a reasonable margin of safety.

Philip Morris International Inc PM

Dividend Yield:

5.5%

Price/Fair Value:

0.76

Wide-moat rated Philip Morris International was the top dividend yielding stock for the period, which is understandable given the name's juicy 5.5% current dividend yield. The stock currently trades at a 22% discount to Morningstar analyst Philip Gorham's fair value estimate. The Ultimate Stock-Pickers at Oakmark Equity and Income appear to agree with Gorham's assessment and recently made a conviction purchase to increase their position. Gorham attributes the significant outperformance of Philip Morris International in 2017, and its subsequent underperformance this year, to the growth and recent stagnation of heated tobacco. He notes that Philip Morris International's heated tobacco product, iQOS, gained substantial market share in Japan, up to around 20% in 2017, but abruptly stabilized in 2018, which prompted the recent sell-off.

Gorham asserts that the strongest tobacco companies are the ones who are most able to slow the long-term decline in tobacco product consumption rates. His analysis shows that heated tobacco is the category most likely to become a long-term mainstream alternative to traditional smoking, and that Philip Morris is well positioned to reap benefits from this product mix shift. Although the combustible business still represented 93% of Philip Morris' volume in the fourth quarter of 2017, recent volume numbers show volume declines of about 4%, so tobacco companies are eager to find alternative tobacco products. Of all the alternative tobacco incarnations, Gorham thinks that heated tobacco products most closely replicate the traditional smoking experience and therefore should attract smokers looking for a less risky alternative. Furthermore, the competitive advantages in the combustible business that give Philip Morris International such a wide economic moat, including brand loyalty, pricing power, cost advantage inherent in its vast tobacco leaf procurement, and regulatory barriers to entry, are all transferable to some degree to heated tobacco.

Gorham's overarching assumption relating to reduced-risk products in his base-case valuation is that the company's heated tobacco product, iQOS, replicates the current margins of the premium cigarette business. Gorham thinks that strong pricing growth of 4%-5%, mitigated by low-single-digit volume declines, will result in an organic revenue growth rate of 3%. One factor to consider is new regulation on reduced risk products. Gorham expects that margins will depend heavily on the level of taxation, which is still an unknown factor at this early stage. Explicitly commenting on the dividend, Gorham foresees the firm increasing the dividend at a mid-single-digit rate, in line with earnings per share growth and a slowdown from its recent double-digit growth rate.

Although Gorham thinks that Philip Morris International is a strong company with the capacity to deliver price appreciation as well as dividend growth, he recognizes the inherent risks in the company. Recent economic volatility has shown that tobacco manufacturers have been able to maintain pricing power during a macroeconomic shock, so the major risk is government intervention in the market. Gorham recommends that any investor owning tobacco stocks should have the stomach for fat-tail risk. For instance, the threat of government intervention through considerable excise tax increases is omnipresent. Second, plain packaging requirements have the capacity to materially diminish Philip Morris' brand assets, and consequently, its pricing power.

Procter & Gamble Co PG Dividend Yield:

3.4%

Price/Fair Value:

0.86

Wide-moat rated Procter & Gamble appeared on both of our top 10 lists for the second period running. The stock currently trades at a 14% discount to Morningstar analyst Erin Lash's fair value estimate, after appreciating from the last time Procter & Gamble was covered in this series, although Lash shaved an immaterial $1 off the fair value estimate since our last reporting on this stock. During second quarter of 2018, one Ultimate Stock-Picker,

Although there is fierce competition in the consumer goods space, Lash remains confident that Procter & Gamble can earn an economic profit for at least the next 20 years. The sources of this company's sustainable competitive advantage are the company's brand assets and cost advantage. The company's massive marketing and R&D investments continue to bring new, well marketed, products in front of consumers. As Procter & Gamble has around a quarter of the baby care, feminine protection, and fabric care market, and over half of the market share for razors and blades market share, Lash posits that the company's massive scale allows it to maintain valuable relationships with the retailers who distribute its goods. Retailers often give larger operators, such as Procter & Gamble, an advantaged shelf-space position in exchange for its local and category-level data. Lash also argues that Procter & Gamble's gargantuan size gives it negotiating leverage with the end retailer. Further, Procter & Gamble's massive scale also allows it to sell at a lower unit cost than competitors, which gives it a cost advantage.

Lash's valuation thesis is that the market is not appreciating Procter & Gamble's ability to drive sales growth, which, when coupled with firm's capacity to drive margin expansion, paints an attractive investment picture. Lash's analysis shows that the company's focus on 65 core brands will lead to increasing sales and volume growth because the remaining brands are the firm’s best opportunities. Lash thinks a trimmed portfolio allows the company to better focus its personnel and financial resources on the highest-return opportunities. She recognizes that these 65 products already accounted for most of the firm's top line and bottom line, and as such, doesn't think that slimming down the product portfolio will detract from the firm's scale and negotiating leverage. Separately, Procter & Gamble is working on a $10 billion cost savings initiative, which Lash expects will be deployed partially for R&D and advertising and will partially be used to expand the company's operating margin, which she forecasts will grow to around 25% by 2028, material growth from fiscal-year 2018's 21.6%. From a valuation perspective, Lash sees a strong business with top-line growth and margin expansion, which combines with a 3.4% current dividend yield to provide investors with a reasonable margin of safety to purchase this wide-moat name.

Although Lash thinks Procter & Gamble has built a sound economic moat and is trading at a reasonable discount to its intrinsic value, she recognizes that there are risks to potential investors in the company. Given the lackluster growth in consumer spending, many companies in the industry (including Procter & Gamble) have tried a strategy of offering promotions for products, which Lash contends carries the risks that customers would come to expect lower prices or would refuse to pay more for newer and higher-priced products. Further, Procter & Gamble faces the risk that expected sales growth will not materialize, particularly in the company's grooming arm, though Lash notes that the grooming arm is reinvigorating on a sound strategic path to rebut the pressures resulting from lower-price upstarts by recalibrating its pricing, investing in on-trend new products, and launching its own subscription-based sales model.

Unilever UN

Dividend Yield:

3.2%

Price/Fair Value:

0.94

The European consumer goods giant, Unilever, is a low uncertainty, undervalued wide-moat rated company that is currently offering a 3.6% yield. The company trades at a 6% discount to Morningstar analyst Philip Gorham's fair value estimate. This name received some conflicting attention from our Ultimate Stock-Pickers during the second quarter, as Ultimate Stock-Picker

To Gorham, the law of large numbers demonstrates the major problem for consumer goods companies' top-line growth. One of the problems that Gorham points out is Unilever's EUR 53 billion in revenue cannot easily grow in the developed countries due to lower GDP and population growth than in previous economic cycles, particularly when local and artisanal goods are in favor with consumers. To combat this headwind, the company is focusing on using its global brands in emerging markets. Recent financial results demonstrate that this strategy is paying off somewhat, as the Asia/Africa, Middle East, and Turkey/Russia, Ukraine, and Belarus segment generated 6.3% sales growth due to growth in the volume of products sold, which easily outpaces the company's total 1.9% global sales growth. Further, the company is taking steps to rapidly act on local opportunities by using its country category business team structure that empowers local managers to quickly deliver products to market. Although the company faces some structural headwinds from the challenging consumer goods sector, Gorham posits that the market is not fully appreciating that Unilever has a better chance than most of its peer group of reigniting growth in the medium term.

Gorham notes that Unilever has demonstrated a strong capacity for returning capital to shareholders. He recognizes Unilever's relatively strong dividend policy and notes that the company's over 60% payout policy is somewhat higher than other large peers. The company does not only deliver returns in the form of dividends, as Unilever recently announced that it authorized a EUR 5 billion buyback.

Finally, although the current valuations make this low-uncertainty name appear to be an attractive investment, there are material risks with this company. First, although Unilever sells defensive products, it is still exposed to the macro economy, and steep declines could challenge the company's ability to grow volume, price, and mix. Second, Unilever has been particularly acquisitive lately, as it has recently bought up Dollar Shave Club for $1 billion, as well as several beauty products. These acquisitions have generally been paid for with asset sales. Gorham cautions potential investors that Unilever's strategy of portfolio-tweaking through M&A comes with the material risk that management could overpay for targets or not realize fair value for the assets being sold.

Disclosure: Burkett Huey has no ownership interest in any of the securities mentioned here. Eric Compton has no ownership interest in any of the securities mentioned here. 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.

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