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2 Undervalued Stocks With Sturdy Dividends

We think the payouts on these names are sustainable.

Dividend-stock investors have a little more spring in their step this year than they did last year. Indeed, 2020 was a year to forget. For starters, dividend-paying stocks underperformed the broader market in 2020. Worse, as the coronavirus threatened the health of the economy, some companies shored up their liquidity by cutting or suspending their dividends, leaving investors who were relying on that income in a lurch.

This year has been a different story. The economy has bounced back, and dividend cuts are less of a threat these days. But that doesn't mean that all dividends are durable.

"The market's highest yielders are often troubled companies that turn out to be dividend traps," explains Dan Lefkovitz, a strategist for Morningstar's indexes group. "Investors who blindly chase yield can end up sacrificing returns. Dividends aren't guaranteed and their sustainability must be always be gauged."

Moreover, dividends aren't cheap.

"Investors focused on income have been having an increasingly harder time finding new opportunities this year," observes Dave Sekera, Morningstar's U.S. market strategist. "The stock market has been making new highs as earnings growth has been robust, but dividend growth has not been able to keep up with prices. And as such, dividend yields have been falling."

In an effort to find attractively priced companies with defensible dividends, we turn to the Morningstar Dividend Yield Focus Index. A subset of the Morningstar US Market Index (which represents 97% of equity market capitalization), this index tracks the top 75 high-yielding stocks that meet our screening requirements for quality and financial health.

How are the index constituents chosen? For starters, only securities whose dividends are qualified income are included; real estate investment trusts are tossed out. Companies are then screened for quality using the Morningstar Economic Moat and fair value uncertainty ratings. Specifically, companies must earn a moat rating of narrow or wide and an uncertainty rating of low, medium, or high; companies with very high or extreme uncertainty ratings are excluded. We then screen for financial health using our "distance to default" measure, which uses market information and accounting data to determine how likely a firm is to default on its liabilities. The 75 highest-yielding stocks that pass the quality screen are included in the index, and constituents are weighted according to the total dividends paid by the company to investors.

Two of the companies added to the index during its latest reconstitution in June are undervalued according to our metrics today. Here's a little bit about each company. Data is as of July 9, 2021.

Dominion Energy D

Morningstar Rating: ★★★★ Forward Dividend Yield: 3.34%

"Dominion Energy changed its name from Dominion Resources in 2017. More importantly for investors, however, the company has also made a strategic pivot. Since 2010, Dominion has focused on the development of projects with conservative strategies, exited the exploration and production business, sold or retired no-moat merchant energy plants, and made plans for significant investments in moaty utilities infrastructure.

"Dominion has accelerated its capital expenditures and now expects growth investments supporting net-zero carbon emissions to be roughly $72 billion over the next 15 years, including $17 billion for the largest offshore wind farm in the United States. This should support 6.5% annual earnings per share growth, following the earnings decline in 2020 owing to the abandonment of the Atlantic Coast Pipeline and the sale of most of the assets in the gas transmission and storage segment.

"About 90% of earnings will be from regulated electric and gas utilities with constructive state regulation in Virginia, Utah, Ohio, West Virginia, and the Carolinas following the sale of the gas transmission and storage assets. The balance of earnings will come from contracted assets with long-term agreements with mostly investment-grade counterparties.

"Dominion increased its dividend 17 consecutive years before a 33% cut in the fourth quarter of 2020. A dividend increase of 0.8% was declared for first-quarter 2021 and represents a payout ratio of approximately 65% on our 2021 earnings estimate. We believe Dominion's dividend yield and earnings growth outlook could deliver high-single-digit returns through this decade and beyond."

--Charles Fishman, analyst

Lockheed Martin LMT

Morningstar Rating: ★★★★ Forward Dividend Yield: 2.71%

"We view Lockheed Martin as the highest-quality defense prime contractor because of its exposure as the prime contractor on the F-35 program and its missile business. The defense budget and the allocation of the budget is a political process, which is inherently difficult to predict. Therefore, we favor companies with tangible growth profiles through a steady stream of contract wins, ideally contracts that are fulfilled over decades. Thankfully for defense investors, many programs are procured and sustained over decades. For instance, the F-35, which accounts for about 30% of the firm's revenue, will be sustained through 2070. Regulated margins, mature markets, customer-paid research and development, and long-term revenue visibility allow the defense primes to deliver a lot of cash to shareholders, which we view positively because we don't see substantial growth in this industry.

"Defense primes are implicitly a play on the defense budget, which we think is ultimately a function of both a nation's wealth and a nation's perception of danger. The fiscal stimulus used to support the U.S. economy during the COVID-19 pandemic dramatically increased the U.S. debt, and higher debt levels are usually a forward indicator of fiscal austerity. We expect a flattening, rather than declining, budgetary environment as we think that heightened geopolitical tensions between great powers are likely to buoy spending despite a higher debt burden. Despite a slowing macro environment, we think that contractors will be able to continue growing because of sizable backlogs and the national defense strategy's increased focus on modernization, and we think that defense budget growth is likely to return to its long-term trend.

"The three biggest stock-specific growth opportunities we see for Lockheed Martin are F-35 sustainment, a large potential contract for the Future Vertical Lift program, and hypersonic missiles and missile defense programs."

--Burkett Huey, analyst

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

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