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3 Inexpensive Stocks with Sturdy Dividends

We think the payouts on these undervalued names are sustainable.

Last year wasn't the best for dividend-stock investors. For starters, these stocks underperformed the broader market in 2020.

"The pandemic and the related economic downturn hit many dividend-related sectors very hard, and then as equities rebounded across the world, that bounceback was really led by technology-related businesses that are not so rich in dividends," explains Dan Lefkovitz, a strategist for Morningstar's Indexes group.

Worse, as the novel 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.

"It's really critical to be selective when it comes to buying dividend-paying stocks and chasing yield," says Lefkovitz. "Looking for the most yield-rich areas of the market can often lead you into troubled areas and dividend traps--companies that have a nice looking yield, which are ultimately unsustainable. You have to really screen for dividend durability, sustainability going forward."

Lefkovitz argues that "Distance to Default" is an especially useful health screening tool for dividend payers.

"Distance to Default is a measure of balance-sheet strength," he says. "It gauges the likelihood of bankruptcy. It looks at leverage and volatility and gauges whether the sum of a firm's assets are at risk of falling below its liabilities."

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 U.S. 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--with Distance to Default being one of those measures.

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.

Three of the companies added to the index during its latest reconstitution in December are covered by our analysts and undervalued according to our metrics today. Data is as of Jan. 13, 2021.

McDonald's MCD Forward Dividend Yield: 2.43% Morningstar Rating for Stocks: 4 stars

"The global restaurant sector will continue to see uneven guest traffic trends heading into 2021 amid coronavirus operating restrictions and changes in consumer behavior. Nevertheless, we believe investors should prioritize companies that have the scale to be more aggressive on value; give their customers greater access through robust digital ordering, delivery, and drive-thru capabilities; and have healthy balance sheets (both at the corporate and franchisee level). We believe McDonald's meets these investment criteria.

"We're also encouraged by the three pillars of McDonald's 2020 'Accelerating the Arches' plan, which include (1) optimizing its marketing approach; (2) focusing on its core menu; and (3) doubling-down on digital, drive-thru, and delivery efforts. We've seen signs of progress on each pillar already, including the use of social media to market celebrity meal promotions in the U.S. to offset some of the coronavirus-related comp weakness stemming from lost morning daypart transactions (impacted by the decline in morning commuters). McDonald's 2020-21 core menu plans--including a U.S. launch of a premium crispy chicken sandwich, testing a McPlant burger in some markets, and McCafe bakery additions--should also help to keep near-term comps in the mid-single-digit range. We also expect positive contribution from its digital/drive-thru/delivery strategies, including an overhauled digital loyalty program (MyMcDonald's), increased drive-thru capacity (side-by-side lanes and third windows, utilization of Dynamic Yield menu board predictive ordering, and voice ordering), and examining hybrid first- and third-party delivery models in some international markets.

"While it must contend with pandemic-related guest traffic pressures, aggressive industry promotional activity (limiting near-term pricing opportunities), and wage increases across many global markets, we believe McDonald's technology, value, marketing and franchisee advantages will allow it to sustain normalized low- to mid-single-digit system sales growth and high-single-digit operating income growth over longer horizon, implying operating margins improving to the mid-40s over the next five years."

--Rebecca Scheuneman, analyst

Lockheed Martin LMT Forward Dividend Yield: 3.01% Morningstar Rating for Stocks: 4 stars

"We view Lockheed Martin as the highest-quality defense prime contractor, given 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 to 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. As the U.S. budget is looking increasingly bloated with pandemic relief, we're expecting a near-term slowdown in defense spending to flat or even negative growth, but we think that contractors will be able to continue growing due to sizable backlogs and expect that defense budget growth is likely to return. We recognize there is substantial political uncertainty in the budget, but we think that it will be difficult to materially decrease the defense budget without sweeping political change. We continue to think that the Department of Defense's increasing focus on great powers competition is a long-term tailwind for the contractors. We note that one of the most common budgetary compromises of the previous decade has been more nondefense spending for more defense spending.

"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

Atmos Energy ATO Forward Dividend Yield: 2.83% Morningstar Rating for Stocks: 4 stars

"Favorable regulatory frameworks and large infrastructure investment opportunities have driven strong earnings growth and steady dividend increases for Atmos Energy. We expect over $12 billion of capital expenditures during the next five years, above the top end of management's $11 billion-$12 billion target ending in 2025. Over 85% of the total investment is for safety and reliability, replacing bare steel, cast iron, and vintage plastic pipes. We expect this level of investment to receive regulatory support and continue well beyond this decade.

"We estimate capital expenditures of $2.1 billion in fiscal 2021 increasing to over $2.8 billion by 2025, representing over 4 times Atmos' depreciation and amortization expense. This should drive more than 11% average annual rate base growth during this period. We estimate earnings per share will grow more slowly than rate base, about 8% annually, due to the dilutive impact of almost $3 billion of equity issued over this period as the company maintains a strong balance sheet.

"Atmos' board of directors was somewhat stingy with dividend increases in the past, but this changed five years ago. It increased the dividend more than 5% in 2014 and 2015 and bumped it 7%-9.5% over the next five years. In November 2020, the board raised the dividend 8.7% to $2.50 per share annualized.

"Management has targeted a conservative 50% dividend payout ratio. With our earnings growth estimate, we believe Atmos' annual dividend increases have a good chance of being near the top end of management's target of 6%-8% over the next five years.

"Most of Atmos' operations are ultimately regulated by the Texas Railroad Commission, a regulatory body that has historically been constructive to shareholders. We expect this constructive regulatory framework to continue. Given this and the investment and earnings growth visibility, we have a high level of confidence that the company's string of 37 consecutive years of dividend increases will continue through this decade and beyond."

--Charles Fishman, analyst

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