10 income-paying stocks that beat the crowd
These high-quality names slip under yield-hunters’ radar
Stock investors no longer have doubts about dividends, and that’s reason for some doubt.
Shares of high-quality, cash-rich, large-cap companies that yield more than the Standard & Poor’s 500-stock index SPX -0.16% are the new favorites in many portfolios. But many of these success stories have been discovered, boosting share prices and trimming yields.
At this point, investors might do better scouring the S&P 500 for companies that wouldn’t show up on a screen for above-average yielders, but which still enjoy dominant, “wide moat” positions in their business.
“It’s kind of a crowded trade,” said Paul Nolte, managing director at investment firm Dearborn Partners, about the popularity of the high-quality dividend strategy. “Valuations on high-dividend payers are at the upper-end of their historical ranges.”
Indeed, money has cascaded into dividend-focused mutual funds and exchange-traded funds. Dow Jones Select Dividend Index Fund DVY -0.68% , for example, saw assets grow to around $10 billion from $6 billion a year earlier, according to the ETF Industry Association. Similarly robust asset growth was seen at Vanguard Dividend Appreciation VIG +0.02% and SPDR S&P DividendSDY +0.11% .
It’s easy to see why dividends are in demand. They’re an alternative to bonds’ paltry payouts, and cushion volatility. Plus, these stocks offer potential for capital appreciation.
Without dividends, the S&P 500 was flat in 2011; including dividends the market returned 2.1%. The yield-rich Dow Jones Industrial Average DJIA -0.58% fared even better, up 5.5%. And the 10 highest-yielding Dow components, the so-called Dogs of the Dow, returned 12.2%.
“Any time we see a big surge in the popularity of dividends in the market, that means prices have been marked up and it’s tough to find bargains,” said Josh Peters, editor of Morningstar’s DividendInvestor newsletter.
Off the beaten path
Owning financially healthy companies that reward shareholders with meaningful income is certainly still a viable investment idea. Large-cap stocks with little or no debt, that pay consistent dividends, and which grow those payouts over time, have been excellent decisions. And 3% or 4% in cash payments every year is nothing to ignore. Read more: How to elude the Fed’s attack on savers.
Last year, for example, the average S&P 500 dividend payer gained 1.4%, compared to the average 7.6% decline for non-payers, according to S&P. Performance was even better for S&P’s “Dividend Aristocrats” — companies with that have boosted payouts for at least 25 consecutive years, such as AT&T Inc. T +0.41% , Johnson & JohnsonJNJ +0.03% , McDonald’s Corp. MCD +0.16% and Procter & Gamble Co. PG -0.13% .Research S&P’s Dividend Aristocrats.
Many investors now are hoping such dividend magic will apply to Apple Inc. AAPL +0.07% , which earlier this week reported blowout earnings. Apple’s chief financial officer said the company is considering ways to be proactive with a cash hoard approaching $100 billion.
Apple isn’t paying a dividend, but if it did, the dividend world would spin. “If Apple came out with a policy that was going to give the stock a yield of 4%, you bet I would look at it,” said Morningstar’s Peters.
But investing in a company that might pay a dividend isn’t a solid approach; nor is buying the highest yield. Companies in financial trouble often sport unusually fat yields after the shares have taken a beating, and their ability to maintain the dividend is questionable.
Better to focus on dividend-paying companies in robust financial health, and then consider how that quarterly payment could grow. The dividend might not be terrific now, but a well-run operation with a high return on investment is often the kind of company given to dividend hikes. And dividend investing is a long-term strategy; the goal is to “clip coupons” year after year.
“Think in terms of what the yield could be, rather than what it is,” said Don Taylor, manager of Franklin Rising Dividends Fund FRDPX -0.28% .
Ideally, these businesses boast a “wide moat,” meaning they stand apart from competitors because they invest shareholder capital wisely, minimize borrowing, grow revenue streams through smart expansion, and retain cash-generating assets such as patents or other intellectual property.
It’s also crucial that dividend investors choose companies with plenty of cash to cover the dividend — derived from an earnings-based measure called the payout ratio.
Nowadays, with companies banking cash as a buffer against economic uncertainty, the average payout ratio of S&P 500 members is under 30% of earnings, compared to a historical 52%, according to S&P. One upside to this stinginess is that companies have room to loosen their purse strings. Howard Silverblatt, the senior index analyst at S&P, estimates that 70% of the S&P 500 payers will boost their dividends this year.
10 for the money
In searching for attractively priced, profitable companies that wouldn’t necessarily appear on a high-yield screen, MarketWatch enlisted the help of two researchers: Morningstar’s Peters and David Trainer, president of investment researcher New Constructs Inc. in Nashville.
Morningstar’s analysis included wide moat companies with dividend yields below 2.1%, a cash surplus and no debt.
New Constructs’ methodology, meanwhile, dug into financial statements to unearth companies with high excess return on invested capital, increasing economic earnings, low debt-to-total-capital, and high free-cash-flow yield (total cash flow divided by enterprise value). Strong stewardship of capital also suggests that management is acting in shareholders’ best interests.
“You’ve got to have decent return on invested capital to afford a dividend,” Trainer said. “If you’re not making money, you can’t sustain a dividend very long.”
Here are 10 wide-moat companies, culled from the two screens, that are debt-free and have a history of dividend increases:
1. Texas Instruments Inc. TXN +0.49% shows up on Trainer’s screen. The computer and mobile telephone chip-maker sports a a 2.1% yield — slightly more generous than the S&P 500. Its shares trade at a discount to Morningstar’s fair value estimate of $38.
2. Stryker Corp. SYK +0.01% makes both Morningstar’s and Trainer’s list. The orthopedic and medical equipment company recently yielded about 1.5%, with a low payout ratio of about 23%. The shares trade below Morningstar’s estimate of $63.
Trainer’s screen also gives top marks to Stryker for profitability and valuation.
3. Qualcomm Inc. QCOM -0.03% shows up on Morningstar’s screen for many of the same criteria as Stryker. The communications-technology leader yields about 1.5%, with a payout ratio of around 27%. Plus, the shares are discounted to Morningstar’s fair value of $62. Said Nolte: “Qualcomm is a cash machine.”
4. AmerisourceBergen Corp. ABC -0.05% makes Trainer’s screen for earnings strength and a cheap valuation. The pharmaceutical distributor’s shares yield about 1.3%, the dividend is growing, and the stock price is below Morningstar’s $45 fair value.
5. Cisco Systems CSCO +0.31% recently began paying a dividend, and the shares yield about 1.2%. The technology bellwether’s payout ratio is a low 15%, leaving plenty of room for potential dividend growth, and the stock trades at a healthy discount to Morningstar’s fair value of $26 a share.
6. Expeditors International of Washington Inc. EXPD -0.49% comes up on Morningstar’s screen. Recently the shares yielded 1.1%, with a payout ratio of 27%. Morningstar’s fair value on the shipping company’s stock is $61.
7. Franklin Resources Inc. BEN -0.01% yields 1%, but the company’s 12% payout ratio and pristine balance sheet means there’s plenty of room to grow the dividend, or to continue special cash dividends that line shareholders’ pockets.
Morningstar’s screen gives high marks to Franklin Resources on valuation, and the shares are priced far below Morningstar’s $137 estimate. The company is also one of the S&P 500’s Dividend Aristocrats.
8. Oracle Corp. ORCL -0.28% is another relatively new dividend payer. The shares yields 0.9%, while the company’s payout ratio is around 11%. The business software leader has a high return on invested capital, according to Trainer’s screen. Free-cash-flow yield and price-to-economic-book value are also attractive.
Oracle also appears on the Morningstar screen based on valuation and profitability. Its shares trade at a steep discount to the researcher’s $41 fair value price.
Going forward, Oracle could increase its dividend at a “better-than-normal clip,” Nolte said. “You’re getting 1% on your money, big deal, but if you’re compounding that at 10%, that starts to add up over years.”
9. Visa Inc. V -0.06% has a 15% payout ratio, according to Morningstar’s screen, even after a substantial dividend hike last year. The credit- and debit-card payment processor’s shares yield 0.9%, and trade slightly below Morningstar’s $105 fair value estimate.
10. National Oilwell Varco Inc. NOV -0.02% also is a new dividend payer that doesn’t provide much yield, recently 0.6%, but the drilling-rig equipment supplier has already increased its payout. The company still has plenty of available cash — the payout ratio is just 10% — and the shares are discounted to Morningstar’s fair value of $97.
These types of top-drawer stocks combine value characteristics with growth potential. Said Nolte: “You have, from a total return perspective, the ability to grow principal in addition to growing income. And because you’re below the radar, you’re not in that crowded trade and have the opportunity to pick them up at better valuations.”
Jonathan Burton is MarketWatch’s money and investing editor, based in San Francisco.
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