Jan. 27, 2012, 12:01 a .m. EST
10
income-paying stocks that beat the crowd
These high-quality names slip under yield-hunters’ radar
Shares of high-quality, cash-rich,
large-cap companies that yield more than the Standard & Poor’s 500-stock
index 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 , 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 and SPDR S&P
Dividend .
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 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. ,
Johnson & Johnson JNJ +0.01% , McDonald’s Corp. MCD -0.02% and Procter &
Gamble Co. PG -0.29% . 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.Read more: Apple's growth rate will not last.
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. Read more: Is Apple the cheapest growth stock?
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
FundFRDPX +0.03% .
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 -0.63% 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 -0.31% 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 +0.14% 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 0.00% 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 +0.10% 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 +0.00% 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 -0.07% 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 +0.03% 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 -0.58% 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 +0.04% 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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