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10 Dividend Stocks Our Ultimate Stock-Pickers Should Consider

Our top managers could look beyond pharmaceuticals for additional yield.

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By Brett Horn | Associate Director of Equity Research

As you may recall, last quarter we noted that in the midst of all of the economic uncertainty we've seen this year and the historically low yields on fixed-income products, investors have struggled to find not only stability, but also decent income-generating investments, with stocks that provide good dividend yields looking to be a far more attractive option in this type of environment. After all, a healthy and safe dividend yield offers some solace in the midst of market volatility, and (relative to fixed income) can provide patient investors with not only the benefit of higher yields, but also the prospect of long-term capital appreciation. With little changing in the markets (from a volatility perspective), and our continued belief that economic uncertainty (both here and abroad) is far from over, it is no wonder that there is a growing interest in dividend-paying stocks, which are not only providing better yields than some fixed-income instruments these days, but are also less likely to be impacted by market depreciation once interest rates rise.

With this backdrop in mind, we decided to take a much deeper look at the dividend-paying stocks that our Ultimate Stock-Pickers were holding at the end of the most recent period. While we could just have just focused on the four fund managers on our list-- Amana Trust Income (AMANX),  Columbia Dividend Income (LBSAX),  Oakmark Equity & Income (OAKBX), and  Parnassus Equity Income (PRBLX)--that specialize in income investing (especially as half of them are beating the market by a wide margin this year, and the other two are within 50 basis points of the return for the S&P 500 Index), we decided that we'd get a stronger representation by sifting through the holdings of all 26 of our top managers. That said, we have narrowed down our screen to include only securities held by at least five of our Ultimate Stock-Pickers at the end of the most recent period, where the annual yield was greater than that of the S&P 500, and where the firm had either a wide or narrow moat, as well as an uncertainty rating of either low or medium (as we believe that firms with economic moats and lower uncertainty ratings are more likely to be steadier names over the long run and, therefore, are less likely to cut their dividends in the near term).

Top 10 Dividend-Yielding Stocks of Our Ultimate Stock-Pickers

  Star Rating Moat Size Price/Fair Value Dividend Yield (%) Uncertainty Rating # Funds Holding Transocean (RIG) 5 Narrow 0.64 5.5 Medium 5 Vodafone (VOD) 4 Narrow 0.86 5.4 Medium 6 Eli Lilly (LLY) 4 Wide 0.89 5.2 Medium 5 GlaxoSmthKln (GSK) 4 Wide 0.90 5.0 Medium 5 Merck (MRK) 4 Wide 0.77 4.3 Medium 5 Pfizer (PFE) 4 Wide 0.74 4.0 Medium 10 Encana (ECA) 4 Narrow 0.84 4.0 Medium 6 Novartis (NVS) 5 Wide 0.75 3.7 Low 8 ConocoPhillips (COP) 4 Narrow 0.85 3.6 Low 9 General Elctrc (GE) 5 Wide 0.64 3.6 Medium 5

Stock Price and Morningstar Rating data as of 12-02-11.

Looking at the list of top 10 dividend-yielding stocks of our Ultimate Stock-Pickers, a few things stand out. First of all, although there are four new names on the list this quarter compared with last quarter, three of those new names-- Encana (ECA), General Electric (GE), and  Novartis (NVS)-- just barely missed our top 10 cutoff last time around. Their appearance, therefore, is not necessarily a sign of new interest by our top managers as much as it is a reflection of a large enough decline in their stock prices over the last quarter to make their dividend yields a bit more attractive than the names they replaced.

One name that didn't hit our radar at all last time around was  Transocean (RIG). The oil and gas drilling firm has been embroiled in controversy ever since its involvement in the Macondo oil spill (in the Gulf of Mexico in 2010), and poor planning and escalating rig down time more recently have weakened near-term results. As a result, the company recently announced plans to raise equity, which will end up increasing the firm's share count by about 9%. For those bullish on oil prices, though, our analyst Stephen Ellis believes that Transocean is the best-positioned driller to capitalize on numerous drilling technology breakthroughs. Because Transocean owns the world's largest offshore drilling fleet, it will collect billions from customers eager to exploit large discoveries under the sea floor. But he admits that Transocean's dividend could be at risk given its operational struggles and expects Transocean's board to make a final decision on the 2012 dividend in February. Therefore, while he believes Transocean is an attractive investment opportunity, it does not fit the profile most dividend investors are looking for.

Looking over the list, a second point that draws attention is that pharmaceutical companies continue to dominate our list, holding 5 of the top 10 positions. In our article last quarter, we discussed the relative merits of these names as dividend plays in some depth, and (since not much has really changed in those stories over the last couple of months) we think that interested readers should revisit that article for more details on  Eli Lilly (LLY),  GlaxoSmithKline (GSK),  Merck (MRK), and  Pfizer (PFE). That said, it is interesting to note that all 10 of the names on the list look fairly attractive at this point, with most of them trading at at least a 15% discount to our analysts' fair value estimates, and all of them rated either 4- or 5-stars. And the fact that five or more of our top managers own each of these stocks demonstrates to us that our analysts and our Ultimate Stock-Pickers are in agreement that these are all high-quality, stable companies that are currently undervalued, a solid starting point for investors looking for relatively safe dividend plays with decent upside potential.

Given that we have talked through many of these firms in past articles, we thought we'd take a different tack this time around and screen our universe for potentially attractive dividend stocks that did not make the list, but would certainly fit the established criteria for our list of top 10 dividend-yielding stocks of our Ultimate Stock-Pickers. In other words, we searched for dividend names that our top managers might want to consider. To do this, we screened for stocks in the Morningstar coverage universe that are rated either 4- or 5-stars, have a wide or narrow economic moat and medium or low uncertainty, and with a dividend yield in excess of 3.6% (which was the lower end of the top 10 list highlighted above). As our screen returned more than 25 stocks, we polled our analysts for the names that they were most interested in. While this list returned no deep bargains, we feel that investors looking for high-quality companies with relatively safe and ample dividend yields should keep these companies on their radar.

10 Dividend-Yielding Stocks Our Ultimate Stock-Pickers Should Consider

  Star Rating Moat Size Current Price (USD) Price/Fair Value Dividend Yield (%) Uncertainty Rating Hlth Care REIT (HCN) 4 Narrow 49.53 0.84 5.7 Medium Exelon (EXC) 4 Wide 43.33 0.75 4.9 Medium Amrcn Elctrc Pwr (AEP) 3 Narrow 39.25 0.98 4.7 Low Westar Enrgy (WR) 4 Narrow 27.28 0.94 4.7 Low Firstmerit (FMER) 4 Narrow 14.47 0.80 4.4 Medium Waste Mgmt (WM) 4 Narrow 31.23 0.89 4.4 Medium BioMed Rlty Trust (BMR) 4 Narrow 17.90 0.85 4.3 Medium Paychex (PAYX) 4 Wide 29.22 0.77 4.3 Medium Bank of Hawaii (BOH) 4 Narrow 42.37 0.88 4.3 Medium M&T Bank (MTB) 4 Narrow 73.88 0.83 3.8 Medium

Stock Price and Morningstar Rating data as of 12-02-11.

As you can see, the companies that drew the most interest among our analysts from a dividend perspective were concentrated in utilities-- Exelon (EXC),  American Electric Power (AEP), and  Westar Energy (WR)--and financial services-- FirstMerit (FMER),  Bank of Hawaii (BOH), and  M&T Bank (MTB)--which have traditionally been two of the most stalwart sectors for dividend investors. With the financial services sector having lost some of its traditional standing as a safe haven for dividend investors during the financial crisis, it is notable that no financial services names appear on our list of top 10 dividend-yielding stocks held by our Ultimate Stock-Pickers (or even the top 25 dividend-yielding stocks held by our top managers) at the end of the third quarter. However, while the investing world continues to focus on the struggles of large money center banks like Bank of America (BAC), our analysts continue to believe that there are many well-run regional banks that offer relative safety.

On the Utilities front, it is not too surprising to us that no companies from this sector have made our Ultimate Stock-Pickers dividend list, as our top managers have generally dedicated less than 1% of their aggregate holdings to the sector (versus the S&P 500, where utilities currently account for around 3% of the index). While these stocks may be a bit too staid for our managers to flex their stock-picking muscles, other investors should feel no such compunction. Beyond utilities and financials, we discovered a couple of moaty companies that operate in areas not traditionally viewed as fertile with dividend opportunities. Believing that all of these names warranted further consideration, we've collected some commentary from our analysts reflecting their current thinking on these holdings, including their thoughts on the dividend prospects for these firms.

 Health Care REIT (HCN)

Morningstar analyst Jason Ren believes that a diversified portfolio of quality health-care assets allows Health Care REIT to earn excess returns, with its competitive positioning burnished by its favorable leasing agreements. He believes that Health Care REIT should continue to see steady profitability as the economy recovers, with the firm's appetite for balance sheet growth remaining strong. After investing approximately $3.2 billion in 2010, Ren sees Health Care REIT spending more than $4.8 billion in 2011 through acquisitions, developments, and joint ventures. He notes, though, that there are risks and rewards to such robust balance sheet growth. Initial returns could come in lower than expected, especially if a lagging housing and economic recovery or legislative changes make it difficult for its tenants to operate profitably. However, Ren recognizes that Health Care REIT's balance sheet position and access to capital markets place it in a better position to expand its balance sheet than privately held owners and operators, who might still be overleveraged and credit-constrained. With net debt as a percentage of gross real property owned hovering in the upper 40s and limited near-term debt maturities, the firm's debt profile affords it a good margin of safety to continue its expansionary efforts. While Health Care REIT recently raised its dividend, and the current yield looks attractive, Ren notes that further near-term dividend payout growth could be limited given its current expansion commitments.

 Exelon (EXC)

With the largest nuclear power plant fleet in the United States, Exelon is best-positioned to benefit from an improving economy, rising commodity prices, and tougher environmental regulations than many of its peers, according to Morningstar analyst Travis Miller. While dividend growth has stalled as the economy and power markets have taken a nosedive, he thinks that a turnaround can produce an earnings leap in 2014, allowing the firm to reinstate dividend growth (that had topped 10% prior to the 2008 collapse of the credit and equity markets). Miller also sees no threat to the firm's dividend or interest coverage in the near term even as Exelon's earnings bottom in 2012 near $3 per share. Even though he does admit that the firm's pending $7.9 billion acquisition of  Constellation Energy (CEG) gives away some of Exelon shareholders' upside, it does offer the prospect for more stable cash flows to support dividend growth longer term. Miller also believes that Exelon's earnings could eventually hit $6.00 per share on a normalized basis, suggesting a dividend that could top $3.00 per share, which offers what he feels is an attractive entry point at current prices for long-term investors.

 American Electric Power (AEP)

After a period of slow earnings and dividend growth, our energy analysts feel that AEP has the potential to grow faster than most other regulated utilities over the next several years. Significant infrastructure investments and certainty around its regulatory framework in Ohio support what they believe will be 5%-7% ongoing earnings growth between 2010 and 2014. Our analysts have further noted that AEP has turned free cash flow positive, and expect it to remain so throughout their forecast period, which should allow dividend growth to keep pace with earnings growth over the next five years. Assuming management maintains its recent rate of dividend increases, our energy analysts believe that the company's 2012 dividend could imply a 5% yield at current prices, offering what they feel is an attractive total return opportunity for investors given the diversity of operations and growth prospects.

 Westar Energy (WR)

Located in the Kansas wind alley, Westar has an enviable pipeline of high-return transmission projects, which, according to Morningstar analyst Travis Miller, should connect rural wind farms to population centers looking to meet renewable-energy standards. Since 2008, the utility has increased core earnings at a 9% average annual rate, and Miller thinks it can sustain that pace through 2014 (pending, of course, the outcome of its 2011 rate case). In his view, a favorable regulatory structure with mandates to invest in clean coal and transmission should provide Westar with better growth prospects and more consistent cash flow than its peers. By 2014, he believes that the firm's investments should lift Westar's earnings above $2.40 per share. While dividend growth might lag earnings growth in the near term, Miller feels that Westar's long-term investment potential and 5% dividend yield make for a compelling total return package for income-oriented investors.

 FirstMerit (FMER)

In Morningstar analyst Jason Ren's view, FirstMerit played it safe while larger banks chased growth before the recession. He believes that this caution has put the bank in a position to expand while others are hurting, with FirstMerit actually expanding its lending footprint and loan book while others continue to cleanse their bruised balance sheets. While Ren thinks more synergies can be found if the firm acquires banks within its traditional lending footprint in northeast Ohio, it nonetheless is picking up deposits and branches in Chicago cheaply thanks to the FDIC. Ren believes that its conservative underwriting practices and controlled operating expenses should lead to steadily increasing value to shareholders. He also notes that FirstMerit's caution over the past few years leaves it with comparatively fewer credit headaches than its competitors. As a result, Ren feels that the firm has ample capital to grow internally and through acquisitions, as well as to maintain its dividend in the near term.

 Waste Management (WM)

According to Morningstar analyst Barbara Noverini, Waste Management's unparalleled dominance in landfill ownership (with close to 300 landfills) makes it a formidable competitor in the integrated waste services space, covering the nation with disposal sites even as the overall number of domestic landfills shrinks due to strict environmental regulation. She also feels that the company's massive scale in collection routes creates a symbiotic relationship between company-owned haulers and landfills, creating efficient waste streams that ultimately funnel volumes to valuable landfill space. With steady, annuity-type revenues in its collection segment and pricing power at landfills, Noverini notes that Waste Management's core business generates strong cash flows as it provides necessary services to residential, commercial, and industrial customers. Given a healthy dividend yield, she believes that patient investors will benefit as pricing and volumes in the company's core business improve through strategic execution and overall economic improvement, while they get paid to wait for this upside.

 BioMed Realty Trust (BMR)

According to Morningstar analyst Jason Ren, Biomed Realty is a health-care real estate investment trust that specializes in providing research and office space for the life sciences industry. The company's 150 properties are clustered near universities in the medical research hubs around Boston, the D.C. area, San Diego, and San Francisco. In addition to being favorably located, Ren notes that Biomed's properties are fairly specialized, involving high-fixed-cost investments for reinforced floors, environmental controls, and upgraded utilities. These high costs limit the number of REITs and other investors that can successfully compete with Biomed in this space. Moreover, over 90% of Biomed's tenants are triple-net leased (which leave tenants responsible for reimbursing Biomed for property-level expenses, affording the firm net operating income margins of about 70%). Additionally, these leases are typically signed for five to 15 years, with fixed rent escalators, which help offset the effects of inflation. With less than 10% of its leases scheduled to expire through 2012, Ren feels that Biomed has a high level of protection against re-leasing properties through a tough leasing environment and recovery. Moreover, the firm is currently paying what he considers to be a conservative level of its funds from operations as dividends; this should help secure the dividend in the near term. Still, Ren notes that Biomed serves a somewhat volatile industry, which could limit the company's ability to increase its dividend, despite the fact that the current yield looks attractive right now.

 Paychex (PAYX)

Morningstar analyst Vishnu Lekraj notes that investors have received a steady payout from Paychex since the firm was founded in 1979. Return on invested capital has averaged 70% over the past five years, with the firm turning 27% of its revenue into free cash flow, on average, over this same time frame. Lekraj notes that a number of positive factors inherent in its operations have enabled Paychex to generate these outstanding returns. First, because of the difficulty in switching outsourced human resources processes to another provider, Paychex is able to lock clients into its service. Lekraj notes that this stickiness allows the firm to raise prices with very little resistance. Second, minimal capital requirements and a large 550,000-member client base allow the firm to spread costs and stay price competitive. And finally, Lekraj feels that Paychex's strong brand plays a significant role, since clients are hesitant to entrust their critical HR functions and payroll cash to an unproven competitor. He notes that management has consistently returned the bulk of its free cash flow to shareholders through its dividend, and the minimal amount of capital required for operations and the firm's significant competitive advantages should keep those dividends flowing.

 Bank of Hawaii (BOH)

In Morningstar analyst Jason Ren's opinion, Bank of Hawaii is one of the best regional banking franchises in the United States, regularly netting returns on equity above 20%. He notes that the bank has the most branches, accounts, and ATMs of any bank in its namesake state, with nearly one third of Hawaii's deposits in its coffers. This high market share has led to low funding costs, while conservative, steady underwriting has kept credit costs low. Though the bank is under new management with Peter Ho taking the CEO reins from Allan Landon, there has been no change in strategy, which leads Ren to believe that its high performance should continue. Overall, he feels that Bank of Hawaii's strengths are durable and imply a fair value at a higher multiple of book than its mainland peers. With a healthy capital cushion, Bank of Hawaii is restarting share repurchases, which Ren notes is a current rarity in the banking sector. This leaves him with little concern that the company can maintain its dividend in the near term.

 M&T Bank (MTB)

Morningstar analyst Jim Sinegal believes that M&T Bank's management team has proven its mettle through recessions that have decimated the company's peers. He feels that the company's conservative underwriting standards and substantial core earnings power should enable it to continue improving its performance at a faster pace than many of its peers. Despite its seemingly unfavorable location in the sleepy markets of upstate New York, Sinegal notes that M&T has grown from $2 billion in assets in 1983 to nearly $80 billion in mid-2011. He also highlights the fact that M&T is one of the very few large regional U.S. banks that managed to maintain its dividend throughout the downturn, and that the company's enviable history of dividend payments and share repurchases ensures that capital is seldom wasted.

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Disclosure: Brett Horn does not own shares in any of the securities mentioned above. 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.

The Morningstar Ultimate Stock-Pickers Team does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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