For many stock investors, 2012 is off to a hopeful start. Major market barometers have steadily moved higher through the middle of March, bringing a dose of relief to battered portfolios. But despite the recent bout of optimism, the outlook for the global economy still has some dark clouds. Future credit problems may erupt in Europe, causing economies around the globe to be impacted. High gasoline prices and still-high unemployment levels remain hurdles in many developed countries. Risks like these may serve to not only halt the upward march of stock prices, but could trigger another bout of stomach-churning market volatility.
This sort of environment makes stocks with good dividend yields a potentially attractive option for investors. A healthy and safe dividend yield offers some solace in the midst of market volatility, and, relative to fixed income, patient dividend investors could potentially get the benefit of both higher yields and the prospect of long-term capital appreciation.
With this backdrop in mind, Morningstar has analysed the holdings of some top fund managers who specialise in income investing and we found 10 solid income-generating investments, three of which are traded on the London Stock Exchange. According to our data, the annual yields of these companies have been greater than that of the S&P 500.
Traded on the London Stock Exchange:
GlaxoSmithKline (GSK) – Wide Moat
Unilever (ULVR) – Narrow Moat
Vodafone (VOD) – Narrow Moat
Traded on International Exchanges:
ConocoPhillips (COP) – Narrow Moat
Eli Lilly (LLY) – Wide Moat
General Electric (GE) – Wide Moat
Johnson & Johnson (JNJ) – Wide Moat
Merck (MRK) – Wide Moat
Pfizer (PFE) – Wide Moat
Sysco (SYY) – Wide Moat
Looking through the list of these favourite dividend-yielding stocks held by top managers, a few things stand out. First, the list continues to be dominated by wide-moat companies, which means that these companies are considered to have a competitive advantage over their peers. (When a company has a wide moat, that means the company is operating in a profitable industry and has a large, sustainable competitive advantage over its peers. A narrow moat means the company has a smaller competitive advantage over its peers. The idea of a moat was originally coined by star investor, Warren Buffett) Seven out of the 10 stocks listed above carrying a wide moat rating. We're not surprised to see top managers veering toward moaty stocks, but given that Morningstar assigns a wide moat rating to only about 10% of the stocks we cover, the fact that 70% of this list is rated wide moat implies that our managers are not just looking for current yield, but are also focusing on companies profitable enough to maintain their dividends through difficult periods, as well as increase their payouts longer term.
Take note that health-care stocks have dominated this list, with drug manufacturers accounting for half of the top 10 dividend-yielding stocks. With concerns about health-care reform now squarely in the rearview mirror, the relatively stable free cash flow of these companies and their relative independence from the economic cycle continue to capture the attention of professional investors. While there remains some risk to the earnings power of the drug companies, as many of them are facing patent expirations in the near term, it is unlikely, in the view of our analysts, to result in dividend cuts for the names listed above. However, it’s entirely possible that dividend growth may be stalled as these firms work through a major patent cliff.
Believing these 10 names warrant further consideration, we've collected commentary from our analysts reflecting their current thinking on these firms, including their thoughts on the dividend prospects for the companies in the near to medium term.
GlaxoSmithKline (GSK)
While GlaxoSmithKline faces patent expirations on some of its drugs, most notably the respiratory drug Advair, its largest revenue generator, Morningstar analyst Damien Conover believes the firm is in a much better position than many of its peers. He sees management pursuing growth in other areas and believes that initiatives in areas like emerging markets, consumer health, vaccines, and biologics will help to position the company for long-term growth. His research also indicates that the company's product pipeline has improved, featuring a lineup of products that includes several drugs focused on orphan indications, which have strong pricing power. And while the threat to GlaxoSmithKline's Advair asthma drug from generic alternatives is a reality, manufacturing challenges may delay and limit the competitive threat. Generally, he believes that the company's broad strength across its operations should support slight growth in its dividend over the next few years.
Unilever (ULVR)
While Unilever is the third-largest packaged foods firm in the world, operating margins have suffered over the past several years as the company failed to present a clear global strategy and inefficiently ramped up its product base and overhead. Our analysts believe Unilever has made significant strides of late to improve the efficiency of its business, though, and that the diversified consumer products firm has just begun to scratch the surface. Focusing on opportunities in developing and emerging markets years earlier than its peers, Unilever has also realized some of the benefits of being a pioneering company, generating half of its sales from these key growth markets. While the company recently noted it will face challenges in 2012, as growth in some emerging and developing markets slows, our analysts believe Unilever should be able to raise its dividend in the mid-single digits annually over the next five years. The company has also not ruled out the potential for a separation of the firm into its two parts--household/personal care and packaged foods--which it feels would be a value-enhancing move for shareholders.
Vodafone Group (VOD)
According to Morningstar analyst Allan Nichols, Vodafone is the largest wireless phone company in the world by revenue, with the firm's core European operations generating the solid free cash flow needed to fund its dividend, as well as make acquisitions and reinvest in the business, while the company's emerging markets exposure provides it with growth opportunities. For many years, Vodafone took on debt to pay for acquisitions, but the company has recently begun selling minority stakes to reduce its debt load and buy back stock. Nichols remains confident in the firm's ability to reduce its net debt further while still meeting management's stated goal of increasing the dividend 7% annually through fiscal 2013. Although the firm will benefit this year from a $10 billion special dividend from Verizon Wireless (in which Vodafone maintains a 45% stake), he does not expect as large of a contribution from Verizon Wireless going forward, which could lead Vodafone to halt dividend increases beyond fiscal 2013, as the firm will then be paying out virtually all of its directly generated free cash flow. Nichols remains confident that Vodafone will maintain its dividend in any year that free cash flow is insufficient to cover the projected dividend and distributions from Verizon Wireless fail to make up the difference.
ConocoPhillips (COP)
Faced with a tightening resource market, ConocoPhillips made significant acquisitions over the past decade to boost reserves and increase production. The ensuing fall in commodity prices made those acquisitions appear poorly timed, though, according to Morningstar analyst Allen Good, who notes that management did change course last year by selling off assets and reducing investments and is taking steps this year to spin off its downstream assets into a separate company (potentially as early as May 2012). Even with all of these changes, Good expects ConocoPhillips to maintain the current dividend payment for the remaining upstream company, while initiating a new dividend payment for the downstream company, to be called Phillips 66, after the spin-off. He does, however, note that the challenges ConocoPhillips faced as an integrated firm are likely to persist once the spin-off is complete, but that the company will probably offer one of the highest dividend yields in its peer group, which could attract yield-hungry investors in search of commodity exposure.
Eli Lilly (LLY)
Morningstar analyst Damien Conover believes that Eli Lilly faces one of the steepest patent cliffs in the pharmaceutical industry, with more than 40% of its current sales mix encountering generic competition over the next couple of years. While he does believe that the drug manufacturer will be able to post flattish top-line growth during the next decade, as the company's strong late-stage pipeline helps to offset its patent losses, this next generation of pipeline drugs is less profitable, leading to a slight decline in margins and earnings power. As such, Conover believes that investors in Eli Lilly, while less likely to see dividend cuts over the near to medium term, are probably not going to see much in the way of dividend increases. That said, significant upside potential does exist for the firm if its pipeline products report strong clinical data. In particular, positive Phase III data on Solanezumab could be a game changer not only for the treatment of Alzheimer's, but also for Lilly's prospects.
General Electric (GE)
Considering the fact that General Electric has raised its dividend four times since June 2010, increasing its payout 70% over that time frame, it appears to us like the firm is trying to appease income-focused investors (after it cut its dividend in early 2009). Morningstar analyst Daniel Holland believes General Electric has the potential to pay out even more, pointing to strength in the firm's industrials business, as well as improvements at GE Capital. He notes that it has been three years since GE Capital has paid a dividend to the parent company, and he expects that drought to end sometime this year, with the one remaining obstacle being regulatory approval by the US Fed. Part of the delay in getting a decision from the regulators has been that there is no model for evaluating a company like General Electric, which is unlikely to be viewed as a bank holding company. Once the dividend resumes, Holland believes GE Capital could pay out as much as 45%-50% of its earnings to the parent company, which he feels is looking to extract the capital it had to inject into the finance arm back in 2009 sooner rather than later.
Johnson & Johnson (JNJ)
In contrast to the patent cliff facing the rest of the drug industry, Johnson & Johnson has largely passed this hurdle following the loss of patent protection on antipsychotic Risperdal and neuroscience drug Topamax. Morningstar analyst Damien Conover notes that with only near-term patent losses on anti-infective Levaquin and neuroscience drug Concerta, Johnson & Johnson's new potential blockbusters should return the company to steady long-term growth. Within this group of new drugs, Xarelto for cardiovascular disease, Bbapineuzumab for Alzheimer's, and Telaprevir for hepatitis C offer the potential to revolutionize treatment. Conover is also encouraged by the firm's revitalized medical-devices business, which is benefiting from Johnson & Johnson's acquisition of the growing orthopedic company Synthes. With both its drug and device segments poised for steady growth, Conover believes that Johnson & Johnson's dividend payments should see steady increases over the next five years as earnings rise.
Merck (MRK)
The obvious recurring theme among the drug manufacturers is patent losses, and Merck is no exception. In contrast to several of its peers, Morningstar analyst Damien Conover notes that Merck is investing heavily in research and development, which may slow earnings growth in the near term, but offers stronger growth potential over the long run. In the meantime, the firm's 2009 acquisition of Schering-Plough provided Merck with a solid lineup of new products, including drugs for hepatitis C (Victrelis), schizophrenia (Saphris), immunology diseases (Simponi), and asthma (Dulera). He thinks that Saphris and Bridion (used to counter the effects of anesthesia) are the least appreciated of the new drugs in Merck's stable. Moreover, recently launched drugs, such as Januvia for diabetes and Isentress for HIV, are already strong performers. The Schering-Plough deal also led to a major cost-cutting plan at Merck, which should help boost its bottom line and allow the firm, in Conover's view, to slightly grow its dividend.
Pfizer (PFE)
With several major patent losses (including the loss of exclusivity of Lipitor last year) slowed Pfizer's sales momentum, Morningstar analyst Damien Conover still expects flat revenue growth at the firm over the next several years. Conover believes the company's 2009 acquisition of Wyeth helps insulate it against any one particular patent loss. Several underappreciated factors, such as expansion into emerging markets and aggressive cost-cutting, should also play well into the firm's long-term potential. Emerging markets are demanding health-care products at an accelerating pace, which could allow sales of Pfizer's blockbuster drugs to increase dramatically, and Pfizer is significantly cutting its cost base as a result of the Wyeth acquisition, less marketing support for drugs losing patent protection, and a structural realignment to reduce R&D spending. Conover notes that with a quarterly dividend of $0.22 per share, Pfizer boasts a dividend yield close to 4%, and he expects the dividend payout ratio will increase over the next few years.
Sysco (SYY)
Our analysts covering Sysco believe that concerns about sluggish restaurant traffic and food cost inflation have been a bit overdone and are unjustly weighing on the company's shares. Sysco has traditionally been able to pass along rising food and fuel costs to its customers, which was once again the case in its most recent quarterly results. That said, there is always some lag time involved in passing these costs along, and the double-digit inflation that has been seen in categories such as dairy, meat, and seafood has made this pass-through even more challenging for the food distributor. Volume has also been difficult to generate, with a consumer rebound still in its early stages and restaurants and other customers that Sysco serves being more cautious about building up inventory. Our analysts believe the firm is doing what it can, though, which should leave it in a good position to take advantage of a more consistent and positive trend in restaurant sales once one emerges. In the meantime, they forecast Sysco to raise its dividend in the high single digits annually over the next five years.
Disclosure: Gaston F. Ceron does not own shares in any of the securities mentioned above.
The original version of this article was published March 20, 2012 on Morningstar.com, a sister site to Morningstar.co.uk.
