By Greggory Warren, CFA | Senior Stock Analyst
Even with all of the uncertainty we've seen in the markets this year, the S&P 500 TR Index is up close to 15% since the start of 2012. While one would assume that this has been a big positive for managers of U.S. stock funds, the reality is that most managers of U.S stock funds have struggled with investor redemptions, even as the value of the holdings in their portfolios has increased. According to data provided by Morningstar DirectSM, close to $115 billion flowed out of actively managed U.S. stock funds during the first 11 months of 2012. This was greater than the record level of outflows that affected these funds during 2008, with the financial crisis leading to $108 billion in net redemptions from actively managed U.S. stock funds, and was more than $14 billion higher than levels recorded last year (as outflows increased dramatically during the third quarter in response to the European credit crisis and the squabbling over the debt ceiling here in the U.S.). What's odd about this year's outflows is that domestic markets are up double digits this year, compared to a 37% decline during 2008 and what ended up being a 2% gain last year (after a 14% decline during the third quarter).
As we've noted on a few occasions, we believe that this rush for the exits this year has far more to do with the performance of active managers than it does with the overall direction of the markets. With just about every domestic stock fund category underperforming the S&P 500 TR Index during 2012, investors have been voting with their feet, as outflows from actively managed U.S. stock funds have actually increased as the year has progressed. Our Ultimate Stock-Pickers have not been immune to this trend, with just about half of our mutual fund managers experiencing net outflows this year. And, ironically enough, of the eight fund managers on our list that have been outperforming the market this year, three of these top performing funds--Dodge & Cox Stock (DODGX), Fairholme (FAIRX), and Hartford Capital Appreciation (ITHAX)--have seen the worst of the outflows, with each fund losing at least $2 billion to net redemptions since the start of 2012 (even as Bruce Berkowitz at Fairholme and the nine-person investment policy committee at Dodge & Cox Stock have put together some of the best performances in the group for the year to date).
It should come as no surprise then to note that the majority of investor inflows this year have been focused on taxable bond funds, which investors consider to be "safer" investments, despite the fact that yields remain at historic lows. Inflows into bond funds overall (which includes both taxable and tax-exempt fixed-income funds) are set to exceed $350 billion this year, compared to the record level of just over $400 billion which flowed into these funds during 2009. It also marks the fourth straight year in which flows into fixed-income funds have been at elevated levels, with total inflows averaging about $50 billion annually in the decade before the financial crisis, and only two years--2002 and 2007--seeing net inflows in excess of $100 billion. Since the end of 2008, average annual flows into bond funds have been closer to $300 billion. We continue to be confounded by this trend, especially with the yield on 10-year U.S. treasuries at just 1.625%, and the 30-year bond yielding 2.75%. At this point, even the S&P 500 Index, which is currently yielding a little over 2.0%, could be viewed as being somewhat more attractive, given that bond prices are going to fall once interest rates rise.
Finding stocks that are yielding more than the benchmark index, but which operate in stable industries, where there is less uncertainty surrounding their future cash flows, is bound to offer some downside protection for investors. While one could certainly look to an actively managed equity-income fund for this exposure, the median annual yield (after expenses) for these funds tends to be no better than the yield offered by the S&P 500 TR Index, making individual stocks with good dividend yields a potentially more attractive option for investors. After all, a healthy and safe dividend yield can offer some solace in the midst of market volatility, and, relative to fixed income, potentially produce both higher yields and long-term capital appreciation for investors.
Few of Our Ultimate Stock-Pickers Focus Solely on Dividends
As many of you already know, few of our Ultimate Stock-Pickers focus solely on dividend investing. In fact, of the 22 mutual fund managers on our Investment Manager Roster, only four of them--Amana Trust Income (AMANX), Columbia Dividend Income (LBSAX), Oakmark Equity & Income (OAKBX), and Parnassus Equity Income (PRBLX)--focus more heavily on income investing. Of these, the latter two run slightly more concentrated stock portfolios, with Oakmark Equity & Income holding 53 stocks at the end of the most recent period, and Parnassus Equity Income running a portfolio with just 39 stocks. Both funds had about 40% of their portfolios invested in their top 10 stock holdings as well, compared to 25% at Amana Trust Income and 30% at Columbia Dividend Income. That said, Oakmark Equity & Income appears to focus less on dividend yield than it does on finding firms trading at significant discounts to their true business value, which explains why less than half of its stock holdings (based on the percentage each stock makes up of the total portfolio) yield more than S&P 500 TR Index. This compares to Amana Trust Income and Columbia Dividend Income, both of which have more than three quarters of their holdings generating yields in excess of the benchmark index, and Parnassus Equity Income, where stocks yielding more than the S&P 500 TR Index accounted for more than half of its holdings at the end of the most recent period.
That said, these four managers are not the only source for dividend-paying stocks among our Ultimate Stock-Pickers. In fact, we think we get a much better representation of higher-conviction dividend-paying stocks when sifting through the holdings of all of top managers. To hone in on the higher-quality names held with a greater degree of conviction by our top managers, we've narrowed our screen down to include only stocks held by at least five of our Ultimate Stock-Pickers, with yields greater than the S&P 500 Index, representing firms with Wide or Narrow economic moats, and where our stock analysts have an uncertainty rating of either Low or Medium on their fair value estimate. We think that by focusing on Wide- and Narrow-moat firms we should be able to hone in on firms with competitive advantages that can allow them to generate the cash flows they'll need to maintain their dividends longer term. And considering only those firms with Low or Medium uncertainty ratings means that we are looking only at firms where our analysts have a greater degree of conviction behind their fair value estimates. It should also be noted that our dividend yield calculations are based on regular dividends that have been declared over the last year, and do not include the impact of any special (or supplemental) dividends paid during that time.
Top 10 Dividend-Yielding Stocks of Our Ultimate Stock-Pickers
| ||Star Rating||Moat Size||Current Price (USD)||Price/ Fair Value||T4Q DVD Yield (%)||Uncertainty Rating||# Funds Holding|
|GlaxoS-K ADR* (GSK) ||4||Wide||44.12||0.9||5.3||Medium||6|
|ConPhil (COP) ||2||Narrow||57.69||1.11||4.6||Medium||6|
|Intel (INTC) ||4||Wide||20.53||0.76||4.4||Medium||8|
|Eli Lilly (LLY) ||2||Wide||47.79||1.09||4.1||Medium||5|
|Novartis ADR* (NVS) ||4||Wide||63.19||0.92||3.9||Low||8|
|Merck (MRK) ||3||Wide||43.54||0.95||3.9||Medium||7|
|Philip Morris (PM) ||3||Wide||87.75||0.95||3.7||Medium||7|
|Pfizer (PFE) ||3||Wide||25.18||0.93||3.5||Medium||8|
|Sysco (SYY) ||4||Wide||31.76||0.88||3.4||Medium||7|
|J&J (JNJ) ||4||Wide||70.69||0.92||3.4||Low||13|
Stock Price and Morningstar Rating data as of 12-14-12.
*Dividends for American Depository Receipts (ADRs) can be affected by changes in currency exchange rates. Our calculations also adjust for special dividends.
Much as we've seen in previous periods, our list of the top 10 dividend-yielding stocks held by our top managers is dominated by health-care stocks, with drug manufacturers accounting for six of the 10 names listed above. The relatively stable free cash flows that are generated by these firms, which tend not to be affected as much by economic cycles than other dividend-producing stocks (with the exception of utilities), makes them somewhat more attractive to our managers. While there is some risk to the drug companies' earnings power, as many 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 (although that does not mean that dividend growth won't be stalled as these firms work through a major patent cliff). What is also interesting about the list is that half of these names currently trade at price levels that are closer to our analysts' consider buy prices than the average discount to fair value estimate seen in our coverage universe overall. Believing that all these stocks warranted further consideration, we've collected commentary from our analysts reflecting their current thinking on the names, as well as thoughts on the dividend prospects for each firm in the near-to-medium term.
While GlaxoSmithKline faces potential generic competition to 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, and vaccines offer the potential for strong long-term growth without the typical sales cliff associated with patent losses in traditional drugs. While he does not envision any large acquisitions in GlaxoSmithKline's future, given the firm's relatively large debt position, Conover sees the potential for the company to make several smaller tuck-in acquisitions in order to increase its exposure to emerging markets. His research also indicates that the company's product pipeline has improved, with a strong lineup of late-stage drugs, along with several drugs focused on orphan indications (which can provide strong pricing power and a more supportive regulatory environment). And while the threat to GlaxoSmithKline's Advair asthma drug from generic alternatives is real, manufacturing challenges and the complexities around generic respiratory drugs may delay and limit the competitive threat. Conover also believes that the firm's broad strength across its operations should support slight growth in its dividend over the next few years.
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 changed course last year by selling off assets and reducing investment, while moving forward this year with a spin-off of its downstream assets into a separate company, Phillips 66 (PSX). But life as an independent E&P has proven to be difficult as well, with the firm having to confront the dilemma that is often faced by E&Ps when commodity prices fall like they have this year. As a result of the drop in oil and gas prices, Good believes that ConocoPhillips will likely outspend its operating cash flow this year and potentially next. He does note, however, that the firm's sizable cash balance means that it will not need to trim its capital spending plans at this time. Good also highlights the fact that the firm has sacrificed share repurchases that would have otherwise been funded by asset sales to backstop its capital expenditures and ensure the firm's dividend in the near term. That said, if commodity prices do not hold over the next year and asset sales do not materialize, he believes that the company may be forced to trim spending and forgo production growth, as the dividend remains its top priority.
Morningstar analyst Andy Ng notes that Intel is the largest semiconductor firm in the world and that the firm dominates the PC microprocessor market. He believes that Intel's greatest asset is its technological prowess in semiconductor manufacturing. By being the runaway leader in driving Moore's Law, the firm has the capabilities to build better-performing processors at lower per-unit costs than smaller rival Advanced Micro Devices (AMD). While the growing popularity of tablets running on chips designed by ARM Holdings (ARMH) has raised concerns about Intel's PC processor business, with the firm having trouble penetrating the mobile device chip market, Ng expects Intel's Atom processors to become much more competitive in the next couple of years. Either way, he thinks that the mass adoption of tablets will benefit Intel, as it will require substantial buildouts of the cloud, which in turn will drive server chip sales at the firm. Ng also notes that while Intel has a significant cash hoard, it is justified, in his view, by the deeply cyclical nature of the semiconductor industry. It also provides the firm with the resources and flexibility to invest heavily in research and development, as well as the most cutting-edge, chip-fabrication processes, while still maintaining its dividend and pursuing share repurchases.
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 believes that the drug manufacturer will be able to post flattish top-line growth during the next decade, as the firm's strong late-stage pipeline helps to offset its patent losses, this next generation of drugs will be 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. The company has also been serious about improving its bottom line, which should allow it to generate about$4 billion in annual cash flows from its operations during the next several years, allowing Lilly to more than adequately fund its annual dividend and capital expenditures of $2 billion and $1 billion, respectively.
Novartis is in front of all of the tailwinds moving the pharmaceutical industry during the next decade, according to Morningstar analyst Damien Conover. He notes that the firm's strategy of targeting unmet medical needs with its drug pipeline should yield several drugs with strong pricing power, and ranks Novartis' pipeline as the best in the industry. Conover expects the company's Sandoz generic division to benefit from patent losses on major blockbuster drugs, as well as the potential for generic biologics, and thinks that Novartis' strong exposure to the fast-growing emerging markets should help propel growth. That said, Conover does note that manufacturing issues in the company's consumer division, as well as an increasingly competitive generics industry, will likely weigh on Novartis' near-term prospects. With regards to the firm's capital structure, Conover notes that the firm still looks a little heavy on the debt side, with Novartis taking on close to $20 billion in debt to complete the Alcon transaction, but that this inflated leverage position still looks highly manageable in comparison with most firms. Over the next several years, he expects the company to use its robust cash flows to pay down debt quickly. By 2013, Conover believes that Novartis will begin to aggressively buy back shares, increase its dividend at a much quicker rate, and start looking for some midsized acquisitions.
The recurring theme among the drug manufacturers is patent losses, and Merck is no exception. Morningstar analyst Damien Conover notes that despite the Singulair patent loss in 2012, Merck is relatively well positioned for steady growth during the next five years. Partly based on the Schering-Plough acquisition, Conover sees Merck backing away from its patent cliff with a strong lineup of new products including Victrelis (hepatitis C), Bridion (anesthesia), Saphris (schizophrenia), Simponi (immunology diseases), and Dulera (asthma). He also notes that recently launched drugs Januvia (diabetes) and Isentress (HIV) have already developed into blockbusters and should continue to post steady gains. That said, Conover believes that Merck's pipeline does face one challenge, which is that most of these new drugs will enter markets crowded by good generic drugs. As such, he thinks that efforts aimed at cost-cutting will be essential for keeping Merck's free cash flows strong, with the firm's most recent round of cuts eliminating more than $4 billion in annual costs by 2015. Believing that Merck's free cash flows from operations will average close to $12 billion per annum over the next four years, Conover does not expect the company to have any trouble funding its annual dividend of approximately $5 billion along with annual capital expenditures of $2 billion.
Philip Morris International (PM)
Morningstar analyst Thomas Mullarkey notes that Philip Morris International is a cash-generating machine. The company, which produces industry-leading operating margins and returns on invested capital, boasts a wide economic moat that he thinks is fortified by a bevy of powerful brands, a global manufacturing and distribution system, and an addictive product. While the company, which competes in 180 countries, has seen dwindling demand for its tobacco products in some of its mature markets, Asia continues to serve as a key driver for growth. Mullarkey does note, however, that Philip Morris had to lower its EPS outlook this year due to a strengthening U.S. dollar, but expects the firm's long-term prospects to be more robust. He also notes that since its separation from Altria (MO) in March 2008, the international tobacco company has responsibly increased its leverage while returning more than $35 billion to shareholders in the form of dividend payments and common stock repurchases. With the firm generating free cash flow in excess of 30% of revenue, Mullarkey believes that Philip Morris should remain in robust financial health--capable of not only meeting its debt obligations as they come due, but continuing to return cash to shareholders through dividends and share repurchases.
With several major patent losses (including the loss of exclusivity of Lipitor last year) slowing Pfizer's sales momentum, Morningstar analyst Damien Conover continues to expect flat revenue growth at the firm over the next several years, believing that the company's 2009 acquisition of Wyeth will help insulate it against any one particular patent loss. Conover also thinks that several underappreciated factors, such as expansion into emerging markets and aggressive cost-cutting, should contribute to the firm's long-term potential. With emerging markets demanding health-care products at an accelerating pace, sales of Pfizer's blockbuster drugs could increase dramatically. In addition, the firm has been significantly cutting its cost base as a result of not only the Wyeth acquisition but due to less marketing support for drugs losing patent protection, as well as a structural realignment to improve R&D efficiency. Conover also notes that Pfizer's pipeline is developing into one of the best in the industry, setting the foundation for strong long-term growth. Even though the firm's current quarterly dividend of $0.22 per share produces a dividend yield of 3.5%, Conover sees the potential for a significant increase in the dividend over the next several years, noting that Pfizer had cut its dividend by 50% in 2009 to help fund its purchase of Wyeth.
Morningstar analyst Erin Lash believes that even though Sysco is dealing with a difficult macroeconomic landscape that there have been some underlying positive trends--such as a slight moderation in food cost inflation and a modest uptick in case volume growth--to support her thesis that an expansive distribution network will enable Sysco to remain the dominant player in North American food-service distribution. That said, she also notes that the firm's business transformation efforts are taking longer to put into place than management initially anticipated, and that the lumpy economic recovery will likely continue to plague domestic consumer spending. Despite this, Lash believes that the market's concerns regarding sluggish restaurant traffic and persistent food cost inflation are overdone and are unjustly weighing on Sysco's shares. She also points out that Sysco's continued emphasis on stringent cost management has allowed the firm to realize returns that are about 3 times the level of its peers'. Although Lash expects Sysco to continue to return excess cash to shareholders in the form of dividends, acquisitions are also likely. In her view, appropriately priced acquisitions would be a prudent use of capital, as about 70% of the market remains highly fragmented. Lash does believe, though, that the firm can still raise its annual dividend at a high-single-digit rate over the next five years.
Johnson & Johnson (JNJ)
In contrast to the patent cliff facing the rest of the drug industry, Morningstar analyst Damien Conover notes that Johnson & Johnson has largely passed this hurdle following the loss of patent protection on antipsychotic Risperdal and neuroscience drug Topamax. With only minor near-term patent losses to contend with, he expects Johnson & Johnson's new potential blockbusters to return the company to steady long-term growth. Within this group of new drugs, Conover notes that Xarelto for cardiovascular disease and telaprevir for hepatitis C offer the potential to revolutionize treatment. He 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 longer-term, Conover believes that Johnson & Johnson's dividend payments could see steady increases over the next five years as earnings rise at the health care firm. That said, he does note that some of the near-term challenges that the company currently faces, especially in its consumer division, could lead to a deceleration in the high-single-digit rate of growth that was seen in the dividend over the past five years.
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Disclosure: Greggory Warren owns shares in the following securities mentioned above: Amana Trust Income and Altria. 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.