By Joshua Aguilar | Associate Equity Analyst
The vast majority of our Ultimate Stock-Pickers have never been mistaken for dividend investors. That said, a handful of them-- Amana Trust Income AMANX, Columbia Dividend Income LBSAX, Oakmark Equity & Income OAKBX, and Parnassus Equity Income PRBLX--are more focused on income-producing stocks in their pursuit of investment gains.
Warren Buffett at Berkshire Hathaway BRK.A /BRK.B has also spoken affirmatively of returning capital to shareholders and is not against investing in and holding higher-yielding names. Four of Berkshire's top five holdings--narrow-moat rated Kraft Heinz KHC, wide-moat Wells Fargo WFC and Coca-Cola KO, and narrow-moat IBM IBM--all yield more than the S&P 500 TR, which is currently yielding 1.9%, and currently account for over 50 percent of the insurer's equity investment portfolio.
As you may recall from our previous dividend-themed articles, when we screen for top dividend-paying stocks among the holdings of our Ultimate Stock-Pickers we try to hone in on the highest-quality names that are currently held with conviction by our top managers. We do this by taking an initial list of the dividend-paying stocks held in the portfolios of our Ultimate Stock-Pickers and then narrow it down by concentrating on firms that we believe have competitive advantages, which, in our view, should allow them to generate the excess returns they'll need to maintain their dividends longer term.
We also look for firms where there is lower uncertainty on our analysts' part regarding their future cash flows. We accomplish all of this by screening for holdings that are widely held (by five or more of our top managers), are yielding more than the S&P 500, represent firms with Wide or Narrow economic moats, and have uncertainty ratings of either Low or Medium.
Once our filtering process is complete, we create two different tables--one that reflects the top 10 stocks with the highest dividend yields and another that represents the stocks that are the most widely held by our top managers while also paying dividends in excess of the S&P 500. In our view, finding stocks that are yielding more than the benchmark index and operate in more stable industries where there is less uncertainty surrounding their future cash flows should offer some downside protection for investors. With markets at or near all-time highs and interest rates still at lower-than-normal levels, many investors are left searching for yield wherever they can find it. We should note, though, that the dividend yield calculations in each of these two tables are based on regular dividends that have been declared during the past 12 months and do not include the impact of any special (or supplemental) dividends that may have been paid out (or declared) during that time.
Looking back to our list of top 10 dividend-yielding stocks from last time around, we note that five names--wide-moat rated Emerson Electric EMR, Nestle NSRGY, Verizon VZ, Novartis NVS, and Sanofi SNY--fell off the list and were replaced by wide-moat rated Intel INTC, Procter & Gamble PG, Philip Morris PM, and Wells Fargo, and narrow-moat rated Omnicom OMC. The S&P 500's yield of 1.9% at the time is on par with its current yield of 1.9%, and the benchmark index has increased in price over 11.5% during the past nine months.
Top 10 Dividend-Yielding Stocks of Our Ultimate Stock-Pickers
- source: Morningstar Analysts
Despite concerns over the fractured state of politics in Washington, the S&P 500 TR Index has risen over 13.1%, as investors have shrugged off such worries and continue to allocate dollars to equities. While not all stocks have recovered--with the Healthcare, Energy, and Communication Services sectors trading in aggregate at a discount of between 10% to 20% of our fair value estimates--many have rallied. Several sectors that have traditionally been associated with yield and safety--like Utilities and Consumer Defensive--continue to be bid up in the process. Searching for yield in this type of environment can be fraught with risks, including everything from price risk to the risk that a firm cannot meet its commitment to its dividend. In an effort to offset some of these risks, we eliminate stocks with higher uncertainty ratings from our screening process. Even after doing this, we're still looking at seven out of our top 10 dividend-yielding names trading at 95% or more of our analysts' fair value estimates, which, if bought at today's prices, would potentially diminish the opportunity for outsized total returns for long-term investors. With that in mind, we expect to focus on the names that have both a solid yield and a more favorable price to fair value ratio. General Electric GE, which we extensively profiled in a recent issue, trades at the most substantial discount of any of our top-yielding names, with a discrepancy of 25% from our analyst's fair value estimate. Other names that appeared attractive to us were newly appearing Omnicom as well as Buffett's favorite bank and Ultimate Stock-Picker staple, Wells Fargo.
Widely Held Dividend-Paying Stocks of Our Ultimate Stock-Pickers
- source: Morningstar Analysts
Looking more closely at the list of top 10 widely held securities that met our criteria for dividend-paying stocks this time around, there was less overlap with our list of top 10 dividend-yielding stocks, with only wide-moat rated Wells Fargo and narrow-moat Cisco CSCO making both lists. Continuing a theme from our last dividend-themed article, the majority of names on our list of top 10 widely held securities are held by 11 or more funds. While our top managers remained net sellers for the period, as they were in the prior five quarters, the buying activity that did occur was focused to some degree on these higher yielding names.
With valuation and safety being a top concern for investors, especially with markets again hovering near all-time highs relative to normalized interest rates, we continue to believe that the best way for investors to protect their capital is to invest in quality businesses trading at attractive prices. As such, we focus on names whose business prospects have a lower uncertainty, along with defensible moats, and that are currently the most undervalued--a list that includes wide-moat rated Microsoft MSFT, United Technologies UTX, as well as previously mentioned Wells Fargo. We think these names are more likely to offer investors both the yield they are looking for and prices that provide a relatively better margin of safety.
Microsoft Corp MSFT
Wide-moat rated Microsoft is the most widely held of our top 10 dividend-yielding stocks for the period. The stock currently trades at a 9% discount to our analyst's fair value estimate. Morningstar analyst Rodney Nelson recently raised his fair value estimate to $83 per share, a reflection of his rosier outlook for the firm's two flagship cloud properties: Office 365 and Microsoft Azure. With Office 365, Nelson believes that Microsoft has diminished a substantial amount of migration risk in its enterprise customer base by building a comprehensive set of cloud services under the Office 365 umbrella. He thinks that this franchise will follow a similar path to Adobe's ADBE Creative Cloud franchise, which experienced substantial revenue uplift by adopting a subscription-based selling model. For support, Nelson points to sales data from Microsoft's most recent earnings release that reveals Office 365 commercial revenue rose 43% versus the prior-year period, while the firm added another 800,000 Office 365 subscribers, bringing the total subscriber base to 27 million. While Microsoft has an outsized amortization of intangibles bill from its LinkedIn acquisition, Nelson does not view Microsoft's compressed operating margin expectations with concern, particularly when viewed in light of the firm's Commercial Cloud gross margin of 52%. This represents an increase of 10 percentage points over the prior year.
In the case of Azure, Nelson believes that Microsoft has solidified itself as one of two long-term strategic public cloud vendors, alongside Amazon Web Services AMZN, that enterprises will look to for their infrastructure needs. Sales data from the most recent quarter reveals that Azure continues to deliver impressive results, with revenue rising 97% year over year. More importantly, Azure's premium services revenue grew in excess of 100% for a 12th consecutive quarter, supporting Nelson's thesis. To Nelson, the latter figure signals that customers are becomingly increasingly enveloped in the Azure ecosystem, beyond commoditized compute and storage systems. Nelson thinks this trend heightens the likelihood that enterprise customers will become long-term Azure users. He sees both Office 365 and Azure carrying mid-30s operating margins in the long term. Given Office's dominant market position, he believes there is possibly upside to this figure, as he thinks Office represents a wide-moat franchise as a standalone entity based on switching costs and network effects. He ultimately believes that both the Office 365 and Azure franchises will drive the majority of revenue and profits for the consolidated entity by the end of his explicit forecast period, a level of growth that he thinks the market continues to discount.
Wide-moat rated United Technologies is another one of our top 10 dividend-yielding stocks, with four top managers holding the name. The stock currently trades at a 16% discount to Morningstar analyst Barbara Noverini's fair value estimate. Noverini believes that the name is poised for growth as secular tailwinds support long-term expansion across its four operating segments. She recently raised her fair value estimate to $134 from $129 on the heels of United Technologies' announced purchase of narrow-moat rated aerospace supplier Rockwell Collins COL. The deal, which was announced earlier this month, prices Rockwell at $140 per share. United Technologies will finance the deal using cash, debt, and equity, with nearly two thirds to be paid in cash and the remainder with United Technologies' stock.
Noverini thinks this move makes strategic sense because it broadens United Technologies' aerospace portfolio, which remains highly dependent on the geared turbofan engine. That said, she thinks the deal seems a touch expensive. Noverini points to the acquisition price of an enterprise value/EBITDA multiple close to 14 times. This contrasts with other large aerospace deals of around 13 times according to PitchBook data. The acquiring firm pegs cost synergies at $500 million. Noverini points out that United Technologies once delivered $500 million in cost savings on its 2012 Goodrich acquisition, which was about 6% of Goodrich's operating costs. Based on this, Noverini assesses that the proposed cost savings seems realistic, albeit slightly stretched, since they equate to a slightly higher percentage of Rockwell's overall operating costs at 7%. Compounding this issue, analyst Chris Higgins believes Rockwell is very well run and as such, cost savings may prove difficult to find.
Nevertheless, Noverini believes that United Technologies will increasingly trade like an aerospace stock and estimates it will generate roughly 60% of its 2019 revenue from aerospace and defense. This makes Noverini question what's in store for OTIS and climate, controls, and security, or CCS. She forecasts these segments at lower growth rates but higher margins than the aerospace business. Furthermore, given the limited overlap between the two companies' product lines, Noverini doesn't expect any antitrust challenges. That said, Airbus EADSF has publicly hinted that the Rockwell acquisition will distract United Technologies from delivering on its GTF engine program. This engine powers Airbus' A320neo model and has faced operating problems with airlines. Noverini ultimately expects that Rockwell will be folded into United Technologies' Aerospace Systems business and that management will argue that the GTF engine program, in spite of its critical phase, won't be affected. In addition to specific program concerns, Noverini thinks that Airbus, as well as Boeing BA, are negotiating hard with their suppliers to find cost savings and efficiencies, and that having an aerospace behemoth sitting in their supply base isn't in their interest. Even so, the airframers are unlikely to have a say in this merger, and Noverini thinks that they are unlikely to participate in such a deal.
Omnicom is the last of the names we are highlighting from our top 10 list of dividend-yielding stocks. The stock, which is making a first-time appearance, currently trades at a 14% discount to analyst Ali Mogharabi's fair value estimate. The narrow-moat firm is the second-largest player, based on annual revenue, within the advertising space. In Mogharabi's view, Omnicom holds valuable intangible assets around its holding company's brand equity and the strong reputations of its various advertising agencies around the world. Mogharabi also believes that the firm's continuing investments in consumer data accumulation and analysis give it a sustainable competitive advantage. Finally, and to a lesser extent, Mogharabi thinks the firm benefits from customer switching costs associated with further integration of the firm's resources with its clients' marketing departments. Given the utilization of the firm's moat sources and overall execution, Mogharabi believes that Omnicom will earn excess returns on capital for at least 10 years.
Omnicom's performance during the second quarter of 2017 exceeded Mogharabi's expectations on both the top and bottom lines. While Omnicom and its peers are facing disruption in the ad space, brought forth by technology and consulting, Mogharabi believes their data and analytics investments allows them to compete effectively by combining their expertise in creativity with changes in the advertising market. Consolidation within the fragmented industry has resulted in five companies, including Omnicom, generating nearly 30% of total global ad revenue. Mogharabi believes that three factors drove this space toward consolidation: globalization, the emergence and growth of digital media, and more cost-control initiatives taken by clients. In contrast to peers, Omnicom has attained its market share position more through organic growth, as opposed to pursuing inorganic opportunities. Mogharabi expects Omnicom to maintain its market share position as it generates competitive organic growth, continues to make acquisitions, and increases focus on the faster-growing emerging markets and the overall digital ad markets.
Examples of promising sources of growth Mogharabi points to include the addition of large accounts, such as AT&T T and McDonald's MCD, along with many small accounts. Mogharabi expects the pace of acquisitions to accelerate in order for Omnicom to gain further traction in other faster-growing international markets. Mogharabi reasons that globalization of businesses in specific industries has increased demand not only for industry-specific advertising expertise (vertical advertising), but also for experience, knowledge, and a clearer understanding of different cultures and regulations (horizontal advertising). Mogharabi also points out that Omnicom's clients are allocating more advertising dollars toward below-the-line, or more targeted, digital campaigns, creating additional avenues for growth. Mogharabi forecasts revenue growth at a 10-year compound annual growth rate of 3% through 2026, driven primarily by overall GDP growth.
Wells Fargo & Co WFC
Wells Fargo is the only name from our top 10 list of widely held, dividend-paying stocks we are highlighting. While we extensively profiled the name in our last issue, analyst Jim Sinegal recently published some additional insights about the bank, which trades at a 33% discount to his fair value estimate. The bank announced that a more intensive review of customer accounts found 3.5 million potentially fraudulent accounts opened between January 2009 and September 2016. While Sinegal acknowledges that the absolute number of faulty accounts is large, problems occurred with just 2.1% of total accounts reviewed, even while using a more comprehensive methodology to look for problems.
Additionally, Sinegal points out that only 190,000 of these accounts actually incurred any fees, and as a result, the bank is refunding just $6.1 million of revenue generated by these accounts to customers. In Sinegal's view, this supports his thesis that the vast majority of Wells' revenue comes from legitimate sources. Sinegal believes that a more well-rounded sales incentive program is likely to reduce the cost of wasted employee time, improve front-line morale, and result in higher long-term shareholder value over time. That said, Sinegal acknowledges that changes in company culture will not happen overnight for Wells. He also adds that additional misdeeds are likely to come to light as Wells Fargo remains in the spotlight for the wrong reasons. Given enough time to repair its reputation, Sinegal is still convinced the stock remains attractive, particularly in tandem with its current dividend yield. Only one U.S. lender with more than $50 billion in assets has produced higher returns on average assets over the past decade than Wells Fargo. Sinegal continues to believe that the biggest factor contributing to the bank's profitability is its high-quality deposit base. Only two competitors even relatively comparable to Wells' size have funded their balance sheet at a lower cost over the past decade. Customer behavior metrics measured since the crisis was uncovered continue to confirm Sinegal's view that this cost advantage remains intact.
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Disclosure: Except for Berkshire Hathaway (BRK.B), Joshua Aguilar has no ownership interest in any of the securities mentioned here. Eric Compton has no ownership interest in any of the securities mentioned here. 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.