The vast majority of our Ultimate Stock-Pickers are not dividend investors. That said, a handful of them-- Amana Income AMANX, Columbia Dividend Income LBSAX, Oakmark Equity And Income OAKBX, and Parnassus Core Equity PRBLX--focus more on income-producing stocks in their pursuit of investment return. Warren Buffett at Berkshire Hathaway BRK.B has spoken highly of companies that return capital to shareholders and is not against investing in and holding higher-yielding names. Three of Berkshire's top five holdings--wide-moat Wells Fargo WFC, Bank of America BA, and Coca-Cola KO--yield more than the S&P 500, and they account for about one third of the insurer's equity 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 find 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 sustainable competitive advantages, which should allow them to generate the excess returns necessary to maintain their dividends over the longer term. We also look for firms where there is lower uncertainty on our analysts' part regarding their future cash flows. We accomplish 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, have 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 lists stocks that are widely held by our Ultimate Stock-Pickers and pay dividends in excess of the S&P 500, which is currently yielding 1.9%. We should note 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 the current list is quite similar to the previous list. The only difference is that narrow-moat CVS Health CVS replaced wide-moat rated Procter & Gamble PG. Aside from the number one dividend-yielding stock, Philip Morris International PM, every other stock on the top 10 list either moved up or down on the list. Wide-moat rated Gilead Sciences Inc GILD, United Parcel Service UPS, and Wells Fargo moved up the list, while wide-moat rated Pfizer PFE, Unilever UN, Novartis NVS, and PepsiCo PEP and narrow-moat rated Kimberly-Clark KMB moved down the list. The top 10 widely held dividend-paying stocks also remained fairly consistent this period. Seven of the 10 widely held dividend-paying stocks were present in the second quarter's top 10 list. Comcast CMCSA, CVS, and TE Connectivity TEL emerged as new names on the top 10 widely held dividend-paying stocks this period.
Top 10 Dividend-Yielding Stocks of Our Ultimate Stock-Pickers
After repeated sirens by our top managers over the state of rising valuations and interest rates, the S&P 500 TR Index finally corrected during the fourth quarter. The S&P 500 closed at 2930.75 on Sept. 20, 2018, and fell to close at 2351.1 on Dec. 24, representing a peak-to-trough decline of about 20%. Since late December, the overall market has recovered substantially. Although valuations are looking slightly more reasonable, the current S&P 500 price/earnings ratio of about 21 is still higher than its historical mean and median levels. As a consequence, several sectors that tend to be associated with higher dividend yield—such as utilities, consumer defensive, and healthcare—can have lower yields due to higher stock prices. 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 mitigate some of these risks, we eliminate stocks with higher uncertainty ratings from our screening process.
After doing this, we have found quite a few attractively priced quality stocks. Seven out of the top 10 dividend-yielding stocks are materially undervalued, including quality names such as wide-moat rated Philip Morris International, Gilead Sciences, Wells Fargo, Pfizer, Unilever, Novartis, PepsiCo, and narrow-moat rated CVS Health. The average price to fair value estimate for the top dividend-yielding stocks was .90, indicating that these high-yielding stocks are generally attractively priced. The top 10 dividend-yielding stocks are heavily overweight to the consumer defensive and healthcare sectors, as both of these sectors contributed four stocks to the top 10 list. This story is slightly different in the top 10 widely held dividend-paying stocks, which has three healthcare stocks, two consumer defensive stocks, two financial services stocks, and two technology stocks. The most widely held stock that was also present on the top 10 dividend-yielding stocks list this period was wide-moat rated PepsiCo. Gilead Sciences, Kimberly-Clark, Wells Fargo, and PepsiCo were the most widely purchased top dividend-paying stocks this period.
Top 10 Widely Held Dividend-Paying Stocks of Our Ultimate Stock-Pickers
Looking more closely at the list of top 10 widely held dividend-paying securities, there was a reasonable amount of overlap with our list of top 10 dividend-yielding stocks. Wide-moat rated Wells Fargo, Pfizer, PepsiCo, as well as narrow-moat rated CVS Health were on both top 10 lists. Continuing a recurring theme, the majority of names on our list of top 10 widely held securities are held by nine or more funds. This period's list of widely held dividend-paying stocks was not as undervalued as the top dividend-paying stocks. Five of the 10 stocks were materially undervalued, compared with seven on the top 10 dividend-paying stocks.
We continue to believe that the best way for investors to protect their capital is to invest in quality businesses that are trading at attractive prices. Our valuation shows that narrow-moat rated CVS Health is the cheapest, so we will focus on this stock in this piece. We also intend to highlight wide-moat rated and Wells Fargo, Philip Morris, and PepsiCo, since all these stocks are undervalued.
Narrow-moat rated CVS Health was the stock that had the most compelling valuation on both our top 10 lists. The stock trades at a 40% discount to Morningstar analyst Jake Strole's fair value estimate of $92, which implies roughly a 14 times 2019 earnings multiple. Overall, Strole recognizes that CVS' pharmacy business is continuing through a period of prolonged weakness, and he thinks the market appears to be taking an overly pessimistic view while not recognizing the longer-term earnings power of a combined CVS and Aetna.
CVS is a combination of the leading pharmacy benefit manager, retail pharmacy, and a top managed care franchise. Strole thinks that these businesses form three pillars that position the firm to better compete in a consolidating healthcare services sector over the next 10 years. Strole recognizes that each of these three business segments is unique but thinks that they each demonstrate cost advantages that support a narrow economic moat.
The pharmacy benefit manager business has consolidated into three major players. CVS is the largest of the three, adjudicating 1.9 billion in adjusted scripts annually. The pharmacy benefit manager's ability to consolidate buying power helps it receive discounts from both pharmacies and drug manufacturers for its clients, which is evidence for Strole's cost advantage argument.
Second, CVS' pharmacy business dispenses over one quarter of all prescriptions filled outside the hospital, which to Strole helps support economic profits by leveraging fixed costs and creates synergies with its pharmacy benefit manager in order to create more cost-advantaged pharmacy networks.
Third, CVS recently purchased Aetna, which is the fifth largest managed care organization nationally, measured by premiums written, but is more likely the third or fourth largest by membership given its sizable fee-based enrollment mix. Strole thinks that scale drives cost advantages in the managed care business for two reasons. First, a larger membership base allows for greater centralized fixed cost leverage, increasing the profit potential of the marginal member on the overall enterprise, Second, a larger membership base allows for greater negotiating leverage versus the providers that an insurer needs to create a plan network, allowing for lower medical costs per member and the opportunity to lower premiums or improve its benefits offering to secure enrollment growth.
Based on all of these strengths, Strole believes the earnings power of the combined CVS/Aetna franchise is likely ahead of what the market appreciates. While he admits the outlook for CVS is a bit muddied over the near term, as the firm's pharmacy business catering to the long-term care market continues through a period of prolonged weakness, Strole encourages investors to look through this volatility toward the longer-term earnings power of a combined CVS and Aetna.
The shares of wide-moat rated Wells Fargo are also trading at a substantial discount to our fair value estimate. The stock appeared on both of our top 10 lists of dividend-yielding stocks and is about 10.7% of the equity holdings of Berkshire Hathaway. Morningstar analyst Eric Compton thinks that the market has been overly pessimistic about Wells Fargo. Compton's fair value estimate of $65 represents 13.5 times his 2019 earnings per share estimate and 2 times reported tangible book value per share as of December 2018.
Wells Fargo's fake-account scandal has led the company into a multi-year long cultural, reputational, and legal upheaval. While Compton recognizes that predicting the exact timing of a reversal in the negative news cycle and sentiment is difficult, he believes that Wells is closer to the end than the beginning. The bank recently came to a settlement with the attorneys general of all 50 states, which he views as evidence of progress here. While Wells' legal situation continues to be a mixed bag, Compton continues to believe that the mix will skew less negatively. The bank is currently trading well below its historical tangible book value multiple and has the highest dividend yield among the big four banks. Revenue-wise, Compton recognizes that the regulatory decision to not lift Wells' asset-cap in 2019 will be a negative for the bank but thinks that Wells is continuing to manage its balance sheet admirably given the asset cap. Compton forecasts that the bank has the most room for operating income growth independent of revenue growth simply due to retreating legal and other accruals. To Compton, Wells is not a revenue growth story but instead a story of declining expenses and improving sentiment. Recent performance is showing that Wells is capable of reducing these legal expenses, as management met its previous expense guidance and even reiterated its guidance for 2019 and 2020. As highlighted in the recent Select piece, “New Regulatory Proposals Will Change Stress Test Landscape,” published in July 2018, Wells may also have some of the most room to return capital to shareholders over the medium term among the big four. This should serve as a further backstop to the share price through share repurchases, and, of course, a healthy dividend.
Compton understands that Wells still has issues to resolve, including consent orders, stemming the loss of financial advisors, and returning to offense among its small business and consumer clients. Since the bank has been on the defensive for so long, Compton now sees Wells lagging behind in certain areas of investment compared with some of its toughest competitors. That noted, Compton does not believe the franchise has been fundamentally impaired. Compton remarks that the inappropriate sales practices generated essentially no profits for the bank, and a number of the more recently disclosed issues have been self-reported and occurred, in some cases, years ago. Many of the board members and managers present during the scandal have been replaced, and Compton believes that it is only a matter of time before the microscope is removed from Wells and the bank returns to business as usual.
Philip Morris International
Wide-moat rated Philip Morris International has been our top dividend-paying stock for the last three issues of the dividend-focused Ultimate Stock-Pickers article. This stock is currently trading at an 11% discount to Morningstar Analyst Philip Gorham's fair value estimate of $102, which implies a forward 2020 multiple of 18 times earnings per share. Gorham continues to see upside in Philip Morris at current levels. A major focus of Gorham's thesis on Philip Morris is that the company is developing a first-mover advantage in the transition away from traditional cigarettes to reduced risk products.
Gorham likes Philip Morris' investment in heated tobacco products, as they most closely replicate the smoking experience and so should attract smokers looking for a less risky alternative. This leads Gorham to believe that Philip Morris' multiple premium over peers is appropriate because the company has claimed a first mover advantage, at least temporarily, through the early commercialization of its heated tobacco product, the iQOS. That said, Gorham recognizes that there are still many unanswered questions about the evolution of heated tobacco. Much depends on the regulatory environment and whether regulators publicly acknowledge that the category is safer than smoking. The FDA is expected to announce its opinion on the matter later in 2019. Gorham thinks that with scale, these heated tobacco products can be at least as profitable as premium cigarettes but that the margins will depend heavily on the level of taxation. At the moment, the overarching assumption relating to reduced-risk products in Gorham's base-case valuation is that iQOS continues to increase its share of Philip Morris' volume mix and that this product is margin dilutive, largely due to his assumption that these products will eventually be taxed as heavily as other tobacco products. 2018's results support this thesis, as the consolidated operating margin of 38.4% in full-year 2018 fell by almost 2 percentage points, lending support to his thesis that the tobacco manufacturers will face significant headwinds to margins going forward. Even while projecting these headwinds, Gorham still views shares as undervalued.
The final stock we will highlight is wide-moat rated PepsiCo, which was the second most widely held dividend-paying stock and the tenth top dividend-paying stock this period. Morningstar analyst Sonia Vora thinks that PepsiCo’s leading portfolio of beverage and snack brands has carved out a wide moat for the firm, which is based on intangible assets and a cost advantage. This low-uncertainty stock is currently trading at a modest discount to Vora's fair value estimate of $122.
Commodity cost inflation has been weighing on firms across the food and beverage space, but Vora thinks that Pepsi's wide moat will allow it to pass on these costs to consumers. Vora argues that Pepsi's product innovation has allowed it to drive net pricing increases by an average of 1.7% above inflation over the past five years. Pepsi's portfolio includes 22 brands that generate over $1 billion in revenue annually, leading to sticky relationships with distributors and retailers that depend on leading brands to generate store traffic, a dynamic that Vora expects to continue, given the resources that Pepsi has to reinvest in its brands. Recent results show that this thesis is playing out, as Pepsi increased prices in five of its six operating segments. Vora also appreciates Pepsi's plan to strengthen investments in advertising and marketing in 2019, which should help ensure that its brands align with evolving consumer tastes.
Vora also thinks Pepsi benefits from significant cost advantages. Vora notes that despite the company's broad geographic reach, the beverage maker's widespread network of plants, warehouses, and distribution centers allow it to minimize transportation costs and increase its supply-chain efficiency. The combination of the food and snack businesses provides $800 million to $1 billion in synergies, according to management, and allows Pepsi to benefit from lower distribution and in-store marketing costs for its products since they can be shipped or promoted together.
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Disclosure: Except for Berkshire Hathaway (BRK.B), Burkett Huey 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.