How to find the healthiest dividend-paying stocks for your portfolio

Stock selection for equity income became even more difficult at the onset of the pandemic last year when loyal dividend payers like

Southwest Airlines

(symbol: LUV),

Boeing

(BA), and

Walt disney

(DIS) suspended their payments to preserve capital.

While the overall health of dividends has improved markedly since then and looks good by 2022, it’s important to keep quality in mind. However, it can be difficult to determine what separates these stocks from the rest of the pack, given the subjective nature of the definition of quality.

Barron spoke to three fund managers for advice and to learn more about some of their favorite dividend-paying stocks.

A quality payment “is not only sustainable, but can preferably increase over time,” says Mike Barclay, senior portfolio manager at Columbia Threadneedle Investments. “This is one of the reasons we don’t focus on performance,” he adds. Barclay is a $ 39 billion manager

Colombian dividend income
funds (LBSAX). As of October 31, its main holdings included

Microsoft

(MSFT),

JPMorgan Chase

(JPM), and

Johnson & johnson

(JNJ).

A dividend yield, says Barclay, “is just a formula” and “it doesn’t really tell you about the health of the business or the ability to pay that dividend in the future.”

Steve Goddard, founder and chief investment officer of the London Co., which manages money in segregated accounts, prefers companies with high returns on capital and strong balance sheets. “High return on capital companies typically generate, by definition, much more free cash flow than the average business,” he says. And the cash flow is what pays the dividend.

In the third quarter of this year, the top 10 stocks in the London Co., based in Richmond, Va., Equity income strategy included

Apple

(AAPL), which recently sold 0.5%; chip maker

Texas instruments

(TXN), 2.4%;

Microsoft

(MSFT), 0.7%; home improvement retailer

Lowe’s

(LOW), 1.2%; and asset manager

Black rock

(BLK), 1.8%.

Another potential benefit for quality stocks: In addition to offering strong and growing dividends, there are many attractive valuations that trade and trade at a discount to the dollar.

Russel 1000
index finger, said Goddard.

David Katz, chief investment officer at Matrix Asset Advisors in White Plains, NY, quotes the

S&P 500 Dividend Aristocrats Index
when asked about quality companies that pay dividends. The 65 companies in the index, all of which have paid higher dividends for at least 25 consecutive years, include

Target

(TGT),

Chevron

(CLC), and

caterpillar

(CAT).

“They are well-funded companies with a long operating history, good balance sheets, and they have consistently maintained and increased their dividends,” Katz said.

He points out that the stock market, with its tilt towards growth companies, has not treated quality companies with much respect this year.

“You have a lot of really good drug companies that focus on dividends and dividend growth, have good earnings and good earnings growth, but stocks are just miserable,” Katz said, stressing

Merck

(MRK) and

Amgen

(AMGN) as prime examples.

Merck, which returns 3.8%, has returned around minus 4% this year, including dividends, compared to around 26% for the

S&P 500.
Amgen, a biotechnology company whose stock returns 3.6%, is also down about 4% this year.

For Barclay and colleagues, the hunt for quality dividends begins with free cash flow, which is typically calculated as operating cash flow minus capital expenses. “At the end of the day, a dividend cannot be sustained, let alone increased, over time if the underlying cash flow from operations does not increase,” he observes.

He also pays close attention to a company’s balance sheet: the stronger it is, the better for dividends.

“You don’t always get paid for a strong balance sheet, except when you step into a stressed environment” like that of March 2020, when the pandemic hit the United States hard, says Barclay. “If you don’t have a strong balance sheet, you can’t weather this storm.”

Barclay also analyzes a company’s payout ratio, which it defines as the percentage of free cash flow paid out as dividends. Many others define it as the percentage of profits that are paid out as dividends.

“When the payout ratio is low, we know they have a lot of wiggle room for dividend growth,” he says. “The capacity [to pay it] is there. It’s our job to really put pressure on management as to whether or not the will is there to increase the dividend over time.

One stock that Barclay likes the dividend of is Microsoft, which has been increasing its cash outflows at an annual rate of about 10% per year. It returns just 0.7%, well below the S&P 500 average of around 1.3%. However, Barclay says his cost base for stocks – the average of what he paid for stocks – is less than $ 30, which means his return is effectively over 8%.

Two other dividend-paying stocks he favors are analog chipmaker Texas Instruments and banking powerhouse JPMorgan Chase, which returns 2.5%.

The analog chip market is growing, a boon for TI, and the industry is consolidating, he says. As for JPMorgan Chase, says Barclay, it has “a very diverse business model that allows it to ride economic cycles with some consistency.” This allows him to pay and increase his dividend.

Katz likes

Coca Cola

(KO), which recently lost 3.1% but had only returned around 4% this year. He likes the outlook for the beverage company and adds that it “has actually been pretty good in terms of dividends.”

Coke CFO John Murphy said on his third quarter earnings conference call in late October that improved cash flow would help continue “our history of increasing our dividend.”

Write to Lawrence C. Strauss at lawrence.strauss@barrons.com