Top managers' top dividend stocks

Related topics: stock market, dividends, value stocks, mutual funds, investing strategy

Some investors see dividends as a sign of poor growth prospects, but in the long run dividends can help investors earn superior total returns.

In his 2005 book, "The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New," renowned market commentator Jeremy Siegel identified dividends as one of the key drivers of long-term equity outperformance. While companies that pay dividends may not grow as quickly as their successful nondividend counterparts, Siegel's research shows that the income they generate -- in addition to the signals that dividends send about financial strength, business stability and capital discipline -- have been extremely valuable for long-term investors.

"Pay me a dividend, and I know I'm getting something from my investment I never need to give back," said Josh Peters, a Morningstar equities strategist and the editor of the monthly Morningstar Dividend Investor. "Pay me a dividend, and I have the flexibility to help fund my lifestyle in retirement or reinvest my income for additional wealth compounding."

While Peters believes that the stock market has gotten a bit stretched, he sees opportunities for investors to earn returns in excess of the 2.3% yield being offered by the Standard & Poor's 500 Index ($INX).

The 26 money managers who make up Morningstar's Ultimate Stock Pickers tend to favor dividend-paying stocks. While it would be easy to look at just the highest-yielding stocks held by these managers, we found that most of those securities were actually held by fewer than two managers, and that some of the highest yielders on the list potentially lack the ability to sustain their dividend payouts.

So we narrowed the list to those securities held by at least five of our Ultimate Stock Pickers and which exceed the annual yield of the S&P 500.

We've also collected commentary from Morningstar analysts on the dividend-paying stocks they think are most appealing on a price-to-fair-value basis.

Four of the 10 names -- Pfizer, Philip Morris International, Diageo and Sysco -- are holdovers from last year's list of top 10 dividend stocks. That's not surprising, given their long-standing status as dividend payers.

Philip Morris and Diageo are "sin stocks," or stocks of companies that derive a significant portion of their revenue from socially questionable products -- in this case, cigarettes (Philip Morris) and alcohol (Diageo). Such companies traditionally pay higher dividends to attract and retain investors.

The list is also heavily weighted toward companies in the health-care and consumer sectors. We think the health-care orientation is the result of pharmaceutical companies being pressured by a raft of drug patent expirations. That said, just about every health care name on the list is yielding above 4%, a much higher figure than we would expect from this traditionally defensive sector.

As for the consumer names that aren't sin-related, the yields are slightly elevated due to the impact that the downturn in the economy has had on business models.

Lilly's uphill climb

Morningstar analyst Damien Conover believes that Eli Lilly faces one of the most daunting 10-year outlooks in its peer group, which goes a long way toward explaining its high yield.

Conover said that flat top-line growth over the next decade (due to the loss of several high-margin drugs) is likely to pressure Lilly's earnings. Even so, the analyst thinks Lilly offers a compelling valuation on the basis of his cash flow projections (which should support the dividend) and the potential for upside from the company's pipeline.

Lilly's drug solanezumab could shift the paradigm in treating Alzheimer's. Positive data from the drug's Phase III trials (expected in 2012) could dramatically reshape Lilly's prospects, said Conover, who expects Lilly to advance several Phase II candidates into Phase III development rapidly to help mitigate the effect of patent expirations.