How to find the healthiest dividend stocks for your portfolio

Choosing stock earnings became even tougher early in the pandemic last year when solid dividend payers who

Southwest Airlines (ticker: LUV),

Boeing (BA), and

Walt Disney (DIS) suspended their payments to preserve capital.

Although the overall dividend health has improved markedly since then and looks good towards 2022, it is important to have quality in mind. However, it can be difficult to determine what distinguishes such stocks from the rest of the package, given the subjective nature of defining quality.

Barrons talked to three money managers for guidance, and to learn about some of their favorite dividend stocks.

A quality payout “is not only sustainable, but can preferably grow over time,”[ads1]; says Mike Barclay, senior portfolio manager at Columbia Threadneedle Investments. “That’s one of the reasons why we do not focus on returns,” he adds. Barclay is a $ 39 billion manager

Columbia dividend income
fund (LBSAX). As of October 31, the top inventory included

Microsoft (MSFT),

JPMorgan Chase (JPM), and

Johnson & Johnson (JNJ).

A dividend yield, says Barclay, “is just a formula” and “it really does not tell you about the health of the company or the ability to pay dividends in the future.”

Steve Goddard, founder and chief investment officer of London Co., which manages money in separate accounts, prefers companies with high returns on capital and strong balances. “Companies with a high return on capital will usually by definition generate much more free cash flow than the average company would do,” he says. And the cash flow is what pays the dividend.

As of the third quarter of this year, Richmond, Va.-based London Co. its share income strategy top 10 holdings

apple (AAPL), which recently gave 0.5%; chip maker

Texas Instruments (TXN), 2.4%;

Microsoft (MSFT), 0.7%; home improvement dealer

Lowes (LOW), 1.2%; and asset manager

Black stone (BLK), 1.8%.

Another potential plus for quality stocks: In addition to offering solid and growing dividends, many sport attractive valuations and trade at a discount compared to

Russell 1000
index, says Goddard.

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

S&P 500 Dividend Aristocrats Index
on questions 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

Goal (TGT),

Chevron (CVX), and

larva (CAT).

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

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

“You have a lot of really good drug companies that have a significant focus on dividends and dividend growth, have good earnings and good earnings growth, but the stocks have just been lousy,” Katz says, pointing to

Merck (MRK) and

Amgen (AMGN) as good examples.

Merck, which gives 3.8%, has given a return of approx. minus 4% this year, including dividends, compared to approx. 26% for

S&P 500.
Amgen, a biotechnology company whose shares yield 3.6%, is also down around 4% this year.

For Barclay and his colleagues, the pursuit of quality dividends begins with free cash flow, which is typically calculated as cash flow from operations minus capital expenditures. “At the end of the day, a dividend can not be maintained, let alone grow, over time, if the underlying cash from operations does not grow,” he observes.

He also closely monitors a company’s balance sheet – the stronger, the better for dividends.

“You do not always get paid for a strong balance, except when you enter a stressful environment” as it was in March 2020, when the pandemic hit the United States hard, says Barclay. “If you do not have a strong balance, you can not cope with that storm.”

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

“When the payout ratio is low, we know they have a lot of room for dividend growth,” he says. “The ability [to pay it] is it. It is our job to really push the management regardless of whether the will is there to increase the dividend over time. “

One stock whose dividend Barclay likes is Microsoft, which has increased its payout by an annual rate of around 10% a year. It gives only 0.7%, well below the S&P 500’s average of around 1.3%. However, Barclay says his cost base for the stock – the average of what he paid for the shares – is below $ 30, which means that his return is actually over 8%.

Two other dividend stocks he prefers are the analog chip maker Texas Instruments and the banking powerhouse JPMorgan Chase, which provide 2.5 percent.

The market for analog chips is growing – a boon for TI – and the industry is consolidating, he says. As for the JPMorgan Chase, says Barclay, it has “a very diversified business model that allows it to run the economic cycles with a certain consistency.” It allows it to pay and increase dividends.

Katz likes

Cola (KO), which recently gave 3.1%, but only had a return of around 4% this year. He likes the beverage company’s prospects and adds that it “has actually been pretty good in terms of dividends.”

Cokes’ chief financial officer, John Murphy, said during the third-quarter results call in late October that improving cash flow would help continue “our track record of increasing dividends.”

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