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Hard-Core Dividend Growth Manager’s Stock Picks

Carla Fried

The smart money has always known that the key to exploiting the dividend advantage is to focus on the capacity of a company to consistently increase its dividend, rather than get all worked up about the current yield. That’s become doubly timely lately as rising interest rates have diminished the appeal of stocks that were popular as fixed income surrogates during the epic rate repression since 2008.

Every since Ben Bernanke lobbed the first mention of taper, yield standouts have been slammed, as seen in this chart of the performance of the utility and REIT sectors (price only) since mid May.

^SPX Chart

^SPX data by YCharts

With the case for dividend growth moving back to the forefront -- where it always belonged -- scouring the portfolio of the $16.6 billion Vanguard Dividend Growth mutual fund can turn up some interesting stocks to conduct further financial research on. Manager Don Kilbride is resolutely focused on growth, not yield; the fund’s 1.9% income payout is merely in line with the S&P 500 dividend yield.

Kilbride’s tight portfolio of 50 stocks tends to be held for the long term. The average holding period is more than nine years, compared to about one year for the average stock mutual fund. The fund’s 8.4% five year annualized gain is more than a percentage point ahead of the S&P 500. Over the past three years, Vanguard Dividend Growth’s 18% annualized gain trails the 18.4% for the index. Given that this fund distinguishes itself in large part by losing less in down markets than the market norm, that slight lag during a stretch of strong market performance is pretty impressive. According to Morningstar, Vanguard Dividend Growth has captured 84% of the market’s upside over the past three years while absorbing just 62% of the loss during down markets.

So what’s a dividend growth guy who cares about valuation investing in? Health care. The fund’s 21% health care stake is its high for the past three years and a serious overweight to the S&P 500’s 13% allocation to the health sector. (For the record, Kilbride has just 1.3% of the portfolio invested in the high yielding/slow growth utility sector and 1% in real estate.)

In the second quarter, Kilbride trimmed stakes in both Johnson & Johnson (JNJ) and Roche (RHHBY), though that was seemingly to keep the strong performers from taking on an outsize weight in the portfolio.

At the end of the quarter Johnson & Johnson (3% of assets) and Roche (2.6%) were among the fund’s top five holdings. Kilbride also added to existing position in Cardinal Health (CAH) -- a stock called out by the Leuthold Group recently -- as well as UnitedHealth Group (UNH) and Teva Pharmaceuticals (TEVA).

The only new position in the second quarter also came from health care: the fund now has a 2.4% stake in Merck (MRK). The pharma company is not going to show up in any indexes or portfolios that insist on a 10 or 25 year history of dividend growth. From 2006 through 2011 Merck didn’t raise its payout, a stark contrast to Johnson & Johnson, which for all its missteps still managed to deliver dividend growth to investors.

But Merck seems to have rediscovered some payout religion. The company raised the quarterly payout from 38 cents per share to 42 cents in late 2011 (payable in January 2012) and a year later managed a slight bump up to 43 cents a share. Given its recent habit of increasing the payout in the fourth quarter, we’ll have to wait a few months to see if there is a 2013 dividend boost.

In terms of dividend maneuver-ability Johnson & Johnson clearly has the edge over Merck. As this chart shows, Johnson & Johnson’s dividend cover ratio - - how much of dividends that can be paid straight out of earnings -- is above 1.00 and once again trending in the right direction.

JNJ Dividend Cover Chart

JNJ Dividend Cover data by YCharts

That said, Pfizer (PFE), another Kilbride holding (that was trimmed in the second quarter to 1.9% of fund assets) has an even better dividend coverage ratio nearing 4.0.

Again, you won’t find Pfizer in backward looking dividend portfolios. In 2009 Pfizer slashed its quarterly dividend 50% to 16 cents per share. That banishes it from all rigid screens demanding consistent dividend growth. While the 24 cent quarterly payout is still below the 2009 pre-cut high of 32 cents, Pfizer has managed stronger dividend growth than Johnson & Johnson over the past four years:

PFE Dividend Chart

PFE Dividend data by YCharts

Kilbride also added to big positions in two household names outside of healthcare during the second quarter.

Before Steve Ballmer announced his retirement and the company spent $7.2 billion on Nokia’s phone business, Kilbride raised his fund’s Microsoft (MSFT) stake 40% during the quarter. He also boosted the fund’s McDonald’s (MCD) stake by about 50% during the quarter. At 3.3% and 3.2% of fund assets, they are the two largest positions in Vanguard Dividend Growth. Both companies have aggressively increased their dividends over the past five years and yet with dividend coverage ratios of 2.9 and 1.8 respectively they aren’t bumping up against any ceilings in terms of potential future hikes.

From a valuation standpoint, Microsoft is cheaper. A new metric at YCharts, PE 5, captures five years of valuation history -- more than the standard 1-year look back and less plodding than the PE 10 (also known as the Shiller Cyclically Adjusted PE.) At near 20, McDonald’s PE 5 is appreciably higher than the 15 reading for Microsoft.

Granted, Microsoft is the poster child for every “value trap” conversation out there. But with a dividend that has grown nearly 77% over the past three years and a payout ratio that is still below 35%, patient investors see it’s a cash cow capable of returning more cash to investors. Meanwhile, a 2.9% dividend yield doesn’t exactly hurt.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.

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