Cabot’s Best Dividend Stocks

Cabot's Best Dividend Stocks

Plus DRIP Investing 101 and Why You Should Invest in Dividend Aristocrats

By Chloe Lutts Jensen, Chief Analyst, Cabot Dividend Investor

As chief analyst of the Cabot Dividend Investor advisory, dividend-paying stocks are the bread and butter of our portfolio. Preferred stocks can provide consistent income, and some fixed income investments offer more security, but the wide, wide world of dividend-paying stocks will always be our first love.

But it is an ever-widening world (more on this later). With so many dividend stocks to choose from these days, it's important to look for certain factors so that you can find the right dividend stocks. In a minute, I'll give you a few of my favorite dividend stock recommendations. But it's helpful to know what makes a good dividend stock.

Here are a few things I look for:

Dividend History The first requirement for any Cabot Dividend Investor recommendation is an impressive dividend history. A long and consistent history of paying dividends--and even better, increasing dividends-- tells me both that the company consistently generates enough cash to reward shareholders and that management is committed to prioritizing shareholder returns.

You don't want to see any dividend cuts, especially recently. Cuts suggest that either the company's cash flow isn't reliable or predictable or that the company distributes dividends it can't afford.

Cash Flow While dividends are a good sign of consistent cash flow, looking at income itself is equally important. For most businesses, I use free cash flow (FCF) as the best indicator of available funds. Free cash flow simply equals operating cash flow minus capital expenditures. In other words, it's what's left of income after the company spends what it has to. That number is important because, when all is going well, it's where the money for dividends comes from. (Companies that can't afford to pay their dividends out of free cash flow are forced to either cut them or find the money elsewhere, which is usually only a temporary solution. You can tell this is happening by comparing free cash flow to dividends paid.)

Companies with strong free cash flow can also invest in growth, make acquisitions and repurchase shares. In the Dividend Growth Tier of our portfolio, earnings per share (EPS) and FCF must both show consistent growth (and it's a bonus in other Tiers).

Payout Ratio The payout ratio links the two pieces of information above, telling you how much of its earnings a company is giving to its investors. Most websites report the payout ratio as the stock's annual dividend payment divided by its EPS, but I also calculate payout ratios based on FCF, mentioned above.

For example, a company that reported EPS of $3.00 per share in 2015 and made four quarterly dividend payments of $0.20 each (for a total yearly dividend of $1) would have a payout ratio of 33%.

Ratios in the range of 20% to 50% are usually considered good, although higher or lower payout ratios can be acceptable depending on the business the company is in, how mature the company is, and other factors. In addition to looking at the payout ratio on its own, I also compare the current payout ratio to the company's historical payout ratio, to see if the company's earnings and dividends are growing at the same rate or if one is outpacing the other.

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The primary red flag to watch out for when looking at payout ratios is a number that's too high. With some exceptions for MLPs, utilities and other entities created specifically to pass along cash to investors, the payout ratio should generally show that the company has some cash left over to put back into the business, buy back shares and create a cushion for leaner times ahead.

A company handing over 90% of its earnings to shareholders, in other words, may have a hard time affording that same payment down the road. Younger, faster-growing companies generally hold onto more of their income for growth and stability than older, slower-growing companies that may feel the best use for the money is paying back shareholders.

Story The three factors above give me the most direct, unfiltered look at an investment's ability to continue rewarding investors through dividends and long-term growth. But I also consider less quantitative factors. Those include a business model that generates steady earnings and catalysts for growth at the company or in the industry.

Companies can also be eliminated based on "story" factors, even if they have strong earnings numbers and long dividend histories. For example, stocks that have a strong dividend history but are in shrinking industries, like newspapers, will be eliminated at this step.

Additional Factors Depending on which Tier I am considering an investment for, I may also consider additional quantitative and qualitative factors.

In investments I'm considering for the Safe Income Tier, relatively low volatility is important. To assess volatility, I look at stock charts, consider the stock's beta (< 1 means less volatile than the benchmark, > 1 means more volatile) and research industry factors. Established businesses in growing or stable industries are much less volatile than smaller companies and those in more cyclical industries. Longevity is also a concern--the company and its industry must both be viable long term, and stocks in faddish industries, like 3D printing or social media, are simply inappropriate.

In the Dividend Growth Tier, I require a company to demonstrate above-average earnings growth, and I also like to see company-specific or industry-wide catalysts for more growth. And in the High Yield Tier, of course, the investment's current yield must be significantly above average.

Cabot's Best Dividend Stocks

Now that you know what I look for in dividend stocks, let's get to the good stuff: actual stock picks! (That is, after all, probably what enticed you to read this free report in the first place.) Here are five of my favorite dividend stocks, all of which are currently part of the Cabot Dividend Investor portfolio.

General Motors (GM) Automaker General Motors is a household name in the U.S., but these days the stock is associated more with the 2008 auto industry bailout than with its past as a must-own blue chip.

But GM has changed since the bailout. The company has grown revenues in five of the last six years (2015 sales slipped a tad, by 2.3%). Most recently, low gas prices have driven consumers back to GM's trucks and SUVs, boosting sales and margins.

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However, analysts are still concerned about how the slowdown in China's economy will affect GM. The company's recent announcement that it plans to unveil 60 new models to the Chinese market over the next five years, 40% of which will be SUVs and high-end minivans, will put that theory to the test.

Though the growth of the Chinese auto market slowed to 4.7% last year, from 7% in 2014, GM still expects the market to deliver solid growth of 3% to 5% over the next few years.

Because of its dependency on China, unpredictably of earnings or simply a lack of love from investors, GM is deeply undervalued today. The stock's current P/E ratio is in the basement, at a mere 5.3. And the company's price-to-book ratio is very reasonable at only 1.2.

Technically, the stock is still in an intermediate-term downtrend, but above its 50-day moving average at 31 after bottoming just below 27 in mid-February.

The new GM is still young and somewhat unpredictable, and the company's turnaround plan is still in progress. It may be some time before a new uptrend is confirmed. However, the stock's current yield of 4.9% makes it easy to wait for investors to start coming back to this name.

And they will, if GM's growth lives up to expectations. Analysts are currently predicting EPS growth of 9.2% this year, followed by 5% growth next year.

While the old GM was a reliable dividend payer, the new GM has a measly one-and-a-half years of dividend history. The old GM paid a $1 per year dividend, but suspended payments in 2008 before filing for bankruptcy. The new, post-bailout company declared its first dividend in January 2014, and has paid nine quarterly dividends to date, raising it twice in the past year.

This short history earns GM Dividend Safety and Growth Ratings of only 3.2 and 3.9 respectively (both out of 10). However, both ratings have potential to improve quickly if GM continues to prioritize shareholder returns. The current quarterly payment of $0.38 works out to a generous annual yield of 4.9%, but with a current payout ratio of a mere 23%.

CVS Health (CVS) CVS has paid dividends since 1985 and has increased the dividend annually since 2004. Over the past five years, each boost has averaged 28%, a stellar growth rate for a company of this quality. The latest dividend increase, announced in the first quarter, boosted the stock's annual dividend from $1.40 to $1.70, for a current yield of 1.7%.

The company targets a payout ratio of 35%, leaving some room for further increases based on the current TTM payout ratio of only 30%. Combined with analysts' expectations of double-digit EPS growth for the next five years, CVS's dividend history earns the stock a perfect Dividend Safety Rating of 10 and a stellar Dividend Growth Rating of 9.8.

CVS is one of the largest drugstore chains in the U.S. and a leading provider of pharmacy and pharmacy-related services. In addition to its 7,900 retail pharmacies, CVS operates over 1,000 walk-in clinics and a pharmacy benefits manager with over 70 million members. Last year, CVS expanded its reach into assisted living homes, acquiring Omnicare, the leading provider of pharmacy services to long-term care facilities.

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Most recently, CVS acquired Target's pharmacy business in a deal completed in December 2015. CVS will rebrand and operate Target's 1,672 pharmacies and 79 in-store clinics, and will also open MinuteClinics and CVS Pharmacies in new and existing Target stores.

The company describes its expansion strategy as "capturing a growing share of a growing pie," referring to the ongoing demographic changes that are driving greater demand for all types of pharmacy and health services.

CVS's expansion is translating into higher revenues and more money for investors. Over the past five years, CVS has grown net income per share consistently, by an average of 10% per year. Analysts expect the company to report 13% EPS growth this year and next year, and for growth to average 14% over the next five years. In addition, analysts expect CVS to report revenue growth of about 18% this year, and 9% next year. Long term, CVS is targeting 9% to 13% net revenue growth and 10% to 14% adjusted EPS growth per year.

After a strong advance in 2014 (and two pretty good years before that), CVS spent most of 2015 consolidating, and the stock is roughly flat over the past 12 months, presenting an attractive buying opportunity for long-term investors. In fact, our value analyst, Roy Ward, added CVS to the Cabot Value Model portfolio earlier this year based on the stock's low valuation relative to forward earnings.

After bottoming at 89 in early February, the stock has rebounded nicely, topping 100 in mid-March. Investors looking to add a high quality undervalued health care stock with excellent dividend growth potential can do the same.

Home Depot (HD) Home Depot is the world's largest home improvement retailer, with 2,200 stores in the U.S., Canada and Mexico. Sales are driven by people building, buying and furnishing new houses (or renovating old ones), so the company's fortunes are closely tied to the health of the U.S. housing market, and strong housing data has provided a floor under HD and other housing-related stocks.

Home Depot's exposure to the cyclical housing market is one concern from a long-term perspective; however, the company has worked hard to become a leaner, better-managed company since the 20062011 housing crash, creating a cushion for future downturns.

Far from becoming complacent as the housing market has improved, Home Depot has used the last few years of plenty to whip the company into the best shape it's ever been in. Margins and return on investment have improved every year since 2009, and management is very close to hitting its best-inclass operating margin and ROIC targets of 13% and 27%, respectively.

More important from a dividend investing perspective, Home Depot delivers remarkably regular cash flow growth. Operating income has grown by double digits each of the last seven years, with 16% EPS growth in 2015 and another 15% EPS growth expected this year, supported by revenue growth of between 5% and 6%.

Growth today is driven primarily by increases in profitability as well as a growing e-commerce business. The company has opened three huge new facilities to fulfill online orders in the past year. Online sales still make up only 5% of Home Depot's business, so the growth potential remains high.

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