4 High Quality Dividend Stocks for Income Investors, Part III

In our earlier articles focusing on high-quality stocks, we highlighted the fact that high-quality stocks outperform low-quality stocks and the broad benchmarks during market declines, periods of increased volatility, widening credit spreads, and steepening yield curves. Given the elevated level of market volatility and record-low interest rates, dividend-paying high-quality stocks should represent a natural magnet for investments. Over the past year, these stocks have outperformed the S&P 500 by a margin of some 2.3 percentage points.

For the purpose of our evaluation of high-quality stocks we screen the S&P High Quality Rankings Index constituents, representing those S&P 500 stocks that have a record of sustainable long-term earnings power and solid growth and stability of dividends. We continue our series focusing on two industrial conglomerates and two defense contractors that offer value or attractive income. These stocks have market capitalization of at least $7 billion, an average dividend yield of 3.3%, and high free cash flow yield, return on equity (ROE) or return on invested capital (ROIC).

Phill Gross

Emerson Electric Co. (NYSE:EMR) is a $35 billion industrial conglomerate that provides manufacturing equipment and services. It produces equipment for paper and pharmaceutical processing companies, air conditioning, refrigerators, and motors for both consumer and industrial uses. Over the past five years, the company’s EPS grew at an average annual rate of 7.9%, while dividends increased at a rate of nearly 9% per year. Analysts forecast that the EPS growth will accelerate to an average rate of 11.4% per year for the next five years. The company has strong revenue and EPS growth, widening profit margins, and a generally solid balance sheet. Its free cash flow yield is 3.5%, ROE is high at 22%, and ROIC is attractive at 16.4%. The company’s large exposure to Westerns Europe and the strengthening dollar are currently weighing on sales and profits. However, a rebound in the global economic activity after the ongoing slowdown should revive demand for Emerson Electric’s products in the next several years.

Emerson Electric Co. (NYSE:EMR) is a dividend aristocrat. It has raised dividends for 55 consecutive years. The company currently pays a dividend yield of 3.3% on a payout ratio of 51%. Its competitors General Electric Company (NYSE:GE), Roper Industries Inc. (NYSE:ROP), and Rockwell Automation (NYSE:ROK) pay yields of 3.3%, 0.6%, and 2.8%, respectively. In terms of its valuation, the stock is trading below its peer group and the company’s own historical metrics. The stock is changing hands at $47.33 a share and is flat over the past 12 months. Fund managers John A. Levin (Levin Capital Strategies—see its top picks), Phill Gross (Adage Capital Management), and Richard Chilton (Chilton Investment Company) hold the largest stakes in the stock among institutional investors.

3M Co. (NYSE:MMM) is another industrial conglomerate. This $62 billion company makes some 55,000 different products ranging from adhesives, Scotch tape, and bandages to dental braces, medical products, and wide screen LCD TVs. Over the past five years, 3M Co.’s EPS expanded at an average rate of 3.3%, while dividends rose at a rate of nearly 4% per year. Analysts predict that the company’s EPS growth will average a much higher 11.3% per year over the next five years. Analysts base their bullish prediction on the assumption that a broad-based global economic rebound will buoy the demand for the company’s products. The stock boasts a free cash flow yield of 3.8%, ROE of 26.5%, and ROIC of 20.9%. The company has a low debt-to-equity ratio. In the short-term, given the company’s large international exposure, the firming dollar is taking a bite out of the total value of sales. In the long run, the company’s diversified product offering stands to benefit from the faster growth and rising living standards in the emerging markets.

3M Co. (NYSE:MMM) has paid dividends since 1916 and has raised them each year for the past 54 years. Currently, the company is paying a dividend yield of 2.6% on a payout ratio of 39%. Its competitors Tyco International Ltd. (NYSE:TYC), General Electric Company (NYSE:GE), and Johnson & Johnson (NYSE:JNJ) pay dividend yields of 1.8%, 3.3%, and 3.5%, respectively. The stock is priced below industry on a P/E basis, but well above its peer group based on a price-to-book ratio. The shares are trading at $90.08 a share, up 5.6% over the past year and only 2.2% away from their 52-week high. Value investor Jean-Marie Eveillard (First Eagle Investment Management) had $490 million invested in the stock at the end of the first quarter of 2012.

Lockheed Martin Corporation (NYSE:LMT) is a $28.5 billion aerospace, defense, and security company, and the single largest U.S. government contractor by revenues. Over the past five years, its EPS and dividends increased at average annual rates of 6.3% and 22.7%, respectively. The company is expected to see its EPS growth average 7.1% per year for the next five years. This is despite lower government spending on defense, from which the company derives the lion’s share of its revenues. Also noteworthy is the expectation that share buybacks and cost cutting will help sustain EPS growth in the coming years. Additional budget cuts planned under the process of sequestration could hurt the company’s future growth. The stock has a free cash flow yield of 2.6%, and spectacular ROE of 102.3% and ROIC of 33%. The company has been boosting its ROE each year since at least 2002.

Lockheed Martin Corporation (NYSE:LMT) has paid a dividend since 1995 and has raised them each year over the past 9 years. Currently, its dividend yields an attractive 4.5% on a payout ratio of 47%. Competitors Raytheon (NYSE:RTN), General Dynamics (NYSE:GD), and Northrop Grumman (NYSE:NOC) pay lower dividend yields of 3.6%, 3.2%, and 3.3%, respectively. The stock is priced below its industry on a P/E basis; however, its price-to-book ratio dwarfs that of its industry peers on average. The stock is trading at $88.45, up 20% over the past year. At the end of the first quarter of 2012, Jean-Marie Eveillard had some $350 million and John Shapiro (Chieftain Capital) had $160 million invested in the company.

L-3 Communications Holdings Inc. (NYSE:LLL) is another aerospace and defense industry player with a total market cap of close to $7 billion. More than 80% of the company’s revenues come from the U.S government. Over the past half decade, the company’s EPS and dividends grew at average rates of 16.5% and 16.8%, respectively. Analysts see its EPS growth averaging a much smaller 2.4% per year for the next five years. Still, the company has a broad-based, balanced business mix, and is improving its operational efficiencies, which should help its bottom-line growth in the future. Like other defense contractors, its performance hinges on the defense budget outlook, which is currently getting gloomier due to the sequestration. L-3 Communications Holdings (NYSE:LLL) has an exceptionally high free cash flow yield of 15.4%, ROE of 14%, and ROIC of 8.8%. It pays a dividend yield of 2.8% on a low payout ratio of 22%. Its peers Lockheed Martin Corporation, Raytheon (NYSE:RTN), and Honeywell International (NYSE:HON) pay dividend yields of 4.5%, 3.6%, and 2.6%, respectively. The stock has a forward P/E below that of the defense industry and the company’s own historical metrics. Its price-to-book ratio is currently a third of that for the industry on average. That ratio is also historically very low. Billionaires Cliff Asness, D. E. Shaw (see his top picks), and Jim Simons are all bullish about the stock.