Originally by Bob Ciura, Updated October 11th, 2017 by Nick McCullum
Kevin O’Leary is Chairman of O’Shares Investments, but you probably know him as “Mr. Wonderful”.
He can be seen on CNBC as well as ABC’s Shark Tank. Investors who have seen him on TV have likely heard him discuss his investment philosophy.
Mr. Wonderful looks for stocks that exhibit three main characteristics. First, they must be quality companies with strong financial performance and solid balance sheets.
Second, he believes a portfolio should be diversified across different market sectors.
Third, and perhaps most important, he demands income—he insists the stocks he invests in pay dividends to shareholders.
The O’Shares FTSE U.S. Quality Dividend ETF (OUSA) owns stocks that display a mix of all three qualities. It is an interesting resource to look for quality dividend growth stocks.
This article analyzes the fund’s top 10 biggest holdings in detail.
No. 10: Merck & Co. (MRK)
Dividend Yield: 2.9%
Market Capitalization: $176 billion
Forward Price-to-Earnings Ratio: 16.6
Merck is a global biopharmaceutical company with a market capitalization of $176 billion. Headquartered in Kenilworth, New Jersey, Merck is one of the largest publicly-traded pharmaceutical companies.
Merck’s recent performance has been strong. In the most recent quarter, adjusted earnings-per-share increased by 8.6% to $1.01 (from $0.93 in the prior year’s quarter).
The healthcare industry has been one of the stock market’s strongest performers through history. The sector is also extraordinarily recessin-resistant. With this in mind, it’s unsurprising that Mr. Wonderful has such a large stake in Merck.
Merck is trading for a price-to-earnings ratio of 16.6x expected 2017 earnings. The company appears to be a bit pricey relative to its historical average valuation levels. Merck’s average annual price-to-earnings ratio has not been above 16.6 since 2007 – a decade ago.
With that said, Merck is cheaper than the S&P 500 right now – so it isn’t overvalued compared to the overall market. The company’s 2.9% dividend yield also compares favorably to the S&P 500’s dividend yield of ~2%.
Merck is an established company. Earnings-per-share are expected to grow between 5% and 6% a year over the next 5 years. This growth combined with the company’s ~3% dividend yield gives investors expected total returns of 8% to 9% a year, before changes in the company’s valuation multiple.
No. 9: Verizon Communications (VZ)
Dividend Yield: 4.8%
Market Capitalization: $201 billion
Forward Price-to-Earnings Ratio: 13.1
Verizon is the second-largest telecommunications company in the United States behind AT&T (another holding in Mr. Wonderful’s portfolio).
Verizon is a massive company – the company generates more than $130 billion of revenue each year.
Moreover, the company is a free cash flow machine. Verizon generates more than $20 billion of free cash flow each year. With such huge levels of free cash flow, Verizon pays more than $8 billion of dividends to shareholders each year and also repurchases significant amount of company stock.
This also leaves plenty of cash flow left over to repay some of the debt incurred when Verizon acquired Verizon Wireless from Vodafone (VOD).
Even better, Verizon has very high profit margins, thanks to its high-quality customer base. Verizon is able to attract higher-quality customers because of its industry-leading network.
Source: 3Q Earnings presentation, page 8
Wireless customer churn is usually very low for Verizon. This is partly because of the company’s massive size, which allows it to generate economies of scale and pass savings onto customers.
This also provides the company with pricing power. Verizon’s EBITDA margin is nearly 50% for the wireless business.
Going forward, Verizon’s growth catalysts will be in 5G, digital advertising, and the Internet of Things.
Growth is very exciting in these areas. First, Verizon plans a test roll-out of 5G network capability in 2017.
Separately, Verizon acquired AOL to boost its digital advertising business. AOL’s net revenue is growing in the high single digits – very rapid growth for such an established enterprise.
Finally, connectivity is a compelling growth catalyst. IoT revenue is growing in the solid double-digits.
This growth should allow Verizon to continue raising its dividend. Verizon stock pays a 4.3% current dividend yield. The company has increased its dividend for 10 consecutive years.
No. 8: Philip Morris International (PM)
Dividend Yield: 3.8%
Market Capitalization: $179 billion
Forward Price-to-Earnings Ratio: 23.8
Philip Morris International operates the Marlboro brand outside the U.S. It operates in several markets with higher economic growth than in more developed markets.
PM benefits from leading market share rates across several key operating regions.
Source: Annual Shareholder Meeting presentation, page 7
The company was spun off from Altria in 2008, so that it could be free to operate on its own, without the stricter U.S. regulations weighing it down.
But it’s PM that has suffered since the split. It has had to deal with a brutal foreign exchange market, resulting from the strong U.S. dollar.
A higher U.S. dollar makes exports less competitive and reduces the value of revenue generated overseas. Unfavorable currency fluctuations shaved multiple billions of dollars off of Philip Morris’ revenue in recent fiscal years.
The good news is that thanks to its strong business model, PM has remained highly profitable. Pricing is a big reason why the company can grow in spite of currency. Philip Morris has the unique ability to increase prices at rates that exceed growth in the consumer price index, thanks to the addictive nature of its products.
This has allowed it to continue raising its dividend, even during a very difficult operating environment. PM has more than doubled its dividend payout since its 2008 spin-off.
Moving forward, the company is turning to product innovation for growth. A primary growth catalyst for PM is its reduced-risk portfolio. This is the name management has given to its heated tobacco product, iQOS.
Source: Global Consumer & Retail Conference presentation, page 5
iQOS is now available in key cities in 13 markets, and the company expects iQOS to continue its rapid expansion over time.
Strong brands and growth in new products means PM can sustain its 3.8% dividend yield.
No. 7: Home Depot (HD)
Dividend Yield: 2.2%
Market Capitalization: $195 billion
Forward Price-to-Earnings Ratio: 22.6
Home Depot is the largest home improvement retailer in the United States with a market capitalization of $195 billion. Its only competitor of similar size is Lowe’s (LOW).
It’s not hard to see why Mr. Wonderful is a fan of Home Depot. The company has long been a leader operator in its industry, and passes its financial success onto its shareholders in the form of steadily rising dividend payments.
Fiscal 2016 was another successful year for Home Depot.
The home improvement retailer saw sales increase by 6.9%, net earnings increase by 13.5%, and diluted earnings-per-share increase by 18.1% (partly boosted by share repurchases).
The company’s stock price reacted accordingly.
In fact, over the last several years, Home Depot’s stock has soared past the performance of the two major market indicies (the Dow Jones Industrial Average and the S&P 500). The company’s performance is compared to these benchmarks in the following diagram.
As shown above, Mr. Wonderful’s decision to own Home Depot has been rewarding.
No. 6: Pfizer (PFE)
Dividend Yield: 3.5%
Market Capitalization: $217 billion
Forward Price-to-Earnings Ratio: 14.2
Pfizer makes this list for a similar reason to Merck – because healthcare stocks have historically been among the market’s best dividend stocks.
Pharmaceutical companies benefit from the fact that many people cannot go without their medications. This heavily insulates Big Pharma’s bottom line.
And, pharmaceutical companies have the ability to raise prices on key drugs. Because of this, health care stocks like Pfizer are tremendous dividend payers.
Pfizer stock offers a 3.5% dividend yield. The company also returns billions to investors through share repurchases.
The company performed very well in 2016. Revenues and earnings-per-share both grew in the single digits.
This may seem fairly ordinary. But Pfizer’s performance is impressive, given the difficult environment for global pharmaceuticals this year.
In 2016, Pfizer dealt with increasing regulatory pressure regarding drug prices. In the international markets, Pfizer is suffering from the Brexit vote uncertainty, as well as the strong U.S. dollar.
Source: Third Quarter Earnings presentation, page 9
If that weren’t bad enough, Pfizer is still feeling the effects of the loss of patent exclusivity on Lipitor, which was once its most important individual product.
Pfizer has responded by investing heavily in R&D, to restock its drug pipeline.
Source: Citi Global Healthcare Conference, page 3
Pfizer has a robust pipeline, including dozens of late-stage products. It is counting on its product pipeline to replace Lipitor and continue growing sales and earnings.
This growth will help support future dividend growth as well. Pfizer pays out about half of its earnings as dividend payments, which means that the company has the ability to continue raising its dividend even if earnings stagnate temporarily.
No. 5: Intel Corp
Dividend Yield: 2.7%
Market Capitalization: $186 billion
Forward Price-to-Earnings Ratio: 13.2
The technology sector is a surprisingly good source of dividend stocks. Intel Corp is no exception. The company has a juicy 2.7% dividend yield and is well-positioned to benefit from trends such as autonomous driving and the Internet of Things.
More broader, Intel’s products (microchips and semiconductors) will experience increasingly strong demand as the demand for data undoubtedly continues to grow at a torrential rate.
Source: Intel Investor Presentation
Intel has three major focuses that it calls ‘big bets’ and is devoting significant resources to developing.
The first is memory. As an existing leader in this market, Intel is likely to benefit from growth in this fast-growing segment of the technology industry.
The third is 5G, which is expected to connect 50 billion devices once implemented.
These three growth drivers are explored in more detail below.
Source: Intel Investor Presentation
Intel’s market leadership and robust dividend yield of 2.7% certainly seem like quality to us, and definitely contribute to the company being held in Mr. Wonderful’s investment portfolio.
No. 4: Procter & Gamble (PG)
Dividend Yield: 3.0%
Market Capitalization: $234 billion
Forward Price-to-Earnings Ratio: 22.0
Procter & Gamble is a stalwart among dividend stocks. It has increased its dividend for the past 60 years in a row. This makes the company one of only 21 Dividend Kings – stocks with 50+ years of rising dividends.
It has done this by becoming a global consumer staples behemoth. It sells its products in more than 180 countries around the world. P&G generates more than $65 billion in annual sales.
The company is organized into five operating segments:
- Fabric and Home Care (32% of sales)
- Baby, Feminine, and Family Care (28% of sales)
- Beauty (18% of sales)
- Grooming (11% of sales)
- Health Care (11% of sales)
P&G has a heavy international presence; it generates just over 50% of its sales from outside North America.
But this is not a business-as-usual climate for P&G. The company’s sales fell 8% in fiscal 2016, and 5% in fiscal 2015.
The strong U.S. dollar played a significant role in P&G’s sales declines. But it is also struggling to grow the core business.
Organic sales, which excludes the effects of currency translations, increased just 1% in fiscal 2016.
The company has responded by overhauling its product portfolio. P&G has sold off dozens of low-growth brands, in an attempt to streamline its operations.
Before its turnaround, P&G had approximately 170 brands in its portfolio. Now, it has 65 brands.
Going forward, it is focusing on a select group of core brands, which management believes hold the most growth potential.
Source: Analyst Meeting presentation, page 53
The strategy appears to be working. P&G returned to organic growth in the first quarter of fiscal 2017, with a 3% increase. It enjoyed broad-based growth across its product categories.
Source: Analyst Meeting presentation, page 7
P&G management projects 2% organic sales growth for the full-year fiscal 2017.
In addition, P&G is aggressively cutting costs to boost profitability. The company has removed billions of dollars in costs from its supply chain.
Source: Analyst Meeting presentation, pages 18 & 20
P&G has also cut costs by reducing headcount approximately 25%.
It is hoped that this growth will help accelerate the company’s dividend growth, which has slowed lately. For example, P&G’s 2016 dividend raise was just 1%.
In the meantime, the stock has an attractive 3.0% dividend yield.
No. 3: AT&T (T)
Dividend Yield: 5.1%
Market Capitalization: $237 billion
Forward Price-to-Earnings Ratio: 13.1
It should be no secret to see a tobacco company (Philip Morris) on this list. Nor should it be a surprise to see two telecom giants – Verizon and AT&T – make the list.
Like tobacco stocks, telecom stocks generate huge amounts of cash flow and pay hefty dividends to shareholders.
AT&T generates more than $15 billion in free cash flow each year while paying ~$10 billion in dividend payments.
AT&T is a Dividend Aristocrat, a group of companies in the S&P 500 with that have raised their dividends for at least 25 consecutive years.
You can see the entire list of Dividend Aristocrats here.
AT&T has increased its dividend for 33 years in a row.
It can do this because of its highly stable business model. AT&T provides telephone, Internet, and phone service. These are services that the average American does not want to do without, even when the economy deteriorates.
Since it generates such consistent profits, AT&T can reward shareholders with a hefty dividend. The current yield is 5.1%. This is just over the 5% threshold needed for the high dividend stocks list.
Its dividend increases are typically small, in the 2%-3% range. That is because the U.S. telecom industry is very mature and fiercely competitive.
Going forward, AT&T is banking on acquisitions to drive future growth.
First, AT&T acquired major competitor DirecTV for $67 billion including debt. The deal instantly made AT&T the largest pay TV provider in the world, with more than 26 million customers in the U.S. and another 19 million customers in Latin America.
More recently, AT&T announced a massive $109 billion deal for Time Warner. This is a huge deal, that would make AT&T a leader in premium content as well as content distribution.
Source: Time Warner Acquisition presentation, page 6
Not only would AT&T see a huge bump in revenue from the customer additions, earnings-per-share can grow from cost synergies. Since they are similar companies, AT&T expects the deal to be immediately accretive to margins, free cash flow, and earnings-per-share.
Due to these two very large acquisitions, AT&T should have no trouble raising its dividend each year moving forward.
No. 2: Exxon Mobil (XOM)
Dividend Yield: 3.8%
Market Capitalization: $349 billion
Forward Price-to-Earnings Ratio: 23.9
Exxon Mobil is the only oil stock on Mr. Wonderful’s top 10 list. This makes sense, because if an investor is going to own only one Big Oil stock, it should be the biggest of the oil and gas ‘super majors’.
Exxon Mobil is the largest publicly-traded oil company in the world. It has a $349 billion market cap and an unparalleled dividend track record among its peer group.
The company has paid a dividend for more than 100 years. And, it is a Dividend Aristocrat. Exxon Mobil has increased its dividend for more than three decades.
This is an especially challenging period for Exxon Mobil. Oil and gas prices have fallen by about 50% from their 2014 peak levels.
The huge drop in commodity prices has weighed on Exxon Mobil. Fortunately, the company has cut costs, raised cash through asset sales, and has benefited from its integrated model.
This helped Exxon Mobil remain profitable, and continue to raise its dividend.
Source: Annual Meeting presentation, page 15
Exxon Mobil’s strong business model has allowed the company to generate industry-leading returns on capital.
One reason is because of its integrated business model. In addition to upstream exploration and production, Exxon Mobil has large downstream and chemicals businesses.
Activities like refining and chemicals are not as adversely affected from falling commodity prices. These segments have continued to generate profit, which is helping to balance out the poorly-performing upstream business.
Maintaining profitability is crucial for a company, in order to continue raising its dividend. And, Exxon Mobil will be a major beneficiary if commodity prices continue to rise moving forward.
Exxon Mobil stock has an attractive 3.8% dividend yield.
No. 1: Johnson & Johnson (JNJ)
Dividend Yield: 2.5%
Market Capitalization: $360 billion
Forward Price-to-Earnings Ratio: 18.7
J&J is one of the best dividend stocks investors can buy, so it is not surprising to see it in Mr. Wonderful’s portfolio.
The company has raised its dividend for 54 consecutive years.
Its long history of dividend growth is thanks to J&J’s excellent business model. J&J has a very strong brand—approximately 70% of the company’s sales come from products that have either the number one or number two positions in their respective categories.
This brand strength has led to consistent growth for decades. According to J&J, it has achieved positive growth of adjusted earnings for more than 30 consecutive years.
J&J is organized into three business segments:
- Pharmaceutical (47% of sales)
- Medical Devices (35% of sales)
- Consumer (18% of sales)
It is seeing strong results in each of its businesses.
The pharmaceutical business is performing the best so far this year, with 9.1% revenue growth through the first nine months.
The consumer business has grown at the slowest rate, with revenue up 0.4% through the first three quarters. But J&J’s consumer business is very valuable to the company because it has many strong brands that provide a great deal of stability.
Source: Consumer and Medical Devices presentation, page 50
Lastly, moving forward J&J has a robust pharmaceutical pipeline to generate growth.
Source: 3Q Earnings presentation, page 27
J&J stock has a price-to-earnings ratio of 20. The company is trading well above its historical average valuation multiple. With that said, Johnson & Johnson is among the safest investments around for long-term dividend growth. It’s extremely likely Johnson & Johnson is larger a decade from now than it is today. This high degree of safety helps to offset the company’s high valuation relative to its historical average.
While J&J’s valuation is high relative to its historical average, it is not particularly pricey compared to other stocks in the S&P 500. A rising tide lifts all valuations – and J&J is no exception. J&J makes a great core long-term holding for risk-averse dividend growth investors.