4 Dividend Stocks With 4 Big Hedge Fund Buyers

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 |  Includes: BID, COL, PMT, WLT
by: Insider Monkey

By: Jake Mann

There are countless ways to categorize dividend-paying companies. If you follow the Buffett school of thought, though, the most stocks you probably want to hold in your portfolio are 25 to 30. In that light, we could classify these names by yield, payout ratio, sector or even special situations, but it's also worth it to discuss some dividend-payers that hedge funds have been buying of late (discover why this data matters).

In the past week, hedge funds have been very active, but here are four scenarios that should stick out to dividend investors.

Sotheby's

Perhaps the biggest news of the week so far, activist Dan Loeb and Third Point filed an amended 13D on Wednesday disclosing that it was increasing its ownership in Sotheby's (NYSE:BID) to 9.3% of all outstanding shares. Third Point's previous stake totaled 5.7% of the auctioneer company, so this increase is significant.

More importantly, however, the most intriguing part of Dan Loeb's filing was the absolutely scathing letter he sent Sotheby's CEO and Chairman William Ruprecht. In the letter, Loeb and Third Point admitted said they are "troubled by the Company's chronically weak operating margins and deteriorating competitive position relative to Christie's," adding that it is due to "lack of leadership and strategic vision at its highest levels," not anything the competition is doing in particular. Contemporary and modern art, the two areas with the "greatest growth potential" according to Loeb, are cited as the main trouble spots for Sotheby's.

The activist hedge fund also took issue with William Ruprecht's above-average salary and almost non-existent stock holdings (he holds a mere 0.22% interest in his company), and criticized his "imperial" practice of receiving "a car allowance, coverage of tax planning costs, and reimbursement for membership fees and dues to elite country clubs." Primarily citing a lack of innovation, Loeb calls for Ruprecht to step down from his post as CEO and Chairman.

In a plan for improvement, the letter says that in addition to improving its contemporary and modern art divisions, Sotheby's needs to: 1) improve shareholder value, 2) have directors that are passionate about art, 3) improve its nearly non-existent online footprint, 4) expand geographically, 5) improve its relationship with lower value clients, and 6) cut down wasteful spending, particularly by blunting senior management's desire for a "life of luxury at the expense of shareholders."

At 22 times forward earnings and a PEG near 1.7, shares appear fairly valued from an earnings standpoint. Sotheby's dividend yield of 0.6%, however, does show room for improvement at a payout ratio of just 24%. Free cash flow is negative at the moment and with expenses near pre-crisis levels even as revenues are 15% lower (as Loeb's letter points out), there's definite room for improvement. Earnings have also missed Wall Street's expectations in four of Sotheby's last five quarters.

We'll continue to watch Third Point's filings on Sotheby's very closely. If the company's financials can be improved to fit Loeb's demands, there's obvious upside here, and maybe even room for a dividend boost.

Rockwell Collins

Moving on, Rockwell Collins (NYSE:COL) saw Jeff Ubben and ValueAct Capital up their stake to 9.7% of the company, according to an amended 13D filing with the SEC. Another activist, you may know Ubben from his massive Microsoft (NASDAQ:MSFT) stake reported earlier this year, and it appears he's bullish on this underappreciated company as well.

Speaking with Institutional Investor's Alpha, Ubben told the site that he is excited by the prospects of Rockwell's avionics segment due to its "pricing power [which] generates high margins and free cash flow." Ubben also mentioned that he likes Rockwell's acquisition of Arinc Inc. from Carlyle Group (NASDAQ:CG) last month, due to the fact that it should help the company move toward commercial planes to replace defense contracts reliant on waning government expenditures.

Now, let's get one thing straight: Jeff Ubben is not the same type of activist as a Dan Loeb or Carl Icahn. Most of his large positions are geared toward long-term investments and are typically friendly. Upon taking his Microsoft stake, we learned that Ubben did have a multi-year vision for where the tech giant could go, but it's unknown what his exact plan for Rockwell is. It's quite possible that he won't need to ever fight the company if it continues to focus on avionics, particularly in non-military aircraft.

Rockwell offers income investors a dividend yield of 1.8% on a payout ratio of 27%, and it hasn't missed a quarterly payment since it first initiated a 9-cent dividend in 2001. Twelve years later, the company pays out more than three times this amount to investors. Free cash flows have grown by 34% since last year, so it's quite reasonable to expect another dividend hike in 2014 or 2015.

The best of the rest

Last but not least, a couple other hedge fund buys this past week were in Walter Energy (NYSE:WLT) and PennyMac Mortgage (NYSE:PMT). With regard to the latter, which is a residential-focused REIT, Kyle Bass' Hayman Advisors established a 5.1% stake in a 13G filing. PennyMac offers a dividend yield of 9.9%, an improvement of more than 60% since 2010. The company also hasn't missed a quarterly payment since this time.

From a profitability standpoint, PennyMac has beat Wall Street's funds from operations (FFO) targets in four of its past five quarterly reports. The REIT's latest second-quarter report registered a beat of 11% (86-cent FFO vs. 77-cent consensus), and analysts expect FFO to hit $3.18 by the end of 2013 compared to $3.14 one year earlier. Average 2014 estimates predict a 5-cent FFO growth year-over-year from 2013 estimates. Yes, PennyMac's focus on investments in mortgage loans doesn't provide any mind blowing upside, but for investors seeking consistency, it'd be smart to keep watching how Kyle Bass handles his stake.

Walter Energy, on the other hand, saw Dmitry Balyasny's Balyasny Asset Management snatch up 5.2% of its shares in a passive 13G filing on Tuesday. Due to increased domestic competition from natural gas and oversupply from Australia, North American metallurgical coal producers like Walter have been absolutely hated by Mr. Market in 2013. Shares are down almost 60% year-to-date, and earnings have taken a nosedive from $5.79 per share in 2011, to an estimated loss of about $2.91 per share by the end of this year (according to most broader Wall Street forecasts). Morgan Stanley is one firm that thinks coal might be in for a rebound, and it's clear that Balyasny feels the same way. If coal prices can improve - either from increased demand in the U.S. or less supply from Australia - Walter could capitalize.

This is something the Street as a whole is betting on it appears, as the average sell-side analyst expects the company's bottom line to grow between 24% and 25% annually over the next five years. If this scenario takes hold, it's likely that Walter can reinstate its full dividend, which had yielded about 1.7% before taking a major cut this July. Balyasny is a self-proclaimed macro investor that focuses on "misunderstood situations," so it appears that the multi-billion dollar hedge fund is also bullish on the domestic met-coal market over the longer term.

Disclosure: I am long MSFT.

Business relationship disclosure: This article is written by Insider Monkey's writer, Jake Mann, and edited by Meena Krishnamsetty. They don't have any business relationships with any of the companies mentioned in this article and they didn't receive compensation (other than from Insider Monkey and Seeking Alpha) to write this article.