Top 5 Dividend Picks From Barron's Best Equity Income Fund

Includes: MRK, PFE, TROW, VZ, WFC
by: Dividendinvestr

by Serkan Unal

Recent academic research proves that superior active managers can create alpha. Mimicking their top picks can help individual investors achieve outstanding returns with modest additional risk on a total portfolio basis. According to an article in Barron's, a team led by University of Maryland finance professor Russ Wermers has found that "investors can beat the market by four percentage points a year, using a technique that systematically harvests the best stock selections from the (mutual) fund industry." The study referenced in the article can be found here.

Based on the newest rankings of dividend mutual funds by Barron's, here is a closer look at the top 5 holdings of JPMorgan Equity Income Fund (MUTF:OIEIX), ranked as the best-performing dividend mutual fund over a three-year period. Investing in dividend stocks and REITs for current income and capital appreciation, this Fund returned 15.6% annualized over the past three years. The Fund has 90 holdings, a beta of 0.82, and a Sharpe ratio of 1.04. Its top holdings are large-capitalization stocks with above-average yields and consistent long-term dividend growth.

Wells Fargo & Company (NYSE:WFC), the fund's largest holding, has gained 27% over the past year. Its momentum is driven by improving fundamentals, including strong revenue and earnings growth driven by the recovering housing market, trading gains, and loan growth. Despite its contracting net interest margin, the bank has achieved six consecutive quarters of record profits. Given the rising inflation expectations in the market, the bank stands to profit from the steepening yield curve. In that environment, its interest margin should expand, as the bank derives most of its funding needs from low-cost core deposits. The bank's price-to-book is at a 30% premium to the banking industry average of 1, while its ROE of 12.7% is nearly 60% better than its sector's ROE. The bank pays a dividend yield of 2.5% on a payout ratio of 28%. Following a dramatic cut in 2009, WFC's dividend has since increased cumulatively by 4.4 times. The bank is well-capitalized and will see long-term EPS growth averaging 9% annually. Its forward P/E is 9.7x, below industry's ratio of 11.8x. Warren Buffett holds 422.5 million shares of WFC (see Warren Buffett's top stock picks).

Merck & Co. (NYSE:MRK), the fund's second-largest holding, has rallied 11.3% over the past 12 months. The pharmaceutical giant is coping better than peers with patent expirations. Its long-term EPS CAGR is forecasted at 3.6% annually. Despite losing patent protection on its asthma drug Singulair and a failed trial of a cholesterol drug, the company is looking toward future growth with new drug candidates, with some 32 drugs in phase II and III trials. Clinical trials showed positive results for its osteoporosis drug Odanacatib and experimental insomnia drug Suvorexant, for which Merck & Co. expects to receive FDA approvals by mid-2013. The company's promising drugs are a few cardiovascular drugs and treatments for Alzheimer's disease, diabetes, hepatitis C, and psoriasis. MRK yields 4.1% on a payout ratio of 78%. Its five-year annualized dividend growth averaged 2%. The stock is trading at 11.9x versus 14.2x for its industry. The stock is popular with Tiger Cubs at Point State Capital.

Pfizer Inc. (NYSE:PFE), the fund's third-largest holding, has risen 20.0% over the past year. Currently, its dividend yields 3.7% on a payout ratio of 75% of trailing earnings and 41% of free cash flow. Its dividend grew by 37.5% since 2009. The company will see slow EPS growth over the next five years, averaging 2.1% annually. However, the company's long-term perspective is optimistic as its diversified pipeline contains 78 drug candidates, with 8 in the registration process and 45 in phase II and III trials. Especially promising are its auto-immune system drug Tofacitinib and stoke-prevention drug Eliquis. Pfizer is also expanding growth through acquisitions and strategic alliances. The company sold its nutrition business to Nestle in 2012, and is planning to divest its animal division, Zoetis, through an IPO by July 2013. Pfizer has a relatively low long-term debt-to-equity of 38% and high gross margin of 81%. It is trading at below-industry price-to-book. Its forward P/E is 11.9x versus 14.2x for its industry. Value investor Ken Fisher is particularly bullish about Pfizer (check out Ken Fisher's top picks).

Verizon Communications (NYSE:VZ), the fund's fourth-largest position, is a good income stock. It has rallied 10.4% over the past 12 months. Its dividend yield is 4.7% and payout ratio is 72% (even lower at 41% of free cash flow). While averaging only 4% per year over the past five years, its dividend growth may accelerate this year and next on cash flow boost driven by strong profitability amid surging data and wireless sales. Subscriber growth is strong. The company's long-term prospects will be supported by a robust integration of smartphones, with smartphone shipments forecast to increase 32% in 2013, according to Digitimes Research. The company is also expanding into the movie rental business with its latest online video streaming service with Redbox, posing as competitor to Netflix (NASDAQ:NFLX) and even cable companies. With a forward P/E of 16.1x, the stock sells at a premium to its industry and main rival AT&T (NYSE:T). Adage Capital's Phill Gross is bullish about VZ.

T. Rowe Price Group, Inc. (NASDAQ:TROW), an asset manager, is the fund's fifth-biggest holding. A dividend aristocrat, TROW has gained 20% over the past year. The company's dividend yields 2.0% on a payout ratio of 43%. Its dividends grew, on average, by 11.4% annually over the past half-decade. A Sandler O'Neill analyst sees the company benefiting from the investors' greater acceptance of risk this year, which should boost its AUM and EPS growth, allowing for the stock's multiples expansion. The company also stands to benefit from the migration toward equity funds (due to the likely rising bond outflows amid inflation concerns), as the lion's share of TROW's funds are equity and blended asset funds, most of which have outperformed their peers over various investment horizons. The company has shown robust AUM, revenue, and EPS growth in recent quarters. It has a strong cash flow generation capacity. Trading at a forward P/E of 18.1x, TROW is still undervalued relative to its historical metrics. Citadel Investment's Ken Griffin is a fan of this stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: Dividendinvestr is a team of analysts. This article was written by Serkan Unal, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.