Top Holdings Of Dividend ETFs (Part 2a: The Top Defensive Sector Stocks)

Summary

• In Part 1 of this article, I presented the top 50 holdings of 50 dividend-paying ETFs, ranked by using a proportional scoring system that favors larger investments and larger ETFs.
• In Part 2a, I'm showcasing the top Defensive Sector stocks. The article presents the seven top-ranked stocks in each of the Consumer Staples, Health Care, and Utilities sectors.
• Along with key metrics and fair value estimates, I include charts from Portfolio Insight for stocks I consider good candidates for further analysis and possible investment.
• Investors looking to build a diversified portfolio might find this information useful.

Aksana Kavaleuskaya/iStock via Getty Images

In Part 1 of this article, I presented the top 50 holdings of dividend ETFs. The top holdings of Dividend ETRs in May 2021 are Apple (AAPL), Microsoft (MSFT), and Johnson & Johnson (JNJ).

Source: Created by the author

The top holdings are not distributed evenly among the eleven GICS sectors. For example, the Information Technology sector has nine representatives in the top 50 holdings, whereas the Materials sector has only one.

Source: Created by the author

For investors looking to build a diversified portfolio, an uneven distribution across sectors is of little use. In Part 2 of this article, I'm presenting the top seven stocks in each GICS sector, regardless of ranking.

Rather than presenting all 77 stocks in a single article, I decided to split Part 2 into three articles corresponding to the following Supersectors, which is a way to categorize GICS sectors based on how they tend to perform during different phases of the business cycle:

Defensive Sectors are not closely tied to the economy because companies in these sectors provide goods and services always in demand. GICS sectors: Consumer Staples, Health Care, Utilities

Cyclical Sectors are closely tied to the ups and downs of the economy. When the economy is thriving, companies in cyclical sectors do well because unemployment is low and wages increase. In downturns, though, companies in cyclical sectors tend to struggle as consumers are less confident about the future. GICS sectors: Consumer Discretionary, Financials, Materials, Real Estate

Sensitive Sectors are sectors that ebb and flow with the overall economy but to a limited degree. Companies in these sectors are not immune to a poor economy, but economic downturns may not severely impact them. GICS sectors: Communication Services, Energy, Industrials, Information Technology

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This article covers the Defensive GICS sectors and provides key metrics and fair value estimates for the top seven stocks in those GICS sectors. I include charts from Portfolio Insight for a selection of these stocks, particularly for ones I consider good candidates for further analysis and possible investment. Future articles will do the same for the Cyclical and Sensitive GICS sectors.

Picking Candidates

Before presenting the top seven stocks in each Defensive GICS sector, let me briefly explain what I look for when picking candidates for further analysis and possible investment.

Stock Quality

First, I consider the quality of stocks as determined by DVK Quality Snapshots. I've been using this elegant and effective system since May 2019. Developed by SA author David Van Knapp, the system employs five widely used quality indicators from independent sources, assigning 0-5 points to each quality indicator for a total quality score of 25 points.

I rate stocks with a simple mapping of their quality scores, differentiating between Exceptional (25), Excellent (23-24), Fine (19-22), Decent (15-18), Poor (10-14), and Inferior (0-9) stocks.

Furthermore, I consider stocks with quality scores in the range of 15-25 to be Investment Grade. Stocks with lower quality scores are Speculative.

Stock Valuation

A stock's valuation is another consideration. Buying undervalued stocks has built-in upside potential. I routinely estimate the fair value [FV] of stocks on my watch list to identify stocks that trade at favorable valuations.

To estimate fair value, I reference fair value estimates and target prices from trusted online sources, ignore the outliers (the lowest and highest values), and use the average of the median and mean of the remaining values as my fair value estimate.

While I prefer to buy stocks only when discounted, high-quality dividend growth [DG] stocks rarely trade below fair value. For this reason, I allow some leeway to pay premium prices for stocks rated Exceptional and Excellent. In contrast, I demand a larger discount for stocks rated Decent:

Source: Created by the author

Stocks that pass this screen have favorable valuations. I'm adding a new column (Buy Below) to my tables to indicate the highest price I'm willing to pay for a stock.

Dividend Growth Outlook

Next, I consider the Chowder Number (CDN), a popular metric that favors dividend growth [DG] stocks likely to produce annualized returns of 8%. The CDN is calculated as the sum of a stock's forward yield and its 5-year dividend growth rate [DGR].

In my tables, I color-code the CDN based on how likely it is that the stock will produce annualized returns of 8%, according to the Chowder Rule:

1. For stocks yielding less than 3%: red < 10 ≤ yellow < 15 ≤ green
2. For stocks yielding at least 3%: red < 8 ≤ yellow < 12 ≤ green
3. For utilities yielding at least 4%: red < 5 ≤ yellow < 5 ≤ green

Here are the meanings I ascribe to the CDN colors:

• Green: Suitable candidate, likely to produce annualized returns of 8%.
• Yellow: Possible candidates, less likely to produce annualized returns of 8%.
• Red: Unacceptable candidates, unlikely to produce annualized returns of 8%.

The CDN is a growth-oriented metric.

Dividend Income Outlook

I now also consider the 5-year Yield on Cost [YoC] of DG candidates, an income-oriented metric. It was introduced and explained to me in an e-mail by Bob, a follower here on Seeking Alpha.

What is the 5-year YoC?

Assume you buy a stock today and hold it for five years. If the company continues to increase its dividend at the current 5-year DGR, then your 5-year YoC would be the annual dividend you receive after holding the stock for five years, relative to today’s stock price.

To calculate the 5-year YoC is easy:

5-year YoC = Forward Yield × (1 + 5-year DGR)^5

Here, ^5 means to the 5th power.

I color-code the 5-year YoC column as follows:

• red < 2.50% ≤ yellow < 4.00% ≤ green

The 4.00% level matches the one Bob uses when selecting stocks for his dividend portfolio.

Dividend Safety

While Dividend Safety Scores is one of the quality indicators of DVK Quality Snapshots, I also highlight this metric separately. When looking for new stocks to add to my portfolio, I choose only Very Safe and Safe dividends.

Source: Simply Safe Dividends

Once I own a stock and its Dividend Safety Score drops below 61, I'll consider closing or trimming my position. And if the Dividend Safety The score drops below 21, I'll immediately close my position.

Top Seven Stocks in the Defensive GICS Sectors

Below I present the top seven stocks in the Consumer Staples, Health Care, Utilities sectors.

In each table, Rank is the stock's rank as determined by my proportional scoring system. Cells in the Rank column are highlighted for stocks in the top 50 holdings. Freq indicates the number of dividend ETFs containing Ticker in their top 25 holdings. Years are the number of consecutive years of dividend increases. Yield is the forward dividend yield for a recent Price, and 5-DGR is the compound annual dividend growth rate over the trailing 5-year period.

The tables include the additional metrics I use when picking candidates for further analysis and possible investment, the Chowder Number (CDN), the 5-year YoC (5-YoC), the quality score (Qual), my fair value estimate (FV) of each stock helping to identify stocks that trade at favorable valuations. Discounted stocks are shaded green in the Price column. To estimate fair value, I reference fair value estimates from several sources, ignore the outliers (the lowest and highest values) and use the average of the median and mean of the remaining values as my fair value estimate.

Note that I've highlighted stocks I own in the Ticker column.

Consumer Staples

Source: Compiled by the author; includes data from Dividend Radar and DVK Quality Snapshots

I own five of the six Consumer Staples stocks in the top 50 holdings of Dividend ETFs.

With a quality score of 25, Procter & Gamble (PG) is rated Exceptional. I'm willing to pay a premium of up to 10% for stocks rated Exceptional. Therefore, I would consider buying PG below $137. What gives me pause is PG's low CDN and 5-year YoC.

Coca-Cola (KO), PepsiCo (PEP), and Walmart (WMT) are rated Excellent (quality scores 23-24). I'm willing to pay a premium of up to 5% for stocks rated Excellent. KO and PEP qualify, but I prefer PEP given its more generous 5-year YoC.

With quality scores in the range of 15-19, Altria (MO), Philip Morris International (PM), and Walgreens Boots Alliance (WBA) are rated Decent. For such lower-quality stocks, I require a discount of at least 10%. PM is trading above my Buy Below price, while MO has a Borderline Safe dividend. Both MO and WBA are discounted more than 10% and so trade below my Buy Below price.

Lower-Risk Candidate: PEP

PEP is trading just above my fair value estimate of $147, but I'm willing to pay up to $154 for this high-quality stock. According to Simply Safe Dividends, PEP has a Dividend Safety Score of 93, considered Very Safe.

With 49 consecutive years of dividend increases, PEP will soon become a Dividend King. The stock has an impressive dividend growth history, and dividend payouts have been well-covered by earnings:

Source: Portfolio-Insight.com

However, at 75%, PEP's Non-GAAP payout ratio is edging high for Consumer Staples. With a 5-year earnings growth rate of 3.85%, the days of higher dividend increases may be numbered. The company's latest increase was 5.13%, somewhat below its 5-year DGR of 7.8%.

Nevertheless, PEP is a solid defensive stock with a low Beta of 0.61, and I think PEP is a great candidate for further research and possible investment. The stock's current yield essentially matches its 5-year average:

My PEP holding is appropriately sized based on my factor-based calculation of portfolio target weights. Accordingly, I won't be adding more shares at this time.

Higher-Risk Candidate: MO

MO appears to present a good opportunity for investors willing to take on some risk. The stock offers the highest yield and the highest 5-year DGR of the seven Consumer Staples and is the only stock with a favorable CDN. Furthermore, MO is trading at a discount of about 18% to my FV estimate.

However, according to Simply Safe Dividends, MO has a Dividend Safety Score of 55, considered Borderline Safe. A Borderline Safe rating implies a moderate risk of a dividend cut, so investors should understand the risk-reward tradeoff when investing in stocks like MO.

The stock has performed poorly since April 2017, though recent price action looks promising:

MO's dividend growth history is impressive, and dividend payouts have been well-covered by earnings:

Source: Portfolio-Insight.com

With a payout ratio of 79%, Altria does not have much room to maneuver if earnings should disappoint.

Below is a Non-GAAP Earnings-based fair value chart of MO, courtesy of Portfolio-Insight.com. The chart confirms that MO undervalued and suggests a 12-month upside potential of 60% based on earnings estimates:

I'm looking to add about 100 shares to my current MO position, which would boost DivGro's projected annual dividend income by $344.

Health Care

Source: Compiled by the author; includes data from Dividend Radar and DVK Quality Snapshots

I own all six of the Health Care stocks in the top 50 holdings of Dividend ETFs. Another Health Care stock I own, Gilead Sciences (GILD), is ranked #51, and so it just missed making the list.

All seven Health Care stocks are trading below my Buy Below prices, and most of them are discounted, too. Note also that these are high-quality stocks with Very Safe or Safe dividends.

Johnson & Johnson (JNJ) is the top-ranked DG stock in Dividend Radar and a member of an elite group of stocks that are all Dividend Kings, Dividend Aristocrats, andDividend Champions. The stock's dividend is Very Safe, but the combination of dividend yield and 5-year DGR produces a CDN of 9 and a 5-year YoC of 3.5%, so it doesn't make the cut based on those criteria.

Pfizer (PFE) and Merck (MRK) present similar metrics. PFE offers a higher yield, while MRK is discounted more and has a higher quality score. Over the past 10 years, MRK has slightly outperformed PFE on a total returns basis, but both stocks trail the performance of the S&P 500 (SPY) over that timeframe:

Source: Portfolio-Insight.com

UnitedHealth (UNH) is a remarkable stock with a spectacular 5-year DGR of 20.1%. It is by far my top-performing Health Care stock, with an annualized total return of 35%:

Source: Excerpt of author's DivGro portfolio spreadsheet

UNH is slightly overvalued now and does not quite make the cut based on its 5-year YoC. However, I think it is a great selection for growth-oriented investors.

AbbVie (ABBV), Amgen (AMGN), and Gilead Sciences (GILD) are all discounted and offer a good combination of dividend yield and 5-year DGR.

ABBV offers the highest yield and second highest 5-year DGR and is the lowest rated stock with a quality score of 17. The company faces some headwinds in 2023 and beyond when its blockbuster drug Humira (40% of sales) loses exclusivity in America. When earnings drop as biosimilars emerge, ABBV might have to curb its pace of dividend growth until earnings rebound.

GILD offers the second highest yield and a strong 5-year DGR of about 10%, though its latest increase was more modest at 4.4%. The company is still struggling to grow revenue after its hepatitis C drug franchise declined from $19 billion in sales to $2.9 billion:

While ABBV and GILD offer higher yields, I'm favoring the higher-quality AMGN for its stability.

Safe Income Candidate: AMGN

Dividend Contender AMGN has an impressive dividend growth history:

I love consistency, and AMGN's dividend increase history is a model of consistency, for sure! The company has the earnings growth to support its dividend growth and a reasonable earnings payout ratio of 42%:

Source: Simply Safe Dividends

My AMGN holding is a full position, and I won't be adding more shares at this time.

High Growth Candidate: UNH

Dividend Contender UNH has an awe-inspiring dividend growth history:

Once again, UNH has the earnings growth to support its strong dividend growth and an even lower earnings payout ratio of only 31%:

Source: Simply Safe Dividends

Over the past decade, UNH has performed remarkably well as investors, recognizing the stock's qualities, have driven up the share price. As a consequence, the stock's dividend yield has remained modest despite generous double-digit percentage dividend increases!

Source: Portfolio-Insight.com

On a total return basis (including dividends), the stock has outperformed the S&P 500 (SPY) by a margin of 2.70-to-1. UNH's outperformance is even more impressive when we extend the timeframe to 20 years: about 7-to-1!

My UNH holding is a full position, and I won't be adding more shares at this time.

Utilities

Source: Compiled by the author; includes data from Dividend Radar and DVK Quality Snapshots

I own neither of the two Utilities in the top 50 holdings of Dividend ETFs. I own NextEra Energy (NEE), an exciting stock with a renewable energy subsidiary with strong growth prospects. I want to add about 200 shares to my current underweight position, but only if the stock price drops below $70 per share.

All but two stocks are discounted relative to my FV estimates, but only three stocks are trading below my Buy Below prices, Southern (SO), UGI (UGI), and Consolidated Edison (ED).

UGI drops out of consideration due to its mediocre quality score, despite having a Very Safe dividend safety rating. I should note that UGI does not have an S&P Credit Rating, so it misses out on up to 5 quality score points.

Two other stocks to eliminate are South Jersey Industries (SJI) and PPL (PPL).

SJI is rated Poor based on its quality score. The company's payout ratio is rather high following a recent dilutive equity raise, so I expect smaller dividend increases until earnings grow sufficiently to restore the company's payout target.

As for PPL, its dividend is deemed unsafe because the company is expected to cut its dividend after selling its U.K. utility business to National Grid and acquiring National Grid's Rhode Island utility, Narragansett.

Duke Energy (DUK) is growing its dividend at a prolonged rate. On top of that, the stock's CDN is color-coded red, meaning it is presently Unacceptable. Besides, my Buy Below price is $87, so I'm not interested in DUK at this time. Note that at $87, DUK would yield 4.44%, sufficiently raising its CDN and making the stock a Suitable candidate.

Only two stocks remain, SO and ED. They have similar metrics, but ED's dividend is considered Very Safe, and the company has a much longer streak of consecutive dividend increases. Between the two, I'd look at ED first.

ED is a Dividend Aristocrat and Dividend Champion with 47 consecutive years of dividend increases. The stock has a generous yield of 4.32%, but dividend growth is slow and likely to remain so:

Source: Portfolio-Insight.com

At 74%, ED's payout ratio of just about right for Utilities. Note that the payout ratio increased recently, requiring extra scrutiny as ED announces earnings in the future. As long as earnings grow sufficiently to keep that payout ratio intact, there's little to get concerned about.

Below is a yield channel chart showing ED's price line relative to a fair value channel based on past yields. ED is trading just below the green Undervalueprice, indicating now might be a good time to buy the stock:

I do not own shares in ED but would be interested in opening a position. I believe there is some upside for a patient, long-term investor.

Concluding Remarks

Analyzing the holdings of dividend ETFs is one way to identify quality dividend growth stocks. Looking at the top-ranked stocks by GICS sectors provides additional insight, especially for portfolio diversification.

This article showcased the top seven stocks in each Defensive GICS sector: Consumer Staples, Health Care, and Utilities. I selected several stocks worthy of further analysis and possible investment: AMGN, ED, MO, PEP, and UNH.

Please do your own due diligence before investing.

Part 2b of this article will showcase the top seven stocks in each Cyclical GICS sector: Consumer Discretionary, Financials, Materials, and Real Estate.

Thanks for reading, and happy investing!

Analyst’s Disclosure: I am/we are long AAPL, ABBV, AMGN, GILD, JNJ, KO, MO, MRK, MSFT, NEE, PEP, PFE, PG, PM, UNH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.