Picking equity-income stocks got even tougher early in the pandemic last year when stalwart dividend payers like

Southwest Airlines

(ticker: LUV),

Boeing

(BA), and

Walt Disney

(DIS) suspended their payouts to preserve capital.

Though overall dividend health has improved markedly since then and looks good heading into 2022, it’s important to keep quality in mind. However, pinpointing what separates such stocks from the rest of the pack can be tricky, given the subjective nature of defining quality.

Barron’s spoke to three money managers for guidance, and to learn about some of their favorite dividend stocks.

A quality payout “isn’t only sustainable but preferably can grow over time,” says Mike Barclay, a senior portfolio manager at Columbia Threadneedle Investments. “It’s one of the reasons we don’t focus on yield,” he adds. Barclay is a manager of the $39 billion

Columbia Dividend Income
fund (LBSAX). As of Oct. 31, its top holdings included

Microsoft

(MSFT),

JPMorgan Chase

(JPM), and

Johnson & Johnson

(JNJ).

A dividend yield, Barclay says, “is just a formula” and “it really doesn’t tell you about the health of the company or the ability to pay that dividend in the future.”

Steve Goddard, founder and chief investment officer of the London Co., which manages money in separate accounts, prefers companies with high returns on capital and strong balance sheets. “High return-on-capital companies usually by definition will generate a lot more free cash flow than the average company would,” he says. And cash flow is what pays the dividend.

As of this year’s third quarter, the Richmond, Va.-based London Co.’s equity-income strategy’s top 10 holdings included

Apple

(AAPL), which recently yielded 0.5%; chip maker

Texas Instruments

(TXN), 2.4%;

Microsoft

(MSFT), 0.7%; home-improvement retailer

Lowe’s

(LOW), 1.2%; and asset manager

BlackRock

(BLK), 1.8%.

Another potential plus for quality stocks: Besides offering solid and growing dividends, many sport attractive valuations and trade at a discount to the

Russell 1000
index, says Goddard.

David Katz, chief investment officer at Matrix Asset Advisors in White Plains, N.Y., cites the

S&P 500 Dividend Aristocrats Index
when asked about quality companies that pay dividends. The 65 firms in the index, all of which have paid a higher dividend for at least 25 straight years, include

Target

(TGT),

Chevron

(CVX), and

Caterpillar

(CAT).

“These are well-financed companies with long operating histories, good balance sheets, and they have consistently maintained and grown their dividends,” says Katz.

He points out that the stock market, with its tilt toward growth companies, hasn’t treated quality companies with much respect this year.

“You have a lot of really good drug companies that have a significant focus on dividends and dividend growth, have good earnings and good earnings growth, but the stocks have just been miserable,” Katz says, pointing to

Merck

(MRK) and

Amgen

(AMGN) as prime examples.

Merck, which yields 3.8%, has returned about minus 4% this year, dividends included, compared with about 26% for the

S&P 500.
Amgen, a biotech firm whose stock yields 3.6%, is also down about 4% this year.

For Barclay and his colleagues, the hunt for quality dividends starts with free cash flow, which is typically calculated as operating cash flow minus capital spending. “At the end of the day, a dividend can’t be sustained, let alone grown, over time, if the underlying cash from operations isn’t growing,” he observes.

He also pays close attention to a company’s balance sheet—the stronger, the better for dividends.

“You don’t always get paid for a strong balance sheet, except when you get into a stressed environment” like that in March 2020, when the pandemic hit the U.S. hard, says Barclay. “If you don’t have a strong balance sheet, you can’t weather that storm.”

Barclay also analyzes a company’s payout ratio, which he defines as the percentage of free cash flow that’s paid out in dividends. Many others define it as the percentage of earnings that get paid out in dividends.

“When the payout ratio is low, we know they’ve got a lot of room to run for dividend growth,” he says. “The ability [to pay it] is there. It’s our job to really press management whether or not the willingness is there to grow the dividend over time.”

One stock whose dividend Barclay likes is Microsoft, which has boosted its disbursement at an annual rate of about 10% a year. It yields only 0.7%, well below the S&P 500’s average of about 1.3%. However, Barclay says that his cost basis for the stock—the average of what he paid for the shares—is under $30, meaning his yield is effectively above 8%.

Two other dividend stocks he favors are analog chip maker Texas Instruments and banking powerhouse JPMorgan Chase, which yields 2.5%.

The market for analog chips is growing—a boon for TI—and the industry is consolidating, he says. As for JPMorgan Chase, Barclay says, it has “a very diversified business model that allows it to ride the economic cycles with some consistency.” That allows it to pay and increase its dividend.

Katz likes

Coca-Cola

(KO), which was recently yielding 3.1% but had only returned about 4% this year. He likes the beverage company’s prospects and adds that it “actually has been pretty good in terms of dividends.”

Coke’s chief financial officer, John Murphy, said during its third-quarter earnings call in late October that improving cash flow will help continue “our track record to grow our dividend.”

Write to Lawrence C. Strauss at lawrence.strauss@barrons.com