5 Hot Dividend Picks From Income-Focused Mutual Funds (Part I)

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Income mutual funds focused on dividend growth can be good sources of ideas about what’s hot and what’s not in the dividend growth-focused investing of the professionally managed money. Dividend growth investing has been especially appealing for income investors in the low-yield environment, in addition to this particular market-beating strategy.

This has been the case because dividend yields complemented with dividend growth rates often well exceed the rate of inflation, providing for meaningful real income returns. In contrast, fixed-income securities such as government bonds have recently been offering paltry yields that made dividend growth stocks more appealing.

Below is a closer look at five stocks that professional mutual funds’ portfolio managers were adding to their portfolios in recent months. All these stocks yield more than 2% and are selected for review due to their dividend growth potential.

Number one

Whirlpool (NYSE: WHR), the world’s largest appliance seller, has a bright future, particularly as household income in emerging markets grows with rebounding economies. Analysts peg its long-term EPS CAGR at a superb 28.1% for the next five years, which should allow for robust dividend growth given the company’s low payout ratio of 26% of the current-year EPS estimate. While the stock’s yield is relatively low at 2%, the ample room for dividend growth makes it appealing for dividend growth investors. What’s more, the stock is trading at only 11.4x forward earnings, providing for an exceptional value.

For obvious reasons, global demand for Whirlpool’s products has been lackluster in recent years, but the outlook has improved along with the rebound in the U.S. housing market and pent-up replacement demand, which is expected to play out over the medium-term. The company’s strength is its broad geographic exposure and strong brands, as it markets products in nearly every country and has six brands valued at more than $1 billion. Whirlpool boasts a large opportunity in terms of market penetration in emerging markets, especially in India, China, and Latin America, where the company has average penetration of less than 10%, about 20%, and less than 40%, respectively.

The company has been producing solid operating profits, propped up by an improving operating margin due to fixed-cost cutting, improving productivity, and product innovation. Product pricing and mix have also helped boost financial performance. The trend is likely to continue, as the company aims at expanding its operating margin through cost cuts and sales improvements to 8% by 2014 (from the first quarter’s 6%), extending into the future the streak of five consecutive quarters of year-over-year improvements in operating margins. These trends will support strong underlying cash flow generation in 2013 and beyond, providing sufficient room for robust dividend growth.

The best of the rest

Norfolk Southern (NYSE: NSC) is one of the ultimate dividend growers. This rail transportation company makes the ranks of the very few dividend stocks that have achieved average dividend growth of more than 10% for at least 10 consecutive years. In fact, Norfolk Southern has raised its dividend at a 21% CAGR over the past decade and it boasts 11 consecutive years of dividend growth.

The company’s strong operational performance has enabled such dividend growth. Notwithstanding the deep coal traffic slump in recent years, Norfolk Southern was able to achieve its best ever operational performance in the past two years, with record revenue, operating income, net income, and EPS in 2011, followed by the second-best year on record in 2012.

The outlook continues to be dreary for coal shipments due to coal’s weak position amid strong competition from cheaper natural gas, higher stockpiles, and weaker export markets, mainly in Europe and Asia. However, Norfolk Southern’s growth is supported by stronger intermodal and merchandise rail traffic. Intermodal traffic is receiving a boost from continued opportunities for highway conversion and growth with international shipping companies.

To support growth in this segment, Norfolk Southern is launching new intermodal traffic terminals and service lines. On the other hand, the housing market strength, auto industry growth, and oil output expansion and transportation are buoying the rail merchandise segment. These positive trends should continue, as the robust population growth will support doubling of freight traffic by 2050.

Aside from the economically driven fundamentals, the company is also realizing cost efficiencies that are supporting its bottom line. Its indicators of crew starts, re-crews, train and engine service overtimes, and carloads/units per locomotive, have all been increasing at a solid clip. Moreover, Norfolk Southern’s bottom line is buttressed by respectable share buyback activity, including the last authorization back in August 2012 for 50 million shares through the end of 2017. The stock is yielding 2.6% and has a payout ratio of only 36% of the current-year EPS estimate. Analysts’ consensus EPS estimates for both 2013 and 2014 have been going up over the past three months.

Walgreen

Walgreen (NYSE: WAG), the largest U.S. drugstore chain, boasts a track record of 37 consecutive years of dividend increases. The streak is expected to continue into the future, given this company’s low payout ratio of 34% of the current-year EPS estimate and projected EPS growth of 13.5% annually for the next five years. Walgreen is presently yielding 2.2%.

Last year, the company’s operational performance was battered by a standoff with Express Scripts, which resulted in client loss that hurt sales. Resolution of this stalemate has started to result in improved sales trends, even though competitors still retain the majority of Walgreen’s customers gained during the Express Script standoff. The trend, however, is encouraging, and the current momentum looks poised to extend into the coming period.

Final thoughts

Yields on Treasuries have now started to rise, increasing the appeal of these low-risk fixed-income investments. However, the prospect of moderately rising inflation still makes the case for dividend growth investing. The aforementioned trio -- Whirlpool, Norfolk and Walgreen -- represents solid dividend picks moving forward, but we’ve got more for you. Stay tuned for Part II of this series.

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This article is written by Serkan Unal and edited by Jake Mann. Insider Monkey's Editor-in-Chief is Meena Krishnamsetty.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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