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It’s becoming increasingly difficult to invest in the current environment.  Over the last few weeks some of the legends of the investment business have said this market is too difficult and have subsequently shut down their businesses.  It’s no wonder that we’ve seen an increasing demand for bonds and bond related instruments.  But that doesn’t mean equities are dead.  In fact, Morgan Stanley believes this is a perfect environment for high quality dividend paying stocks.  MS believes there is an opportunity here:

“Longer term we believe the rise in the spread between dividend yield and real bond yields may represent a statement about the market’s view on three things:

1) An outlook for weak long-term earnings growth that leaves a reduced possibility of P/E expansion, meaning that dividends
have to be a dominant part of total returns.  Historically a dividend yield of 2% would equate to a P/E multiple of nearly 17x (or alternatively a dividend yield near 3% supports the current market P/E of 14.5x). We do not think a 3% dividend yield is unrealistic. It would require the payout ratio to rise into the low 40% range – a move that would put it back close to the long-term average.

2) A higher risk premium (we estimate the implied ERP is now around 5.2%) that now needs to be compensated by a higher yield.

3) Investors doubt that companies can be trusted to reinvest earnings and create value. Companies are better off enhancing the payout ratio and returning money to investors, something we have yet to see in the current cycle.”

(Earnings and dividends are highly correlated)

MS created a high quality dividend screener to try to capitalize on this outlook.  The screen and results follow:

“We have run some screens to highlight stocks that look attractive on a yield basis. We apply some basic filters to raise conviction levels in the sustainability of current dividends.

1. We create a buffer by only considering stocks with yields more than 1% above the Treasury yield (a cutoff of around 3.7%).

2. We substantially lower earnings estimates for 2011, which have only just started to be downgraded. We cut consensus estimates by 20% for cyclical companies in Discretionary and Materials, 10% for Industrials, Energy and Technology, 20% for
Financials, 5% for non-cyclicals (Telecoms, Utilities, Healthcare, Staples). We then assess how many companies’ dividend payout ratios are still below 60%. Our top picks here are CVX, COP, PFE, ABT, MRK, CAG, JNJ, NEE, PEG and NU.

3. We try to eliminate the risk of future earnings and examine dividend sanctity by looking at how many times the 2011 dividend is covered by cash and marketable securities less short-term debt on the balance sheet. See Exhibit 9 for a list of these stocks. Our top picks here are LTD, LO, CVX, GPC, PFE, JNJ, MCHP, CAG, BMY and MRK. Besides the stocks mentioned above, we also have strong conviction in T, PNW, PM, ETR, CMS, KFT and HNZ on a yield basis.”

Source: Morgan Stanley

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