Healthcare: Are These the Best Dividend Stocks to Buy Now?

Demand in the healthcare sector isn't tied as closely to the state of the economy as it is in most other sectors. Because of that, dividend-paying healthcare stocks may offer income investors some insulation against market declines.

Is this a good time to consider adding Johnson & Johnson (JNJ 1.49%), AbbVie (ABBV 1.06%), and Pfizer (PFE 2.40%) to portfolios? In this episode of The Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes is joined by contributor Todd Campbell to discuss the risks and opportunities associated with owning these top dividend stocks.

A full transcript follows the video.

This video was recorded on Oct. 4, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your Healthcare show host, Kristine Harjes. This episode was pre-recorded in early September and is scheduled for release on Oct. 4. Regular listeners might remember that I missed the last two shows because I was on vacation in Greece, and I'm still there, which is weird to say when I'm currently sitting in Alexandria, Virginia. But, on Oct. 4, I will be in Greece. Much appreciation to my partner in crime, Todd Campbell, who is calling in today to do this episode with me today ahead of schedule. Todd, welcome to the show!

Todd Campbell: Welcome to you as well, and I hope you're enjoying your trip. [laughs] Listeners, I tried to convince her to film from Greece, but no, she wasn't having it.

Harjes: No, the signal just wasn't very good. Future-me told me. Anyway, down to business. Something we see in the data on our fool.com articles is that investors are super interested in dividend stocks, which makes sense. Owning shares of a dividend stock allows you to just sit back and passively bring in income, which is kind of nice. These stocks just pay you to be a shareholder. Todd, we'll do a quick primer for anyone who might be newer to dividend investing, and then we'll talk about some of our favorite dividend-paying stocks in the healthcare space. Sound good?

Campbell: Perfect.

Harjes: Alright. Primer -- I guess I already did a mini-primer, where dividend stocks pay you to own them. Something I did want to mention as part of said primer was the Dividend Aristocrats. These are companies that have regularly increased their dividend payout for the past 25 years or more. These are generally all-around fantastic businesses. They have outperformed the S&P pretty significantly over the last three years, five years, 10 years, because these companies are very well established. They're none of your clinical-stage biotechs that we love to talk about so much on these shows. Rather, they're companies that generate predictable cash flow year in and year out, and are thus able to take some of that and reward their shareholders.

Campbell: Kristine, studies have proven that dividend-paying stocks over time outperform their non-dividend-paying peers. And it makes sense, because if you're reinvesting those dividends back into more shares, theoretically, you're going to get a slightly better return. There are multiple reasons that investors have warmed up to dividend stocks. You've obviously got the potential for appreciation just on the stock itself; you've got the extra return that you can get in the form of those dividend payments; and you've got a situation where your alternative sources of income from investing are really pretty small. I mean, with bond yields the way they are today because of years of low interest rates, it's not that attractive to a lot of investors to go out and buy short-term or mid-term Treasury bonds. They'd much rather own income-producing stocks which can yield 1% to 3% higher than that.

Harjes: Fortunately, these dividend-yielding stocks are also a somewhat safer play than non-dividend-yielding stocks. You see if you look at history that these stocks tend to sink less than the broad market does in bear markets. So, it's a great way to minimize your downside risk without having to go to a completely safe style of investing. For example, I have some numbers here: In 2008, the Dividend Aristocrats index declined 22%, which sounds terrible until you look at the S&P 500, which declined 38%. So, this is a very safe way to play. A lot of retirees are interested in this, and also people with a long time horizon, because you can reinvest the dividends. So they're kind of great for everybody.

Campbell: Yeah, it smooths out your returns over time. They won't rise as much in a rip-roaring-growth bull market, but they won't fall as much in a bear market. And especially as you get a little bit older and you're approaching retirement, you want to shift more of your assets to a slightly "safer" investment, dividend stocks can make sense.

And we talk about some of the best dividend stocks that are out there, and certainly there are dividend stocks that investors want to own across all sectors, but I think healthcare has always been considered one of those areas that investors want to concentrate on for dividend-paying stocks, because you do get that constant source of demand that's tied to the fact that the products sold by these companies aren't really elective. If you need to get surgery or you need a medication, you need that medication. It's not like you're going to say, "Well, I'm just not going to take that right now."

Harjes: Yeah, exactly, as opposed to maybe something in the consumer discretionary sector, where you don't really need to buy that new ... I don't know. Something in consumer goods. [laughs] Clearly not my sector.

Campbell: [laughs] Maybe you'll cut back and not buy as many cans of Coca-Cola, right?

Harjes: Right, not as much Coke, not as many clothes. I don't know. Ask Vince on Tuesday.

Anyway, before we go into some of our favorite healthcare dividend stocks, I do want a very quickly give definitions for two phrases that we might be using on this show. The first one is "payout ratio" and the second one is "cash dividend payout ratio." It's pretty important to note that difference. Your payout ratio is, for every dollar of income, how much does the company pay out to its shareholders; whereas the cash dividend payout ratio is, take your dividends and divide it by cash flow minus capital expenditures minus preferred dividends. That last part isn't super important, but technically, they need to be paid out before any regular dividends, so take them out as well.

The reason that you have to differentiate between the two of these is, earnings are calculated according to a ton of accounting rules, and sometimes that can obscure where the number comes from and where the company is actually getting its cash from and how much cash. If you do the cash dividend payout ratio as opposed to the earnings version, you will get a clearer picture of the company's cash flow situation as it relates to the cash that they're putting back in your pocket, which is a much healthier way of looking at sustainability. It's harder to do. I think that's why people don't do it as much. But it's really important.

Campbell: Yeah, it's actually my preferred way of evaluating dividend stocks. That'll probably start off a firestorm of tweets, because we're going to have this big debate between what payout ratio is best. Maybe use them both, and lean on both of them. But, I do tend, especially when you're talking about stocks that could have a lot of one-time items -- acquisitions, divestitures, legal settlements, all sorts of crazy stuff that could impact on earnings over shorter periods of time, that can skew, in my opinion, the regular payout ratio. That's why I like to look at the cash flow situation better. Because cash flow really is the lifeblood, in my opinion, that's going to be necessary to support those dividend payments.

Harjes: Yeah, absolutely. So, with all of those background items out of the way, let's talk about our first company. This might just be my favorite dividend stock out there. This one is Johnson & Johnson. I think I pitched this on a New Year's resolutions show at the turn of 2016. I think we did an Industry Focus theme week where each of the hosts picked a different dividend stock. I chose Johnson & Johnson. I've been a shareholder of it since then, and I've been very happy to have this company. It's extremely reliable, and it has such a large and diverse business that there's always interesting things for me to learn about how the company is moving. And they have a super-super-reliable dividend that has been growing annually for 55 straight years, which is incredible.

Campbell: Yeah. You said reliable a couple of times. Yeah, it's kind of like that car that you always get in, you never have to worry about it starting and going places. It has a fairly diversified business model within healthcare. You've got the consumer goods business that does things like health and beauty, over-the-counter stuff that you would pick up at your Rite Aid. Then you've got the pharmaceuticals business, which does things like makes drugs for use in HIV, or makes drugs that help to treat cancer. And then you've got medical devices, which does things like surgical implants and surgical intervention. 

Harjes: What you hear talked about the most with Johnson & Johnson is the pharmaceutical division. That's because it's the largest -- correct me if I'm wrong, the largest?

Campbell: Yes, it is.

Harjes: OK, just making sure. It's the largest division, and it's also the one that moves around the most. It has the most moving parts. For example, one of the most important drugs that Johnson & Johnson makes is called Remicade, and that's on the decline, so meanwhile, you're watching other newer drugs like Darzalex and Imbruvica make up for Remicade's decline. 

The way that Johnson & Johnson's pharmaceutical unit operates, and the way it's talked about, is most similar to every other big pharma out there that we discuss on the show.

Campbell: Yeah, they spend a ton of money on R&D. The R&D kicks off a pipeline of products that can theoretically get launched, it'll offset declining sales of older legacy drugs as they lose patent protection. And then, you have the medical device and consumer goods businesses, which are going to be slow, 1% to 5% growth year over year on any given quarter. Pharmaceuticals, like you said -- that's going to be the lever that moves growth either significantly higher or significantly lower. Remicade is a headwind right now, and because it represents a fairly large portion of their pharmaceutical sales, that's going to depress a little bit their financials. But even with Remicade's headwind, this company is still probably not going to show significant revenue or profit declines over the course of the next five years. If you go out 10 or 15 years, based on history -- and of course we all know there's some risk associated with basing it on history -- but if you base it on history, J&J has been one of those companies that rewards investors through thick and thin. And you have to love that 50-plus-year dividend track record.

Harjes: Yeah, sustainability of the dividend is one of the most important components of it. It doesn't matter if a company is going to pay you 50% if it's only going to last two months and then fall apart. But Johnson & Johnson is the total opposite of that. They're yielding only 2.5%, which isn't bad, but it's such a safe dividend. Their payout ratio and cash payout ratio are both right around 50%, which is a very safe range. Generally, we're looking for under 60% there. And they have a ton of cash on the books, they have a ton of drugs in the pipeline, they have firepower for acquisitions if they want. So this is not a dividend that's going to go anywhere any time soon.

Campbell: Yeah, it's a core holding.

Harjes: Yeah, absolutely. Let's talk about a company that might be a little bit more exciting. They have a slightly higher dividend yield. This one is AbbVie. 

Campbell: AbbVie is a very interesting stock, and I think that its higher dividend yield makes it jump out to investors who are looking for healthcare dividend-paying companies. However, there is a caveat to that higher dividend yield.

Harjes: Which is?

Campbell: Humira. Humira represents the lion's share of AbbVie's sales. It's the top-selling drug in the world, with $16 billion in sales in 2016, and it represents something like 62% of AbbVie's sales.

Harjes: Yeah. Humira and what happens with its patents will mean everything. Amgen already won U.S. approval for a biosimilar, which is a generic version to Humira, last year. It hasn't yet launched this biosimilar yet because of a patent lawsuit filed by AbbVie. AbbVie's management says that they're very sure they'll be able to fend off biosimilar competition through 2022. But that's kind of a big question mark -- do we take management's word for that? And even then, it's only through 2022.

Campbell: Right. Humira sales, we did a show on this in early 2016, Kristine, where we talked about it and we were just amazed, how does management come out and actually guide for sales to increase when they lose patent protection? But that just goes to show you the competitive advantage that Humira has. It's a dominant player in and across autoimmune disease. And sometimes, doctors are very nervous about switching patients off of something that works very well to something else. And since it's a complex biologic, that's a whole another story, because then you have to wonder, how similar is a biosimilar to Humira, and how willing am I to move this patient off of it?

I think they're saying that Humira sales could probably climb up until 2018-2020, somewhere in there, then they'll start to trade down. But, Kristine, this is one of those situations where it's not like it's a surprise to AbbVie's management. They've known that they're losing patent protection on this drug, and they've been working very hard over the last three years to try and diversify themselves into other indications, specifically into hepatitis C and cancer, as a way of building out a company that can withstand any threat to Humira.

Harjes: AbbVie has been a thorn in Gilead Sciences' (GILD 0.91%) HCV side for a while now. I remember when Viekira Pak first came out: That was the first time that Gilead Sciences faced serious competition to its HCV franchise, and AbbVie has not relented. Just recently, they got approval for a pan-genotypic 8-week hepatitis C treatment, which, if you follow the space, you'll know that that's pretty impressive, and that's the best out there so far. So, that could certainly be a solid revenue driver for them, although there's also the argument that population of hepatitis C patients is dwindling as some of the easiest to treat people have already been treated by some of the earlier drugs.

Campbell: Yeah, but I think you still have the ability for this to be a blockbuster category, and I think you're still talking about billions up for grabs. This is probably their best threat so far to Gilead, and a lot of it will come down to pricing and what kind of deals each one of these companies is willing to make with payers. 

But, I think, they're going to be a player in hepatitis C for a few more years, at least. And they've already shown, through their acquisition of Pharmacyclics a couple of years ago, that they want to have a really big presence in cancer. As a refresher, when they bought that company, that landed them 50% of Imbruvica.

Harjes: Yes, which is a drug partnered with Johnson & Johnson, actually. So, yeah, that's a huge drug right now approved for blood cancer. I believe they're also studying it in some label extensions as well.

Campbell: Oh, yeah, absolutely. And I think you have the potential out there, some analysts have said that sales could double from here because of those label expansions for that drug. I think that's something to keep an eye on. They also have some interesting drugs in the pipeline. Rova-T, which is being studied in a form of lung cancer or solid tumor cancers, which is an intriguing drug. They've got some interesting things going on in autoimmune disease that may end up producing a successor to Humira. So, maybe they get to a point where, they've protected Humira until 2020, now they've also got this other drug they can start to transfer some of their patients to that instead. So, there are a lot of different levers that management is trying to move up and down to blunt the risk.

Harjes: Yeah. I think AbbVie's management right now sees its own stock as undervalued. If you look at their share-repurchase history, they have been very generous with the buybacks. I think they're trying to take advantage, a little bit, of some of the market's skepticism that they'll be able to overcome the Humira hurdle, and buy back shares now. Which, if management thinks their own shares are cheap, maybe that's a sign that you might want to as well. They do have a really outstanding pipeline. I've seen it called the third-best pipeline out there in biopharma, for whatever that's worth. They currently have a payout ratio and a cash payout ratio that are similarly just under 60%. They've got a solid amount of cash on the balance sheet. And I've seen analysts say that they should be able to deliver average annual earnings growth of around 14% over the next five years, which is pretty solid.

Campbell: Yeah. If you're a little bit more risk tolerant in your portfolio, in your income portfolio, you can make an argument that the shares are undervalued right now because of the risk to Humira. If so, you get a nice two-pronged attack on growth. You get both the chance for shares to rise back up to where the value "should" be, plus you get that nice yield.

Harjes: One other thing about AbbVie that we haven't mentioned yet: They sort of have 45 years of consecutive dividend hikes. The reason I say "sort of" is because that includes the period before the company was spun off by Abbott Labs. But if you include that history, which most people do, then this is another Dividend Aristocrat.

Our third and final company that we want to highlight today is not a Dividend Aristocrat because they cut their dividend during the financial crisis. This one is Pfizer, which yields just under 4%.

Campbell: I put Pfizer in the middle of these three as far as the risk spectrum goes. Pfizer has been dealing for years with the overhang of sliding sales tied to the patent expiration on what was once the best-selling drug in the world, Lipitor, which you and listeners may know as being the most widely used statin for lowering bad cholesterol. 

That was a $14 billion-a-year drug at one point. And obviously, losing patent protection on it created a very big headwind to try and overcome for this company. It appears that they may be finally turning the corner now, and if so, getting back to growth. And if they're getting back to growth, and cash flow trends up because of all the restructuring and all the costs that they x-ed out of their system over the last seven years, then that dividend could expand.

Harjes: Yeah. Pfizer was the poster child for the patent cliff when a ton of its drugs lost their patent protection and had their sales eaten away by generic competition. Lipitor lost its patent in 2011. When I mentioned that Pfizer had to cut its dividend during the financial crisis, this was largely due to a ginormous $68 billion acquisition of Wyeth at a time when capital was kind of hard to come by. So, they had to cut their dividend. And it's actually taken until early this year to get back to the pre-Wyeth acquisition payout levels. But it's something that they kind of had to do back then. They were facing 14 total patent expirations through 2014. That was going to be $35 billion in lost revenue. So, this company had to buy growth. They also had to have organic growth. And they're finally starting to get back on their feet. I think they look pretty strong right now.

Campbell: It was the right move. I really do think it was the right move. I mean, you have famous investors like Buffett who have come out in the past and said, I don't necessarily really like dividend stocks, I'd rather have companies that can reinvest in themselves and get bigger that way instead. I think Pfizer had to make a decision, had to make the decision of, do I try and find the money somewhere in the budget to pay this dividend, or do I reallocate that money to R&D and acquisitions. As a result, it's on very stable financial ground now. It has one of the best balance sheets out there in pharmaceuticals. It was only a couple of years ago that they were proposing a $160 billion merger and acquisition.

Harjes: Which is insane!

Campbell: Yeah. So, they have a tremendous amount of financial flexibility.

Harjes: And they don't have $160 billion in cash. I will point that out. They have $14 billion. But still, if they were to make that, if they had been able to make that Allergan acquisition when they were looking at it, low-interest debt is so much easier to come by now. So, yes, they do have more firepower.

Campbell: Yeah, financial flexibility is the key. They're leaner and meaner than they were before. Sales could come in between $52 billion and $54 billion this year. If so, that's a start in the right direction upward from where they were last year. Earnings are growing more quickly than revenue because of all that cost cutting they did. And the yield is fine, and the payout ratios are fine. I think this is a company that is worth taking a little bit of risk on. We haven't even dived into the potential for things like their biosimilars pipeline, which they bought when they acquired Hospira, or the potential to continue to expand in cancer, which they've done through buying Medivation more recently.

Harjes: Yeah, they have 32 different late-stage clinical programs. I know that nine of them are for one single drug in different cancers. Another four of the 32 are for biosimilars. So, all these different areas that you've mentioned are places where they're not just dabbling but they're pushing pretty hard, and they have late-stage candidates that will hopefully hit the market very soon and continue to drive growth.

Campbell: Time will tell. Listen, income investors have to look at stocks the same way that I think regular investors do, which is that you have to consider the business first. If you look at all three of these names, look at the business first. Do you believe that the business is in a position to continue to kick off increasingly more cash flow? If you believe that, then it's worth investing in it, because more cash flow will mean bigger dividend payouts. If you don't believe that, then don't invest in these stocks.

Harjes: Yeah, no matter what the dividend yield is.

Campbell: Correct. I think that many investors who are new to income investing chase the yield. They say, "This is a high dividend yielding stock, I have to buy it," forgetting that the business itself is more important than the yield.

Harjes: Yeah, absolutely. It takes a little bit more time to do that research, but that's why you have us, hopefully helping you out on this show, and all of the great articles written by Todd Campbell and the like on fool.com.

Todd, thanks so much for joining me today. Folks, thanks for listening. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!