Quality matters. That's particularly true when buying stocks for their dividends. Some stocks claim high yields, but those dividends consume such a large percentage of the company's earnings that continued payout could be in jeopardy.
The health care industry has its fair share of these potential dividend traps. However, some solid dividend stocks can be found in the industry. Here are three I believe stand out as the best of all.
1. Merck & Co. (NYSE:MRK)
Merck's forward dividend yield stands at 3.1%. That's not as strong as the pharmaceutical company's 3.9% average yield over the last five years, but it's still quite attractive.
Can Merck sustain this solid dividend level in the future? The company's payout ratio (the fraction of earnings paid to shareholders in the form of dividends) is 43%. That relatively low ratio is a little suspect, though. It reflects a one-time boost from the $14.2 billion sale of Merck's consumer care business unit to Bayer AG. Without that sale, Merck's earnings declined from 2013 to 2014. On an adjusted earnings basis, the company's payout ratio would be closer to 51%, which is still pretty good.
Even with lower real earnings, I'm not too concerned about the possibility of Merck cutting its dividend anytime soon. Merck's cancer drug Keytruda could prove to be a big winner. It has already been approved in the U.S. for treating melanoma and is in a late-stage study for treating lung cancer. Merck also shouldn't be too far off from jumping into the big-dollar hepatitis C market. MK-5172A, a combination of grazoprevir and elbasvir, is in phase 3 trials.
2. Baxter International (NYSE:BAX)
Baxter comes in just behind Merck with a forward dividend yield of 3%. And that yield is on the rise: Baxter's five-year average dividend yield is 2.7%.
As with Merck, Baxter's 45% payout ratio comes with an asterisk. The company's earnings were inflated by the sale of its vaccines business to Pfizer. Even if we back out the effect of that sale, though, Baxter's payout ratio would be less than 60% -- a manageable level that shouldn't alarms investors.
There is one change on the way that should be considered. Baxter plans to spin off its biopharmaceuticals business within the next few months. That will leave the core company focusing on medical products that treat end-stage renal disease and other conditions. This move could negatively impact Baxter's dividend, but I'd be surprised if it did. Overall, Baxter's dividend appears to be fairly safe.
3. Johnson & Johnson (NYSE:JNJ)
Johnson & Johnson's forward yield of 2.7% trails those from Merck and Baxter. However, J&J can lay claim to an enviable position afforded few companies: the health care giant has increased its dividend for 52 consecutive years.
With that track record, J&J's payout ratio might be less important in assessing whether investors can expect the dividends to keep flowing. For what it's worth, though, that ratio stands at a healthy 48% -- with no caveats to speak of.
Johnson & Johnson is about as solid as companies come. Its pharmaceutical and medical device business segments are growing at impressive rates. While profits for J&J's consumer business segment have been essentially flat recently, the unit still kicked in almost $2 billion to the bottom line in 2014.
You could definitely find health care stocks that have higher dividend yields than these three. However, you would also discover payout ratios that would be significantly higher -- and potentially more concerning.
I should also note that I intentionally excluded real estate investment trusts, or REITs, that focus on health care. There are some great health care REITs that boast strong dividend yields, but this list focused on pure-play health care companies. For investors looking for quality health care dividend stocks, Merck, Baxter, and J&J should be among those at the top of the list.
Keith Speights has no position in any stocks mentioned. The Motley Fool recommends Baxter International and Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson. 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.