Where to find quality and stable US income stocks

Meanwhile, the Bearbull portfolio is encumbered by its obligation to provide income; it is, after all, an income portfolio. Sure, one can ask, what’s the point of that? Any portfolio can be turned into an income generator without needing to hold high-yield stocks.

That’s a discussion for another occasion. Bearbull is committed both to distributing all the income the portfolio receives and to generating a yield of about 1.2 times the average of the UK’s FTSE All-Share index, which currently works out at about 4.4 per cent. In that context, there’s a problem putting capital into an equity market where the current dividend yield is 1.5 per cent, as is the case with the S&P 500 index of US shares. The risk is that the portfolio ends up investing in those American stocks that offer a high yield as phoney compensation for their inferior quality.

Fortunately, it may not come to that. The US market offers pockets that appear to combine a high dividend yield with a good quality business. Two such are the pharmaceuticals and chemicals sectors, both of which have lagged the S&P 500 in the past five years, although not excessively so.

Beyond doubt, there are world-class companies in both sectors. Sure, for some, the dividend yield on offer is too low for an income portfolio. One such is industrial gases supplier Linde (US:LIN), whose growth and stability of earnings have made it an investor’s dream these past five years. Yet its rating of over 24 times 2024’s possible earnings also means the likely income yield is just 1.4 per cent. More is the pity, since Linde is still UK-headquartered, a hangover from its 2006 acquisition of BOC.

Keytruda is the major factor behind the rise in Merck’s share price

Likely candidates with acceptable dividend yields are shown in the tables. Rather arbitrarily, the cut-off is the 2.7 per cent offered by shares in Merck (US:MRK), whose best-known – and top-selling – product is its cancer immunotherapy treatment, Keytruda. In 2022, Keytruda’s sales almost hit $21bn (£17bn) on the way to an annual figure that industry analysts suggest will top out at almost $60bn. To put that into context, Keytruda currently generates the equivalent of almost two-thirds of the annual revenue produced by GSK (GSK) and it would comfortably exceed GSK’s total if its peak is around the amount that analysts pencil in.

Whether this is a cause for celebration is debatable since the cost of Keytruda is controversial. The NHS was pleased with itself when it negotiated a figure with Merck below Keytruda’s list price of about £84,000 per patient per year. The price of a novel and fashionable prescription drug is driven almost exclusively by what the healthcare market will bear, sandwiched as it is between demanding consumers and ruthless drugmakers. As such, prices have little to do with costs, so even the NHS discount on Keytruda isn’t necessarily a cause for celebration; except for Merck’s shareholders, that is. Keytruda is the major factor behind the performance of Merck’s share price, which has beaten the S&P index by 60 per cent in the past 12 months.

That said, Merck looks good on other counts, too. As Table 1 shows, its five-year growth rate in earnings per share is impressive, especially as it is combined with little variation in the rate. That is measured by the column for ‘stability’, where the lower the number, the better. Similarly, and as might be expected of a pharma group, Merck’s average profit margin is fat, as is its return on invested capital, always an important, though elusive, measure.

However, take Keytruda out of the equation, and Merck’s prospects seem less exciting. Wall Street analysts expect earnings to dip in 2023 before reviving in 2024. With a glamorous drug leading the way, it is no surprise that analysts love Merck’s shares. Of the 21 analysts’ forecasts shown by data provider FactSet, not a single one suggests selling the stock and just six are brave enough to label it a ‘hold’. The other 15 all recommend buying, or use the synonym ‘overweight’. The problem with this is a familiar one – thanks partly to the analysts’ influence, all the good news is in the price, which also means that even a smidgen of bad news can have big and bad effect.

Yet, as Table 1 also shows, Wall Street’s pharma sector offers several combinations of corporate longevity and high dividend yield coupled with decent dividend cover. In the bigger scheme of things, there may be little long-term difference between a holding in Merck, or in Bristol-Myers Squibb (US:BMY), Pfizer (US:PFE) or even Abbvie (US:ABBV), except that shares in the last three all come with a UK investor’s perception of a conventional high yield (ie, over 4 per cent).

To the extent that Bearbull is often drawn – perhaps like the moth to the flame – to those companies whose share price performance has been lousy, Viatris (US:VTRS) stands out among the pharma stocks. Sure, the performance of Organon (US:OGN) has been worse in relation to its five-year low (see Table 2). But that’s largely because Organon, a spin-off from Merck that specialises in reproductive medicine, contraception and hormone replacement therapy, has been listed on the New York Stock Exchange only since early 2021.

Viatris is another spin-off of sorts, formed via the merger of Mylan, which was Nasdaq-listed, and Upjohn, a venerable drugmaker that had been passed from pillar to post (most recently by Pfizer). It is best-known as the owner of the brands Viagra, the subject of so many smutty jokes, and Lipitor, the ‘original’ statin.

Fine companies though these two may be – and whilw shares that come with rock-bottom ratings – they struggle to get through the first stage of data screening. Profit margins at Viatris are ordinary, while its return on capital is almost non-existent (although that may be an accounting quirk). At Organon, earnings are shrinking, although there may be a fine business occupying resilient niches just waiting for investors’ approbation.

Similarly, in the chemicals sector, International Flavors & Fragrances (US:IFF) is a defensive business whose shares are deeply unpopular. The New York-based group is the world’s second-biggest operation doing what its name implies. Mostly, it supplies the food industry, but about 40 per cent of its $12bn or so annual revenue is split evenly between the healthcare and cosmetics industries.

Since demand for flavours and fragrances has been around pretty well since civilisation began and is likely to be present when it ends, International Flavors should be resilience in corporate form. Quite possibly, this is what attracted the Rausing family, controllers of the Swedish-Swiss Tetra Laval packaging group, who took a major stake in 2018. That holding has since been diluted to 10 per cent following the merger of International Flavors with the nutrition and biosciences arm of DuPont (US:DD) in 2020. IFF’s share price has not been the same since, which is starting to attract activist investors. That may yet spell an investment opportunity, although that is also for the near future.

For the present, however, there is the need for extra stability in the Bearbull portfolio. Arguably few businesses do ‘stability’ better than Johnson & Johnson (US:JNJ), still very much a healthcare conglomerate. It ranks alongside, say, Nestlé (CH:NESN), Procter & Gamble (US:PG) and maybe Unilever (ULVR) for the reliability of its revenues. That does not always produce the best share price performance, especially against a backdrop of rising interest rates. But factors such as those shown in Table 1 – especially those for the stability of its earnings growth, its return on capital and its balance-sheet strength – persuade me that foregoing a percentage point or so of dividend yield is acceptable; and certainly while I contemplate a bigger shake-up for the Bearbull portfolio. Meanwhile, most of the portfolio’s £20,000 of spare cash has gone into J&J shares.

bearbull@ft.com