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Playing Big Pharma's Strong Dividend Yields

Stocks in this article: GSK AZN

NEW YORK ( TheStreet) -- Investors looking for stocks with solid dividend yields should spend time looking at some of the bigger pharmaceutical companies because it is not uncommon to find selections with payouts of more than 3%.

Although it is important to avoid focusing solely on the yields themselves, the market is still largely devoid of income-producing alternatives and will remain that way until yields in Treasury bonds see sustainable gains.

To capture the attractive dividends that can be found in the sector, investors need to avoid companies with shaky fundamentals and uncertain futures. It is all too easy to find examples of companies that have offered unsustainable dividend yields, and were forced to make sizable reductions later.

Dividend reductions can have drastic effects on stock values, so companies will generally wait to commit to increases in quarterly yield payouts until there is a good level of certainty that those payouts can continue to be made on a consistent basis. That is why younger companies with limited dividend histories are in a weaker position to make those commitments.

This is also why bigger (a higher dividend yield) is not always better. Ideally, we only want to invest in companies that exhibit stable cash flows and sustainable payout ratios, while offering attractive dividend yields for income investors at the same time. Here, we will test this idea by looking at two of the better-established companies in the pharmaceutical sector, and compare their dividend payouts with their fundamental outlooks.

Lower Yields, Stronger Outlook

GlaxoSmithKline (GSK) offers one of the biggest dividend yields in the pharmaceutical sector, at 4.3%. Its payout history is also impressive -- the company has shown a clear commitment to raising its dividend over the last four years. These increases have even come during times of severe earnings pressure, as significant legal costs in 2010 led to declines in earnings per share of more than 50%.

Glaxo's plans to keep dividends rolling, even when experiencing declines in earnings, have held coverage below two times prospective earnings, which is the security benchmark typically used to determine sustainable dividend levels. This year, Glaxo's earnings are expected to show gains of 2%, followed by an 8% increase in 2014. EPS improvements should help push dividends above the 5% mark, while at the same time keeping coverage below the safety reading.

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