10 Best Dow Dividend Stocks for 2012

NEW YORK (TheStreet) -- When it comes to the Dow Jones Industrial Average, time and technology stocks make fools of us all. So, dear reader, if you're approaching this article with a healthy dose of skepticism: good.

Nobody can tell the future, certainly not this author -- rather, the following stock picks are modeled using a combination of arithmetic and historical precedent. If you're interested in seeing how my past Dow picks have fared, skip to the last page of this article. I hold my feet to the fire.

In attempting to identify the best Dow dividend stocks for 2012, here are the criteria I've used to arrive at a list of 10:

1.) Each stock must have a liability-adjusted cash flow yield* 1.5 times greater than the yield of a 10-year U.S. Treasury note.

2.) Each stock must have a return on invested capital greater than 10% (using five-year historical cash flows).

3.) Each stock must show a positive total return (including dividends) over the past 10 years.

4.) The dividend yield of the stock must be less than the liability-adjusted cash flow yield. In other words, cash flow must support the dividend.

Remember, this list is constructed using only quantitative criteria (in other words, strictly by the numbers). That said, a little color has been added to each of the companies mentioned, which are ordered from most expensive to least.

As always, model portfolios should not be treated as gospel; rather, use them as a starting point for your own research. Similarly, all investors should apply their own valuation and qualitative criteria to determine what constitutes a "good buy."

*5-Year Average Free Cash Flow / ((Outstanding Shares x Per Share Price) + (Liabilities - Cash)) -- Free cash flow data is sourced from each respective company's annual filing. Outstanding shares and asset/liability data is sourced from each respective company's most recent quarterly filing.

10. McDonald's

Liability Adjusted Cash Flow Yield: 3.2%

Dividend Yield: 3%

LACFY/10-Year Treasury Yield: 1.55

Return on Invested Capital: 15%

It's hard to imagine that McDonald's ( MCD) traded for less than $13 per share as recently as 2003. As this stock approaches the $100 mark, investors are left to wonder if McDonald's is one of Benjamin Graham's "goodwill giants" (a stock so ingrained in American culture, that it can march upward indefinitely) -- or, if changing consumer tastes (for instance, a move toward healthier eating) will one day derail the world's leading burger magnate.

In June 2010, I called McDonald's an " indefinite hold" -- not much has changed since then. This stock is not particularly cheap, but continues to deliver impressive returns on invested capital; all the more admirable for an industry susceptible to commodity inflation and breathable margins.

9. Coca-Cola

Liability Adjusted Cash Flow Yield: 3.2%

Dividend Yield: 2.84%

LACFY/10-Year Treasury Yield: 1.55

Return on Invested Capital: 19%

The king of cola has some big-time backers, famously among them is Warren Buffett. But let's not forget about the small-time backers. When I visited Honduras last year, I asked my cab driver to speak for her country: Coke or Pepsi?

She laughed in a no-brainer kind of way -- Coke (but she did admit that Pepsi was making inroads).

Coca-Cola ( KO) derives more than 75% of sales from outside the United States. If you're looking for diverse global sales and exposure to multiple currencies, this is a great company to own. But the stock isn't cheap and still hasn't recovered to its frothy peak, recorded way back in 1998.

8. Caterpillar

Liability Adjusted Cash Flow Yield: 3.3%

Dividend Yield: 2.03%

LACFY/10-Year Treasury Yield: 1.59

Return on Invested Capital: 13%

Caterpillar ( CAT), like McDonald's, is a tough stock to recommend at current prices. When the financial crisis came to a boil in 2009, Caterpillar's net income and stock price both fell precipitously. But for those bold investors who bought in March 2009, you're sitting on approximately a 300% gain.

If you believe that a worldwide economic recovery is under way, Caterpillar may continue to be a great investment. But if you believe that the world is teetering on the brink of another crisis, then this high-beta stock looks a little scary. Invest wisely.

7. United Technologies

Liability Adjusted Cash Flow Yield: 4.5%

Dividend Yield: 2.63%

LACFY/10-Year Treasury Yield: 2.17

Return on Invested Capital: 19%

There's a good chance that you've used a United Technologies ( UTX) product without noticing. In addition to Otis (elevators) and Carrier (air conditioners), United Technologies' portfolio of companies includes Sikorsky and Pratt & Whitney -- two prominent suppliers of commercial and military aviation technology.

This year, United Technologies made a $16.5 billion acquisition of Goodrich -- a very big bet on aviation (actually, the biggest bet the company has ever made).

Historically, United Technologies has allocated capital very wisely -- a fact reflected in the company's impressive return on invested capital. However, the same cannot be said of Goodrich ( GR) (5% return on invested capital), an expensive company to buy (1.54% liability-adjusted cash flow yield).

6. Procter & Gamble

Liability Adjusted Cash Flow Yield: 4.6%

Dividend Yield: 3.36%

LACFY/10-Year Treasury Yield: 2.22

Return on Invested Capital: 12%

Despite owning some of the world's best-known "everyday" brands, Procter & Gamble ( PG) is suffering from deterioration in net income and free cash flow.

Many investors don't realize that the consumer products giant has current liabilities in excess of current assets, however, the company's balance sheet is improving (at 0.83, the current ratio is paltry, but the best number since 2006).

Although the company is an old-favorite among dividend investors -- a Dividend Aristocrat, after all -- management frustratingly allocates more cash to share buybacks than paying out distributions to owners. Investors looking for alternatives may wish to look outside the Dow at Church & Dwight ( CHD), a nimbler competitor within the household products space.

5. IBM

Liability Adjusted Cash Flow Yield: 4.6%

Dividend Yield: 1.66%

LACFY/10-Year Treasury Yield: 2.22

Return on Invested Capital: 43%

Warren Buffett recently announced that Berkshire Hathaway accumulated $10.7 billion worth of IBM stock -- a 5.5% stake in the company. Oddly, this news comes as IBM ( IBM) stock is reaching all-time highs.

It's hard to imagine IBM as anything but fairly-to-over valued, yet the numbers suggest that IBM is still one of the cheapest in the Dow. The company's 4.6% liability-adjusted cash flow yield is well in excess of the 10-year Treasury yield (and the 30-year bond for that matter). And at 43%, IBM's return on invested capital in downright spectacular.

If IBM can continue to grow cash flows, the stock will remain an attractive investment. As for the quality of IBM's cash flow, the tech giant has one of the most consistent free cash flow/net income ratios in the business (consistently hovering near 1.0).

4. 3M

Liability Adjusted Cash Flow Yield: 5.1%

Dividend Yield: 2.85%

LACFY/10-Year Treasury Yield: 2.46

Return on Invested Capital: 22%

3M ( MMM) -- like Procter & Gamble -- is a Dividend Aristocrat that dabbles too much in share buybacks. Both companies are quasi-conglomerates with large portfolios of well-known brands. Both stocks have delivered good-but-not-great returns over the last decade. And both companies have similar operational metrics.

3M, however, has a much stronger balance sheet than P&G.

The Post-It note maker has underperformed the Dow by roughly 10% this year and underperformed P&G by about 6%. If you're looking for a solid-yet-unloved company -- and you enjoy going against the crowd -- 3M may treat you well.

3. Exxon Mobil

Liability Adjusted Cash Flow Yield: 5.1%

Dividend Yield: 2.44%

LACFY/10-Year Treasury Yield: 2.46

Return on Invested Capital: 14%

For whatever reason, Exxon Mobil ( XOM) often trades at a discount to its peers while generating industry leading returns on capital.

From a total return perspective, Chevron ( CVX) has trounced Exxon during the last five years and solidly outperformed in the last decade. Therein lies the investor's dilemma:

Do you buy Chevron over Exxon despite the fact that the former is half as effective at investing capital (and 46% more expensive on a cash flow basis)? Or do you stick with the undervalued Exxon in the hope that the market will recognize Exxon's value.

One answer will prove correct, but no matter the answer, Exxon is poised to deliver investors with reasonable returns into the future.

Johnson & Johnson

Liability Adjusted Cash Flow Yield: 6.4%

Dividend Yield: 3.63%

LACFY/10-Year Treasury Yield: 3.09

Return on Invested Capital: 29%

J&J is yet another Dividend Aristocrat that's cash-rich, yet annoyingly dabbles in ill-timed share repurchases. For instance, the company spent 3.12 times the money on share repurchases in 2008 (when the stock hit an all-time high) than in 2009, when the stock hit its lowest level since 2002.

Despite these managerial missteps, Johnson & Johnson ( JNJ) has a very attractive dividend that is solidly supported by free cash flow and backed up by a very strong balance sheet.

J&J won't make you rich overnight, but should offer income investors with steady, compounding growth (assuming that dividends are reinvested).

Hewlett-Packard

Liability Adjusted Cash Flow Yield: 6.9%

Dividend Yield: 1.78%

LACFY/10-Year Treasury Yield: 3.33

Return on Invested Capital: 33%

Hewlett-Packard ( HPQ) is a really tough company to like. But for all its drama, shares of HP have appreciated over the last decade and the stock is one of the cheapest in the Dow. That said, there are myriad questions for potential investors:

How will the company reinvent itself -- again? Will new management stop financial health metrics (current ratio/quick ratio) from deteriorating? Is the Board of Directors competent? Will executive compensation issues continue to plague shareholders?

Even if all of these questions have satisfying answers/conclusions, HP has been a really lousy dividend stock. In the last 12 months the company has used roughly 17 times the capital to repurchase shares than to pay distributions. For buy and hold investors, that just sucks.

Note: Total return data includes reinvested dividends and is measured from the date of original publication to the closing price on Nov. 22, 2011.

Previous Articles

8 Dow Dividend Stocks Most Likely to Outperform -- Sept. 14, 2010

Tickers: JNJ IBM XOM MMM BA UTX DD KO

Portfolio Performance (dividends reinvested): 14.85%

The 20 Best Performing Stocks (dividends reinvested): 18.65%

30 Stocks, Equally-Weighted (dividends reinvested): 7.02%

Dow Jones Industrial Average ETF (dividends reinvested): 12.21%

Analysis: Pretty good. These eight stocks outperformed the Dow Jones benchmark ETF despite a negative return from 3M and poor showings from Johnson & Johnson and Boeing. IBM powered the returns of the portfolio, and -- as the largest component of the Dow -- the benchmark ETF. Alas, the portfolio fell short of its stated goal: to outperform the Dow's 20 best stocks.

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10 Most Attractively Valued Dow Stocks - Aug. 6, 2010

Tickers: MSFT INTC JNJ GE PFE XOM CSCO IBM HPQ MMM

Portfolio Performance (dividends reinvested): 4.86%

The Other 20 Stocks (dividends reinvested): 7.9%

Dow Jones Industrial Average ETF (dividends reinvested): 11.32%

Analysis: Horrible. That's the best way to describe the performance of this portfolio. But in fairness to the author, this was never presented as a list of stocks to buy. Rather, this article largely explored why these stocks were "attractively valued."

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7 Dow Dividend Stocks Safer Than T-Notes - June 30, 2010

Tickers: PG KO INTC XOM JNJ HD PFE

Portfolio Performance (dividends reinvested): 28.2%

iShares 7-10 Year Treasury Bond Fund (dividends reinvested): 14.48%

Analysis: Excellent. These seven stocks outyielded U.S. Treasury notes (using an iShares ETF as a benchmark proxy) From a total return perspective, the portfolio nearly doubled the performance of the benchmark. Not too shabby considering the amount of stock market volatility during the period.

10 Dow Stocks Investors Should Avoid - June 25, 2010

Tickers: T VZ CVX WMT KFT AA BAC JPM MCD CAT

Portfolio Performance (dividends reinvested): 13.5%

The Other 20 Stocks (dividends reinvested): 11.9%

30 Stocks, Equally-Weighted (dividends reinvested): 12.44%

Dow Jones Industrial Average ETF (dividends reinvested): 16.87%

Analysis: Poor. Had you avoided these 10 stocks, you would have been spared a nightmare stock -- Bank of America -- but denied one of the Dow's best performers: Caterpillar. This portfolio used extremely conservative valuation criteria (10-year average cash flow) that ignored Caterpillar's impressive, recent growth. Lesson learned.

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Each of these lists were constructed using only quantitative criteria (in other words, strictly by the numbers). In the original articles, you will find commentary/analysis that supported or refuted my prima facie valuation.

As a final reminder, this year's picks are screened using quantitative criteria.

>>To see these stocks in action, visit the 10 Best Dow Dividend Stocks for 2012 portfolio on Stockpickr.

-- Written by John DeFeo in New York City

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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