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By Josh Peters, CFA | 04-17-2014 02:00 PM

3 Questions for a Solid Dividend Portfolio
As part of his portfolio strategy, Morningstar's Josh Peters examines
dividend safety, growth, and total return of the investment and prefers
companies with midlevel yields.
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Securities mentioned in this video
KO Coca-Cola Co
GOOGL Google Inc
FE FirstEnergy Corp
BRK.B Berkshire Hathaway Inc
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Week
Jeremy Glaser: For Morningstar, I'm
Jeremy Glaser. It's Beat the Market
Week, and we're looking at investors
who have managed to outperform the
market over time. I'm here with Josh
Peters. He is editor of Morningstar
DividendInvestor, and in that role he
manages two real-money portfolios.
We're going to talk about his strategy
and why it has been so successful.
Josh, thanks for joining me today.
Josh Peters: Good to be here, Jeremy.
Glaser: Let's start with how you started
to become focused on dividends and dividend investing. What about this part of the
market attracted you to it?
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3 Questions for a Solid Dividend Portfolio http://www.morningstar.com/cover/videocenter.aspx?id=644086
2 of 9 5/2/2014 8:17 PM
Peters: You always hear that owning a share of stock is owning a small piece of
the business. But most investors frankly don't really treat it that way or seem to
believe it, and a lot of companies frankly don't seem to act like they're
shareholders or actual owners and partners in the business with them. But
dividends are what bridge that gap. They really connect you directly with the
underlying results of the business.
What you find is that companies that pay dividends tend to outperform, particularly
on a risk-adjusted basis over longer periods of time because they tend to be more
mature, have better established businesses, and stronger finances, and the
dividend helps anchor the price of the stock to some sense of value. There is less
chance of making a really bad mistake in terms of valuation.
And then finally, the income is so practical. For retirees, certainly who are making
withdrawals from their portfolios to have this income that's flowing into your
accounts, that doesn't depend directly on whether the stock market is going up or
down. That's hugely valuable. But younger people, too, people who don't
necessarily have withdrawals coming up anytime soon, can benefit from this
strategy, as well. You can reinvest your dividends, and you get the opportunity to
allocate the capital as opposed to the companies taking all of those opportunities
away from you as an investor and hoarding their cash and calling all the shots.
Overall, I think it provides a very strong investment strategy especially for
individual investors.
Glaser: When you're actually building a portfolio of these stocks, though, is it just
a matter of looking for the highest yields and buying those? How do you actually
go about evaluating these firms to decide which shares you'd like to buy?
Peters: Well, my favorite companies tend to be sort of in the middle of what
dividend investors look at anyway. The yield of the S&P 500 is still historically low
at about 2%, but there are stocks out there that yield nothing, certainly many like
a Google or Berkshire Hathaway. And then there are dozens of companies even in
this low-interest-rate environment that seem at least to offer yields of 10% and
3 Questions for a Solid Dividend Portfolio http://www.morningstar.com/cover/videocenter.aspx?id=644086
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Close Full Transcript
Glaser: Can you give us an example of purchase that you have made either recently
or in the past that you think kind of exemplifies this process and that's done well for
you?
Peters: One that I made recently here is Coca-Cola. This is actually the second time
that I've owned Coke in our Builder Portfolio, which has, say, 3% to 4% yields, but
faster growth. We also have our Harvest Portfolio, which looks for a little more yield,
up.
I dont like the really low yielders because obviously then I'm not getting the
income, and that comes first. I don't like the really high yielders either because
that is the market expressing that dividend is not likely to be safe. There is no free
lunch, and if you see something that looks like it yields 10% or 12%, 20%,
chances are that dividend is either just inherently structurally very risky or that
the market is already pricing in a significant cut to the dividend.
So what I like are companies that yield say 3%, 4%, 5%, maybe 6%, but are also
able to maintain good dividend growth over longer periods of time. The Dividend
Drill process that I use to analyze individual companies, it works right off of this
math. The first question is, "Is the dividend safe?" The second is, "Will it grow,
which combines the growth potential of the company with the willingness of the
management to pass that growth along to shareholders in the form of higher
dividends?" And then I ask, "What's the total return?"
I figure if I pay an appropriate price for a stock, hopefully a cheap one, but at least
a fair price for a good company, then the dividend yield plus the long-term
dividend growth rate should roughly approximate my total return because as that
dividend rises, the stock price should follow it up certainly not in lockstep, but over
a longer period of time we're going to have that correlation. And in this type of
process, you're connecting the analysis and the companies that you choose right
back to your individual investment goals.
3 Questions for a Solid Dividend Portfolio http://www.morningstar.com/cover/videocenter.aspx?id=644086
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and a little less growth.
When I last sold Coke back in 2007, the shares yielded only 2.2%. They were kind of
expensive. Now a couple of years later the company has continued to raise its
dividend, and it has every year since 1963, and in fact, the growth rate hasn't even
diminished that much compared with the company's longer-run history. But I was able
to buy the stock at 3.2% yield, a full percentage point higher.
I don't think that this is a double-digit growth story, and there's a lot of negative
sentiment out there about people backing away from sugary drinks or maybe even
diet sodas, but people forget this is a distribution and marketing engine. It doesn't
need to just take the Coke in red cans all around the world. It can take any kind of
beverage. As long as we don't all go back to drinking tap water, I think Coke is going
to continue to grow and continue to capture more share of global beverage volume.
With that I am looking for 7%-8% long-term dividend growth. When I can buy a stock
like this with such good, low risk characteristics at a 3.2% yield and pick up the
potential for that growth, I'd settle for 5% growth. If I can get 7% or 8% growth from
Coke over the next 10 years, I think I'm going to be able to do very well on this stock.
Glaser: What are some of the big risks of the strategy?
Peters: The number-one risk every day, every minute of every day, is that your
dividend gets cut. And you have to avoid those dividend cuts well out in advance
because typically once everybody realizes that a dividend is going to be cut, the stock
has already fallen dramatically.
First Energy, a big utility company, ticker symbol FE, is good example. Shares had
already lost a very large chunk of their value before the dividend cut was announced.
So you have to look out far into the future and say, "Is this a business that is stable
or growing? Is it a balance sheet that can afford some shorter-term problems? Is the
commitment of the management team there to preserve the dividend through thick
and thin, if their backs aren't absolutely up against the wall?"
Hopefully you dont buy a business that ever gets that into that bad of a position in
3 Questions for a Solid Dividend Portfolio http://www.morningstar.com/cover/videocenter.aspx?id=644086
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the first place. You got to avoid those dividend cuts.
After that I'd say another risk is not getting the dividend growth that you would
expect, which has a significant impact on valuation very often. Many years ago, I
bought Johnson & Johnson, actually one of my very first purchases. When I bought it,
it had yield less than 2% and the company's growth rate then slowed, and that meant
that I didn't get that yield-plus-growth type of total return. It was about eight years
before I saw any capital appreciation on balance at all. Now the stock being much
more reasonably priced, I am getting that benefit.
Another risk that a lot of people worry about, but I tend not to worry about it as much
is interest-rate risk. There's this idea out there sort of conventional wisdom that
nobody wants the dividend payers unless interest rates are going down. If rates are
going up that's negative for bond prices certainly and is perceived to be negative for
dividend payers. But I think people overlook the fact that stocks even with good yields
are not in fact bonds. And from any dividend-paying stock that you pick you should
try to get at least some growth, so that then you're outperforming inflation and
hopefully outperforming what you could get from long-term Treasuries, as well.
And yes, I do take some rate risk especially with some stocks like utilities whose
growth rates don't change a lot depending on economic conditions. But when I take
that rate risk, I also get the income. In fact, I can't get a good rate of income without
taking some interest-rate risk, but I'm also limiting my exposure to economic
disappointments.
So I feel like I'm getting a two-for-one deal. I'm getting the income and I'm getting
less sensitivity in an uncertain economy as the economy is always uncertain. I'm
willing to take some interest-rate risk for that.
Glaser: Are there certain market environments that you think this strategy is going
to do better in and some where it is going to underperform?
Peters: Last year was a good example; the stock market did very, very well. The S&P
500 returned over 30%. Both of my portfolios, in 2013 lagged the market; they both
had 20%-plus gains. But it was one of those years where people were much more
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interested in cyclicals and more speculative stocks. So-called momentum stocks got
really hot at the end of the year. And I'm not going to outperform every year, and I
am not even going to try. That isn't even one of our stated objectives.
Instead, I look to manage that stream of income to finds safe dividends that can grow,
that can provide the basis for lasting capital appreciation. And when the market kind
of flattens out or you see declines in the market, typically these stocks outperform.
And on balance between those periods of outperformance and underperformance, the
stocks do better than the market. That's exactly what we've been able to do, since
inception for our portfolios, is beat the S&P 500 with a lot less risk without even
having "beating the market" being an explicit objective.
Glaser: Josh, thanks for sharing your strategy with us today.
Peters: Thank you, too, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.
3 Questions for a Solid Dividend Portfolio http://www.morningstar.com/cover/videocenter.aspx?id=644086
7 of 9 5/2/2014 8:17 PM
Comments

1-4 of 4 Comments Oldest First | Newest First
alanba
Apr 26 2014, 12:39 PM
Warren Buffet has never sold any shares of KO.
Did it really pay to sell Coca Cola in 2007, pay taxes, and buy it
back at higher prices in 2014? Doubtful.
Did the Coca Cola replacement perform better in the subsequent
market downturn or was it another financial stock with a better
dividend that got cut?
Sometimes you pay more for quality and stick with it. Fair value has
a way of increasing as earnings increase and stock prices rise.
Bacholyte
Apr 25 2014, 1:13 PM
Of the three Morningstar newsletters I receive, Dividend Investor is
the one I most look forward to and study most closely. Thanks,
Josh, for your clear thinking and straight talk.
yawkey5
Apr 25 2014, 11:45 AM
Josh: Keep up the Great Work! I own both the Builder and Harvest
Portfolio's.
buylowandwatch
Apr 25 2014, 8:43 AM
Excellent advice Josh. Thank you.


1-4 of 4 Comments Oldest First | Newest First
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