Home>Video>Dividend Investors: Check Into Energy Stocks

Dividend Investors: Check Into Energy Stocks

Mon, 23 Jul 2012

Recent underperformance has made energy a more interesting sector for dividend investors, says Morningstar's Josh Peters, who recommends this undervalued, utility-like energy name that has strong dividend growth prospects.

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Video Transcript

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

Investors are still scrambling to find yields, and dividend-paying stocks are one place that they've been looking.

I'm here today with Josh Peters, editor of Morningstar DividendInvestor, to get a performance update on dividend-paying stocks and see if they are in a bubble or not.

Josh, thanks for talking with me today.

Josh Peters: Good to be here.

Glaser: So let's just take a quick look back at performance so far in 2012 for those higher dividend-paying stocks. What have you seen, and has it changed at all as we went through the second quarter?

Peters: It really changed quite a bit. You roll back to the first quarter of the year, the S&P 500, that being the best proxy for the market overall, it was really on a tear, up more than 10% in total return terms in the first quarter. And your higher-yielding stocks, the ones that investors are most likely to favor for those big dividend checks, were really sitting by the sidelines. You didn't see a whole lot of capital appreciation, frankly, at all.

But once we moved early in the second quarter, and some of the economic news started to deteriorate, people became more concerned yet again about the situation in Europe, you started to have this process of risk aversion take hold where as the market sold off, then dividend-paying stocks really weren't selling off, at least the higher-yielding ones weren't selling off so much. And since then, the market has recovered--still a pretty good year-to-date gain for the S&P 500--but now dividend-paying stocks are really right up there among some of the market leaders, and that in turn has kind of reinstated the problem that we've had, or I should say headwind that we've had, in terms of valuations for some time.

Glaser: So you did mention that we've had that valuation headwind. What's happening with dividend stocks' valuations right now? Are there some sectors that are more attractive, less attractive? Is there really a bubble there of people plowing money [into dividend stocks] to get that extra yield?

<TRANSCRIPT>

Peters: I think "bubble" is a really harsh term. It's really become a pejorative in terms of describing a person's opinion about the valuation of a security or an asset class.

I like the definition that Jeremy Grantham advanced at the Morningstar Investment Conference. He was asked, are bonds, Treasuries, in a bubble? And he said, well, they may be overpriced, but it's not really a bubble, because bubbles are really driven by greed, not fear.

I think a lot of the movement that we've had in dividend-paying stocks, higher-yielding stocks, really over the last two years hasn't been a function of greed. I don't think anybody expects that AT&T's growth rate is going to double and triple to compensate for falling yield. I think people are reacting to an economy that continues to struggle, interest rates that continue to drop. There are just very few good workable alternatives out there. And so we're starting to see these companies--like an AT&T or a Verizon, Southern Company, most of the regulated utilities that I look at--these are now trading at significant P/E premiums to the market, where historically you would expect these slower-growing businesses to be priced at a discount.

So, when I look at regulated utilities, I look at REITs, I look at the tobacco stocks like Altria, I look at telecoms, those are some pretty high expectations now that are built into the prices, but in a very indirect way. People are paying up for the yield, even though they know that the growth rate really hasn't changed, and it wasn't all that great to begin with.

Glaser: Let's take a look at a specific sector, namely energy. It's underperformed the market as investors fret about global growth. Do you see any yield opportunities there?

Peters: Actually, that's the one industry I think that tends to have a lot of opportunity in it right now, in large measure because of that underperformance. You haven't seen valuations get marked up like they have in some other areas of the market.

Now, certainly the price of oil is going to affect the price of, say, a Chevron or a Shell, two of the big oil companies that I favor. But it would take a really, really dramatic and long-lasting drop in the price of oil before you would see these dividends become vulnerable. In all likelihood, both of those companies are going to continue to raise their dividends.

Now I'm fond of saying, even if they trade at 9 or 10 time earnings, that means that more than 90% of the value is out there in future years and isn't affected by what happens to the price of oil today.

But even though you do have some cyclical exposure with the big oil producers, you tend not to have that kind of sensitivity with a stock like Spectra Energy, and here I think that investors maybe need a little bit more of a nuanced approach to looking holistically at the energy sector. I like to make the comparison between Southern Company, which is really probably the best fully regulated utility in the country, and Spectra Energy, which is one of the nation's largest pipeline operators, and both of them are C-corps. There are no unusual tax characteristics. Spectra itself is not an MLP--although it does own one or control an MLP called Spectra Energy Partners--but I'm just looking at these two similar businesses, and when they have similar yields, then I think, OK, who's going to offer the faster growth? And in all likelihood, Spectra will be able to raise its dividend perhaps as much as twice as fast as Southern over the next five to 10 years. That, to me, is a much better total return prospect.

I think Spectra is somewhat undervalued, modestly undervalued here, but Southern Company is overvalued, and they aren't really that different. They both produce very reliable cash flows, they are both recession-resistant, they are both very well-managed companies. The difference is that people are paying up for Southern, even though they are not likely to get any additional growth, while Spectra--being associated more with energy producers than with utilities, [but] behaves more like a utility in terms of the performance of its business--gets left behind. To me that's an opportunity.

Glaser: You mentioned MLPs; that's an area that has pretty attractive yields right now. Do you think that's an area investors should be keeping an eye on?

Peters: I do think it is, for people who are able to participate in the sector. One of the things to remember is that it's not a good idea to own them in tax-deferred accounts--like IRAs, Roth IRAs, 401(k) plans--because of their tax circumstances. And if you own an MLP, then you have some extra paperwork, you get the income reported on schedule K1 instead of the simple Form 1099, but it's a trade-off. If you have the opportunity to look at something like Kinder Morgan Energy Partners, providing a yield that's half again as large as a traditional regulated utility, and providing better growth prospects as well, I think that's the kind of name where it's good a trade-off to have some of the tax complications in order to participate in that better total return.

Again, some MLPs look a little bit pricey, especially if they have a lot of exposure to the natural gas liquids business, but a very well diversified name like Kinder Morgan really is not something we think is overpriced right now.

And if you can't participate in KMP--that being the symbol for Kinder Morgan Energy Partners MLP--by owning it directly, you can participate by owning its general partner, Kinder Morgan Inc., symbol is KMI, and it's a traditional subchapter C taxpaying corporation that pays qualified dividends, and even though it yields less than KMP, it has a much higher growth rate to compensate.

Glaser: Josh, thanks for your update today.

Peters: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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