Fri, 20 Sep 2013
Having interest-rate risk in your portfolio's stock sleeve is an intelligent move, but investors should also be willing to sacrifice returns than seek additional risks, says DividendInvestor editor Josh Peters.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I am here with Josh Peters. He is the director of equity income strategy and also the editor of Morningstar DividendInvestor. We'll talk about risk in equity portfolios and what's the right way to think about it. Josh, thanks for joining me.
Josh Peters: Good to be here, Jeremy.
Glaser: Josh, you run some dividend portfolios and a lot of people think about dividends as a way to maybe take some risk off the table. How do you think about balancing that risk/reward when you're purchasing stocks for your portfolios?
Peters: Jeremy, most of the time I talk about my portfolio strategy in terms of the returns. For my [DividendInvestor] Harvest portfolio, I am looking for yields of 4% to 6%, which is more than double the S&P average. But I am also looking for only safe dividends and dividends that are going to grow at least as fast as inflation.
My [DividendInvestor] Builder portfolio, again, I talk about the returns. I am looking for yields of 3% to 4% and high-single-digit or better dividend growth to drive total returns over the long run. But returns are only half the story. A lot of people are going to talk about the returns of a strategy, and you don't get into the risk. Or you get maybe a quantitative assessment of the risk, but you don't get the underlying idea of "What kind of risks are we taking?"
In my September DividendInvestor cover story, I decided to take a look and discuss some of the individual risks that we've sort of taken more of, some of the risks that we've taken less of, and using that as a way to explain our portfolio strategy from a different direction.
Glaser: What are some of the risks that you're willing to take right now?
Peters: Interest-rate risk is the big one, and it's very much top-of-mind for a lots of investors, especially people who are interested in income right now. We've seen this huge move in the long-term Treasury yield, closing in on 3%. It was below 2% only a couple months ago. It seems like it's been forever. That's put a lot of income-producing stocks out-of-favor; certainly bonds are out-of-favor. Money is starting to come out. But is that an intelligent risk we're taking?
When I think about interest-rate risk, every investment security that provides some return of cash in the future has some sensitivity to interest rates. It doesn't matter whether it's AT&T or whether it's Google. Even though Google doesn't pay a dividend, its value today is still a function of future cash flows, discounted back at some interest rate, or discount rate, that's going to be sensitive to changes in interest rates. The question is: Is all else equal or are there offsetting factors?
Now, if you think about why interest rates will typically go up, it's for one or two reasons, either inflation is going up or the economy is growing faster. There is more demand for capital and better opportunities; money comes out of bonds and perhaps goes into stocks. In that kind of environment, you would expect most dividend-paying companies as being more stable, not as susceptible to riding the booms and busts of the economy overall. They're not going to gain as much in a faster-growing economy as some more speculative names or cyclical names might. So, the interest-rate risk tends to hit them a little bit harder.
But if you try to dodge the interest-rate risk and you go with cyclical stocks as a way to get rid of it or mitigate that or just own all speculative names, names that don't pay a dividend at all, then you're taking more economic risk. I want to think in terms of not just any one risk, but how they balance against each other. Interest-rate risk is fine to be concerned about and try to manage and mitigate. But interest rates will come down if the economy, say, goes back into recession or softens, perhaps as a result of interest rates going up. I am first and foremost concerned with getting the dividend income I expect. I don't want those dividends to be cut if we have a recession. For me, interest-rate risk is an intelligent risk to take.
Glaser: Does that mean that you're trying not to take economic risk, that you're more worried about potentially a slowdown, or how that could impact those more cyclical companies?
Peters: I am more worried about a slowdown. I tend to always be more worried about a slowdown as opposed to a big pickup, and a lot of this comes down to relative versus absolute returns. A lot of people have the frame of mind, especially professionals, that they are supposed to beat the market consistently. They're supposed to stay ahead of the S&P 500. My strategy is to get the income and grow the income, and the total returns will follow. We've beaten the market over the last eight and a half years without it ever being an explicit goal for our model portfolios. We focus on the income.
I am willing to be out of step, and if that means the economy is taking off and it means stocks like, say, General Motors doesn't pay a dividend--probably never should, probably never should have in the old days, certainly no stable conservative income characteristics to a name like that--if GM takes off and leaves Procter & Gamble or Clorox or General Mills in the dust, I can live with that, because eventually the economy will weaken. I won't know when, but it's going to happen. And I want to know that I've got my backside covered and I'm going to continue to collect that growing stream of income even when times are tough.
Glaser: We've talked a lot about this risk/reward trade-off and the sense that if you take more risk, then you could potentially get more reward. Are you worried that you are leaving too much on the table necessarily by backing off on that risk, or do you think that sometimes people are taking on the wrong kind of risks in their portfolio?
Peters: I think it's important to just make sure that you understand the risks that you're taking, and there is lots of different ways to sort through it. Another way I looked at risk for our portfolios in [the September DividendInvestor] issue was to look at our big sector concentrations. Energy is actually our biggest concentration between pipeline operators, pipeline master limited partnerships, and big oil names, like Royal Dutch Shell and Chevron. That's the largest single piece of our portfolios combined. Well, what is that risk? We tend not to have an exaggerated risk in, say, the oil price or natural gas prices because even the big oil names generate so much cash flow even when prices are low that they are not as sensitive to that as, let's say, a little wildcatter might be or a royalty trust that is just paying out a distribution from energy sales.
The pipelines tend to, if anything, be inversely correlated with energy prices because they get paid for transporting volumes or storing volumes. If energy prices are very high and consumers pull back, then that's actually a negative for the pipeline. There is a nice little hedge in place there, but there is not a whole lot of variability. If it's not commodity prices with these names, then what's the key risk? Well, it's really just over the very long run: What's the viability of carbon-based fuels, both oil and natural gas, and everything that can come from them? My view is that technology is going to continue to push us in the direction of more renewables. Oil prices are certainly going to help with that by staying high; it encourages innovation. You can just set all of the political debates and regulatory debate aside. I think that this is something that is going to happen. But it's going to happen over a very, very, very long period of time because you've got literally trillions of dollars of installed infrastructure everywhere around the world that runs on oil and natural gas; that can't just be upended overnight.
Recognizing here with these names that the future, say, over the next 50 years might have stagnant or even slightly negative overall growth prospects, means I want to get big income, I want good capital allocators, I want high-quality assets, and I want high-quality balance sheets. Recognizing that underlying risk helps me make better choices, while staying true to the type of returns that I'm trying to generate.
Glaser: What are some of the risks you don't want to take?
Peters: Really that comes always back to dividend safety and dividend growth. Those are the two pillars that I expect to drive my total returns. I'm not interested in any dividend from any group or any individual company that I think might be cut. A great example is the mortgage REITs. If you own something like an Annaly Capital Management, you're essentially making a bet on future changes in the shape of the yield curve, which I think for a lot of investors who might just see the sticker, see that double-digit yield, they might think it's just a great dividend payer. Well, it's not. Look at the dividend go up and down based on things that most of us can't hope to predict in advance. If you want to speculate on future changes in interest rates relative to the other interest rates, which is basically what it is, then this is a fine vehicle for doing that. But you have to hope that they don't make a mistake with their portfolio because there is a lot of leverage. You have to be willing to ride that income stream up and down. That's just not a risk that I'm comfortable taking.
Business development companies are similar. They tend not to be as leveraged, but they're just financial vehicles. They can pay out big yields, but you don't really know the quality of the assets that are going in there. It's not like a bank where you have regulators that are scrubbing the books and deposit funding to make sure that they can stay in business even under stress. They're black boxes. I don't really want to own them. They work fine as a speculative financial vehicle, but they can't work for your portfolio the way a really solid blue-chip, like a Johnson & Johnson can.
I also tend to be pretty guarded about names where you have a secular decline story, such as landline telecom. Names like Windstream or Frontier Communications have big yield but a lot of risks to the dividend. We've already seen Frontier cut its dividend. We've already seen CenturyLink, frankly out of nowhere, cut its dividend earlier this year. Those are very painful developments for shareholders because the underlying business, just traditional landline telephone service, is in decline. Companies are trying to shift their mix of business into some faster-growth areas and fight that back to a stalemate, but it's tough. These big yields are telling you that there is a lot of risk here, and if nothing else, there is no growth. Windstream has never raised its dividend as a public company. That's a pretty negative sign. Frontier has cut its dividend twice.
Growth is often the best defense against a dividend cut. If the trend is already positive, then there is at least a buffer before things get really bad. Those are, frankly, some names that are popular with a lot of income-oriented investors. They're just risks that I don't care to take. I want a fallback position of a well-funded, well-capitalized, competitively strong business that can pay their dividend through thick and thin.
Glaser: It's always important to take risks, but just make sure that you're taking the right ones.
Peters: You've got to take the risk. You stuff the cash in the mattress, and your house might burn down. You don't have any risk-free options really on the table. Choose your risks intelligently, choose them carefully, choose a risk that matches up with the kind of return characteristics that you're looking for, and if necessary, sacrifice the return rather than take on more risks. An old banker in Georgia once said that profits are the residue of considered risk-taking. If you manage the risk well, the profits will follow. If you just look for the profits, you could wind up with a lot of risk and no profits at all.
Glaser: Josh, thanks for your thoughts today.
Peters: Thank you, Jeremy.
Glaser: For Morningstar, I am Jeremy Glaser.