Home>Video>Earnings Prep Points for Dividend Investors

Earnings Prep Points for Dividend Investors

Fri, 4 Oct 2013

Expectations are muted for the upcoming earnings season, but investors need to focus on underlying company fundamentals and not on one quarter's worth of results, says DividendInvestor editor Josh Peters.

+

Video Transcript

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. What should dividend investors be watching out for this earnings season? I'm here with Josh Peters, director of equity income strategy for Morningstar and also the editor of Morningstar DividendInvestor, to get a sense of what he looks for when his companies in his portfolios report third-quarter earnings.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start with some just general expectations you have for the third quarter. When you look across the companies that you own, what are some of the broad trends that you're expecting to see in terms of economic growth?

Peters: I think we're going to have pretty muted expectations both for the third quarter and the fourth quarter. I remember looking at consensus earnings data for the S&P 500 in the middle of last earnings season and seeing that apparently there were a lot of analysts who were looking for big double-digit increases in earnings by the fourth quarter of the year. That certainly doesn't look to be panning out. The economy isn't really accelerating. Economic indicators might have a little bit of a positive tilt to them, but they're still very much mixed.

What we saw coming out of the great recession period back in 2009 is that companies initially were able to recover their earnings and grow them very quickly by cutting costs, and of course, revenue was coming back, as well. But now, with companies' having maxed out their cost-cutting opportunities for this level of economic growth, we're kind of constrained. It's going to be pretty much, I think, low-single-digit type of revenue increases. Maybe you get a little bit better than that out of per-share earnings if companies are buying in shares, but it's certainly not the kind of environment where you want to get excited and be trapped with high expectations.

Glaser: Do you expect any major announcements of increases to dividends or new buyback programs, or do you think that companies are going to be more cautious?

Peters: Across the market, I think, companies are generally kind of cautious. We've seen a lot of dividend increases, but for the most part they've been the kinds of companies that you expect to raise their dividends every year. There haven't been a whole lot of landmark changes in terms of dividend policies. We're seeing that the dividend payout ratio of the market is moving up this year, assuming that earnings estimates aren't too far off. Maybe a mid-30s type of percent now of earnings are being paid out as dividends as opposed to 30% a year or two ago. I think that marks progress. But I'm not seeing any big change in terms of the trajectory there.

Overall, I think this is the kind of environment that actually favors companies that can do a lot with a little. I'll use Clorox, one of my favorite portfolio holdings, as an example. This is a name where you don't really look for more than 3% or 4% annual revenue growth even when the economy is booming because people are only going to use so much bleach and only going to use so much charcoal, but they're able to see good revenue resilience in the downtimes.  It's really, what's the gap between that 3%-4% rate of long-term sales growth and getting a double-digit return? A lot of it is just internal execution. Can they keep their profit margins high, convert almost all or all of those reported profits to cash, and pay out the good dividend yield, which obviously is not a growth piece but it adds into your total return? Do they make share buybacks and acquisitions that are intelligent uses of the cash flow that they keep that kind of add a couple percentage points to growth?

Clorox is exactly the kind of company that is built for this low-growth environment that we have now, where what starts out as very modest top-line revenue growth turns into a low-double-digit return when you include the dividends and other things that factor into dividend growth.

Glaser: Now, almost invariably, some company is going to come out with disappointing results that were something below expectations. How do you decide if that's kind of a one-off event or something that could really threaten the dividend and maybe lead to a cut a few quarters down the road?

Peters: Typically, if the results in any one quarter could conceivably affect my view of the safety of the dividend quickly, that's not a situation I'm going to own in the first place. Whenever I'm buying a stock, my first question is, "Is that dividend safe?" And unless I can be comfortable with that idea that this dividend can be at least maintained for, say, five years into the future at a minimum, then I'm just not interested. I don't want to buy into a situation where anything that happens faster than that could put the dividend at risk.

I don't always get those stories right, but typically, I want that big margin of safety, a very strong balance sheet, an economic moat protecting the business and its profitability, and a payout ratio that makes sense given the cyclicality and capital investment needs of the business. I'm not going to get into a situation where the dividend should be raised or lowered based on a single quarter's worth of results.

But when I look at the results coming in, then typically I want to see that there is some underlying positive factor that's going to support dividend growth in the future. If the balance sheet is deteriorating, that's going to hurt the rate of dividend growth long before it's going to hurt the ability of the current dividend to be maintained. If the company is making bad acquisitions, if they're buying back stock at prices that frankly don't make sense, these are factors that don't support good long-term dividend growth.

I tend not to put a whole lot of emphasis on any one quarter's results, but most companies now provide some kind of annual outlook in conjunction with their quarterly reporting, and in that case, if I see the estimates, such as management's own forecast for the current year coming down to the point where I don't even see a dividend increase next year perhaps because they're just in a bind, that's another situation where now I can rethink it while I am still worried about the growth of the dividend as opposed to the safety of the dividend.

Glaser: At what point do you decide that it's time to sell, that the [quarterly earnings] report just shows that the company is not going to be able to grow? How do you come to that final decision?

Peters: Sometimes it takes a while to have that fact dawn on me. I've mentioned before in one of our earlier conversations about Sysco, the food-distribution company, and their dividend growth rate has been low, and frankly, declining over time, over the last few years. I finally say that they need probably a couple of good years of earnings growth just to catch up to where they can start to raise the dividend more aggressively. I don't think this is something worth waiting around for. But when I'm going to sell the stock it's usually going to be because I found something better. I've just found a better use of the capital.

In the case of Sysco, I thought Unilever, which actually had a comparable dividend yield, but I thought better long-term growth prospects, was a very easy stock to transition into. I didn't have to come out and conclude that Sysco's dividend was going to be cut, I don't think it will. It was just a matter of looking at the different growth rates between the two of them and being able to spot the opportunity to take a little bit of a step up.

As long as you're always reviewing your portfolio carefully and making sure that the stocks you own are the best ones to own going forward and comparing them with a broader opportunity set of comparable companies that you don't own but maybe you could, that sort of healthy competition, I think, helps to keep your portfolio fresh. By no means does it mean you turn the portfolio over every week or every month or even every year. Our average holding period in the DividendInvestor portfolios is creeping up toward the six-year mark now, and it just seems to get longer with time. But I want everybody in the portfolio to carry their water. I want to be patient, but I don't want to have to start making or taking excuses from portfolio holdings that aren't pulling their fair share of the load.

Glaser: [What you're suggesting is] don't act too rationally from a single poor quarterly report?

Peters: No, you have to put it in a larger and long-term context, while also remembering that the long term is a bunch of short term periods chained together. So if you can get a signal that something is seriously amiss, you certainly want to react to it. But I've generally found it's better to perhaps put up with one disappointing quarter and wait and see how it unfolds, before acting hastily.

Glaser: Josh, thanks for your thoughts on this today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

  1. Related Videos
  2. Related Articles
  3. Comments
  1. When to Sell Dividend Stocks

    Investors shouldn't focus just on yield, but also on other factors, such as dividend growth rates and company familiarity, when considering selling dividend payers, says DividendInvestor editor Josh Peters .

  2. What No Taper Means for Dividend Investors

    Since the taper talks began, conditions have improved for dividend investors, who can now buy quality names without being vulnerable to long -term interest-rate spikes, says DividendInvestor editor Josh Peters .

  3. Why Moats Matter for Equity Income

    An economic moat is one of the best tools to identify the stability of a company's profit stream and long -term dividend-growth potential, says DividendInvestor editor Josh Peters .

  4. Peters: Stay Defensive

    As we're likely to see political squabbles and slow growth continue, investors will be well-served by sticking with defensive firms that have solid dividend-payout records and competitive advantages, says Morningstar's Josh Peters .

  5. Separate Signal From Noise in the Debt Ceiling Debate

    Investors should focus on a suitable overall allocation but otherwise resist making short-term trades around this highly uncertain and potentially volatile D.C. drama, says Morningstar markets editor Jeremy Glaser .

  6. These Discounted Dividend Payers Can Be Portfolio Staples

    Emerging-markets concerns are pressuring consumer defensive stocks and therefore creating buying opportunities for investors, says DividendInvestor editor Josh Peters .

  7. Verizon Deal No Reason to Hang Up on Telecom Dividends

    Verizon's wireless buyout could shake up things for Vodafone shareholders, but the telecom industry is positioned to remain profitable and have good dividend yields, says DividendInvestor editor Josh Peters .

  8. Peters: Look Beyond Dividend Growth

    Balancing above-average current yield with a history of dividend growth should help investors meet their total-return goals, says DividendInvestor editor Josh Peters .

blog comments powered by Disqus
Upcoming Events
Conferences
Webinars

©2014 Morningstar Advisor. All right reserved.