Fri, 11 Oct 2013
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.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. How important are the battles over the budget in Washington to dividends investors? Here for his take is Josh Peters. He's the editor of Morningstar DividendInvestor and also the director of equity income strategy.
Josh, thanks for joining me today.
Josh Peters: Good to be here, Jeremy.
Glaser: It seems like we've been talking a lot over the last couple of weeks about, first, the government shutdown, and the debt ceiling, and then deals potentially to move the debt ceiling by couple of weeks or kind of these short-term fixes. What's your take on all of this rancor in Washington? Do you think that this is something that's here to stay?
Peters: I think we're going to have to put up with this for a while longer. I'm encouraged by the idea that maybe we'll have some short-term fixes, not because I want a short-term fix; I'd like long-term solutions. But obviously, we just can't be put in a position where the Treasury is not going to be able to pay its bills. I'm glad to see some of the news that we've had looking at some shorter-term measures to keep things afloat.
But this is just not going to go away. Our politics and our government are polarized because the country is polarized on all sorts of a different measures. I like reading about politics. I don't ever want to let parties and opinions slip into what I'm writing; that's obviously not my job. But it's also not a political point of view to observe that when you look at the results of elections, the way politics and party results, election results, have involved in different states, the country is more polarized than it used to be. And that's going to continue to hamper the ability of the government to come to a consensus and make policies so that for the rest of the country that actually generates the economic activity needed to pay the bills for the country, that activity can go on.
Glaser: What are the implications of this polarization then for investors? It's nothing you can control, so what can you do about it?
Peters: A problem that doesn't have a solution is not a problem. That's a line I used back in 2011 when we were staring down at debt-ceiling crisis back then. I think it's still true today. A problem that doesn't have a solution is not a problem; it's a condition. It's just something that you have to adapt to.
When I look at this situation, it means that we're probably going to have a recurrence on a fairly regular basis; hopefully, not more than every couple of months, but certainly every year or two of wrangling and brinkmanship over the budget, over taxes, over spending, and over the deficit and the debt. When we have these events, then we're going to see market volatility increase and people are going to become nervous. And then even in the intermittent periods, I think you have to worry that this takes a toll on economic growth because we're not actually solving any of our problems. We're still just kicking cans down the road and lurching from one crisis to the next.
I love to think, if we had actually had that grand bargain back in 2011, and businessmen and consumers, everyone was able to have a longer-term picture with some clarity to it of what the government policy was going to look like, how much faster would the economy be growing now? That would be a plus even for conservative investors. Instead, I think you just have to get used to an environment where you have low economic growth and these periodic bouts of uncertainty.
Glaser: With that macroeconomic backdrop, what does that mean for stock selection, and what does that mean for building your portfolio?
Peters: I think it really comes back to the position that I've adopted over the years which is to stay defensive all the time. On Wall Street we have this practice, they call it sometimes "risk-on, risk-off," where you see the market lurch higher and all of a sudden the growth stocks and speculative stocks, and the cyclical stocks are all the favorites, and the foods stocks, the utility stocks--the boring stuff, the dividend payers all get left behind. And then a few days later, a few months later, situations change, and all of a sudden all of that reverses.
I figure, why play that game in the first place? I can't predict what's going to happen in Washington over the next couple of days. I can't predict next quarter's gross domestic product or interest rates three months from now. I can make some longer-run assumptions that I think interest rates eventually go somewhat higher from here to a more normalized level. I think that inflation remains relatively low, but economic growth remains relatively low. We're then talking about a three-, five-, 10-year type of backdrop that can help you form some opinions about the companies you're actually investing in and how fast they can grow.
But why play the Ping-Pong game? Why not just settle on a position where you're going to remain defensive and stick with those very high-quality companies through thick and thin? And then you have the protection of strong balance sheets, wide and narrow economic moats, and those well-funded dividends coming in so that you won't have had to have darted out of the market right before the next correction or the next recession or bear market; you can ride through them confident that the value will come back and be realized by the market in the long run.
Glaser: But are you giving up too much upside by staying defensive the entire time?
Peters: Again, that's very much dependent on the kind of game you want to play. If your idea of risk is underperforming the market--that your portfolio is, say, up 10% and the S&P 500 is up 20%--yeah, that's not probably going to work. Dividends are not going to outperform in all cycles; high-quality stocks are not going to outperform at all points in the cycle.
What you're looking for is that from cycle to cycle to cycle, with these different shifts in trends and fashions being unpredictable, that you see these companies do tend to float at the top. We see that higher-yielding stocks do outperform the long run. Higher-quality stocks--that overlaps with dividends a lot--also outperform over the longer run because you don't take the biggest losses when those inevitable crack-ups come along.
If you're willing to position yourself so that you can ride through the periods of turbulence where you don't have to be a seller of stocks when prices are low in order to meet other financial objectives, then this takes a big weight off your brain; it takes a bit load off your shoulders. And again, you've got the dividend income coming in that you can use to meet your financial objectives, or reinvest, and why not have that cash to make add-on purchases in your portfolio when prices are low?
Glaser: What are some of your favorite defensive stocks right now?
Peters: I love the fact that staples have come in and utilities, too. I like Clorox; the is symbol CLX. [It has a] mid-3% yield. It doesn't need a whole lot of economic growth in order to generate a low-double-digit total return.
I like American Electric Power. Their dividend-growth prospects, I think, have actually improved since the middle of the last decade and yet the stock trades at a higher yield now than it did then. I think it's already priced for a 4%- to 5%-type of 10-year Treasury yield.
Philip Morris International is great defensive name with great geographic diversification. Obviously, there are some ethical considerations I wouldn't put aside there as an individual investor investing in tobacco. But it is a very strong franchise around the world that now is pumping out a yield well above 4% and as long as 8% to 10%, maybe better than that, long-term dividend growth. And you can buy these names now. They're out-of-favor on Wall Street; they're trading well below our fair value estimates. Yes, they're going to underperform sometimes, but I would be willing to trade that short-term performance for long-term downside protection. And that formula has worked very well for a dividend investor during the last almost nine years now.
Glaser: Josh, thanks for your thoughts today.
Peters: Thank you, too, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.
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