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Why Moats Matter for Equity Income

Fri, 25 Oct 2013

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.

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Video Transcript

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. How much should dividend investors care about economic moats? To get the answer, I'm here with Josh Peters; he is 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: Why should dividend investors care about economic moats, or sustainable competitive advantages? What impact is that going to have on dividend investing?

Peters: The first thing you have to remember about dividend investing is that dividends are paid out slowly, though, relentlessly, and they really add up over time. But if you're going to actually buy a stock for its dividend, then this is going to be probably a five-, 10-, or 20-year-type of relationship. That means you have to think about their earnings potential and growth potential of the company, five, 10, 20 years, or longer into the future.

Now most of Wall Street focuses on those short-term news events. What will [the companies] make this quarter? Will they beat estimates? Will they raise forecasts? But again, if you're hanging around for the dividend over the long run, then you have to think about the long-run earnings power, and that is almost entirely going to be shaped by the company's competitive position in its industry. What's the industry structure like? Can the company actually preserve a good level of profitability and be able to grow in its field over the long term without competitors coming in and slashing away prices and ruining the game for everybody.

So, to have an economic moat and to be able to identify what it is that protects this business and its profits and its future growth potential from competition, is absolutely essential. It may not seem like it has a lot to do directly with dividends, but it really does.

Glaser: Would you buy a company then in your portfolios that didn't have a moat?

Peters: I never have, and I don't think I ever will. In fact I've sold stocks in a couple of instances where we've downgraded the moat rating in some cases to none, where we weren't confident in that long-run dividend outlook anymore. I remember one case many, many years ago when I thought that Tuesday Morning, the off-price retailer, had an interesting story. It just started paying dividends. If you look up to the business, the preceding decade, it had good returns on capital and good growth. But we had started to see that that story was turning, and we changed our minds and downgraded the moat rating to none. In fact, the dividend that they paid the previous year was the last dividend that they paid; now many years later, they still haven't paid anything. So, looking at the company, that company in particular, through the lens of competitive advantage prevented us from making a very large mistake.

Glaser: Are economic moats alone enough to make you think that you can get dividend growth? What else do you need to look at in addition to know if that payment is going to keep increasing?

Peters: Yes. For me, a narrow or wide Morningstar Economic Moat Rating is always a necessary condition, but it's not necessarily going to be sufficient. Another case I can cite is Exelon, where we have a wide economic moat rating. We have had it for some time and still do today. We think in the long run, the value of their nuclear assets is sound and that they will generate very high returns. But in the short run, you had a lot of exposure to commodity prices, indirectly, through the market price of electricity to low prices for natural gas. That culminated earlier this year in a pretty big dividend cut.

So a moat isn't always going to protect you from having something bad happen to the dividend. But what you hope for in conjunction with all the other things that you would look at about a business--the stability of its revenues, especially in tough times; the quality of the balance sheet, there's no rule that says a wide-moat company can't be all loaded up on debt and get into trouble that way--what you want to see is that the company can preserve that level of profitability and cash flow that will be there to pay your dividends in the future.

Also, and this is very important, that whatever retained earnings are in the business--whatever they don't payout to shareholders but are instead reinvesting to expand business--that that is being done within that competitive protection, as well, so that when a company doesn't pay out a $1 of earnings, it turns into more than a dollar's worth of future dividends.

Glaser: When you're considering a company with either a wide or narrow economic moat, do you have a strong preference for wide versus narrow? Or is it more nuanced than that?

Peters: I'd say, it's a little more nuanced. It's more about the interplay between the business and its moat strength, as well as its dividend policy. There are some wide-moat companies out there, quite a few actually, that pay very little dividends or even no dividends at all. That's not going to work for me; the income is always priority number one [for me].

But there are also narrow-moat companies like General Mills, for example. They don't have a patent on Cheerios that prevents other cereal companies from making anything that is even remotely similar. You can buy Generic-O's, Store-Brand-O's. There are other people who make comparable products. So it's harder to make the case that General Mills has a wide moat. But they do have a narrow moat because the name Cheerios, all the advertising, marketing, and innovation that's gone into that brand over many, many decades now does allow them to charge a higher price and consumers are happy to pay it. I pay it myself, and I give Cheerios to my little 10-month-old boy. He gobbles them up, and so many of them wind up on the floor, it makes me wonder if I'm not due for another dividend increase here from General Mills on that alone. But I don't necessarily need a wide moat, but I at least need a narrow moat. A no-moat company, I can't be confident in the stability of that profit stream for the long run.

Glaser: That real key sounds then that the company can sustain itself long enough in order to keep paying you those dividends for that total return.

Peters: Yes. You've got to be able look far into the future and see those dividends coming and growing without any reductions before you can have a lot of confidence that this is going to be a stock that will work well in a dividend portfolio. Moats are one of the best tools out there. In fact, I'd say, perhaps the best tool, the best prism through which to look at these companies in order to accomplish that objective.

Glaser: Josh, thanks for talking with me today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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