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The Friday Five

Fri, 20 Dec 2013

This week: The market takes tapering in stride, a dividend dilemma for investors, and a well-run REIT at a reasonable price.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar, and welcome to The Friday Five. We're giving you five stats from the market and the stories behind them.

Joining me as always with The Friday Five is Morningstar Markets Editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: Glad to be here, Jason.

Stipp: What do you have for The Friday Five this week?

Glaser: The numbers we are going to take a closer look at are $10 billion, $2.6 billion, 3, 35%, and $503 million.

Stipp: $10 billion is the size if the Fed's tapering. They're going to start that in January. It seems like a big number, but it's actually still small compared to their total program.

The market liked this news. What's your take on it?

Glaser: In one of his last acts as Fed Chairman, Bernanke really is putting the beginning of the cap-end on what I think is going to be seen as his signature program, QE3, during his tenure.

The market did like it initially. There wasn't really a huge freak-out like we saw in May, with the "taper tantrum," when we first started discussions of the winding down of this program. I think that shows some maturity in the market and the way that people have really come to view this program differently over the last few months.

What's changed is that, first, people now believe the Fed, that bringing the size of these purchases down in the taper is different than raising short-term interest rates, which obviously would have a big impact. They see that still being a while off. That was important communication from the Fed.

And secondly, the Fed really is moving because the economy does look a little bit stronger. We do now have a two-year budget deal in place. That was important for the Fed to see. They'd been talking about being worried about fiscal policy. Taking that risk off the table for a while gave them the confidence to move forward with this, and that's why the market had more of a benign reaction this time than it did just a few months ago.

That being said, we should still be on the lookout for Fed-related volatility over the next couple of years. These really were unprecedented programs. We don't have a roadmap of what's going to happen when we take away some of the stimulus. We've seen what happens when you raise rates and lower rates. We can look at some historical precedents. We don't have a precedent for the kind of scale of bond-buying we've seen and for the size of the current Fed balance sheet.

I think it's very reasonable to assume that as they start to wind this down, there is going to be potentially some unexpected consequences, like there were in May of this year. Investors should be ready for this--not necessarily overly worried. But they should not take this as a sign that the whole exit is going to be as smooth as this announcement was this week.

Stipp: $2.6 billion--that's the sales at Red Lobster, a restaurant chain owned by Darden. They are spinning it off after some pressure for a while to get rid of this restaurant chain.

Glaser: Darden has had some struggles recently. These casual-dining restaurants have been squeezed by the recession. Customers are eating at home more, and this is not where they want to spend their money. Even with some pretty aggressive promotional activities, they haven't been able to show results. Activist investors have been pushing Darden to spin off potentially Olive Garden and Red Lobster, and focus on some of their high-growth brands, and let them drive the story.

Darden has partially bowed to these demands and is spinning it by saying they are going to spin off Red Lobster by introducing some pretty major restructuring and cost-cutting measures in order to try to bring their profitability up to industry standards, while still being able to invest in these faster-growing ideas.

R.J. Hottovy, who covers Darden for us, sees this as probably a pretty good plan. He had worried that if they spun off both of the big chains, that you'd lose a lot of the synergies and overhead and other corporate spending [economies] that you get from this kind of scale. This gives the idea that Red Lobster, which has a bit of a different customer base and bit of a different menu, can be on its own while the other [chains] can stick together.

That being said, this is hardly a slam dunk. The secular trends against these restaurants aren't going to go away overnight. They are still going to have to face probably very heavy promotional activity that could offset the cost-cutting measures. It's going to be a long road ahead for Darden.

Stipp: A potentially combined T-Mobile and Sprint would still be in the third place in the wireless industry. A lot of these deals have tried to get done recently. What do you think is going to happen with this one?

Glaser: I don't think this deal is going to happen. There are a few roadblocks to this making sense from both a business perspective and from a regulatory perspective.

From a business perspective, Sprint and T-Mobile want to get together in order to go from a distant third and fourth to a slightly less-distant third to the real juggernauts in the wireless industry--AT&T and Verizon. This combination gets them part of the way there but doesn't eliminate any of the headwinds that they are facing now.

There would be really big integration challenges. Sprint and T-Mobile run on different technologies and they have different frequencies, so combining the two networks is not going to be simple. We saw how long it took Sprint to get Nextel together with similar technological difficulties. It was a long road, and they lost a ton of customers and spent a ton of money on it. I think we could see similar problems with a T-Mobile mash-up as well, and it still doesn't help in … getting postpaid customers, who are really where the profit is, into the door.

The other problem is regulatory. The FCC has frowned upon more consolidation in the industry. They like having four players, and ironically the fact that T-Mobile has been innovating so much and has been doing reasonably well over the last year is going to make it harder for a deal to get done. They've introduced some innovative pricing plans, for example getting the phone subsidy away from the service plan and having people finance the phone instead. You don't really see those finance costs, that's gained them some customers.

I think the FCC probably likes to see that competition and wouldn't want that to go away in a merger, which makes it that much less likely [the deal] will get approved. It's certainly possible that they'll try, but I don't think that investors should be holding their breath to see this combination happening anytime soon.

Stipp: 35% is the increase in 3M's dividend. That's news coming out this week. But the yield still doesn't look that great.

Glaser: This really is the case with a lot of companies that we've seen this year. 3M had a good quarter. They gave some good guidance over the next five years. They continue to see their profitability looking strong. And they raised their dividend by 35%, which is a healthy dividend raise, and they hope to continue to increase the size of the dividend with earnings over time.

This comes on the heels of a lot of other blue-chip companies increasing their dividends. Dividend increases for all of 2013 have looked pretty healthy. But stock-price appreciation has been even healthier. That's kept yields looking pretty low--at a little bit over the 2% range for 3M--and for the market as a whole, dividend yield doesn't look terribly attractive.

I think this just shows how difficult it is to find yield in today's market--nothing that's a huge surprise. Investors really need to carefully consider their strategy. [Morningstar director of personal finance] Christine Benz wrote this week about potentially selling some stocks in order to meet your income needs instead of taking on more risk to chase those higher yields in companies that might be more speculative, or where those yields might not be as secure.

In this kind of market cycle when stocks are so fully valued, that [strategy] might make some more sense right now. 3M increasing so much and still having a pretty paltry yield is another sign that this might be a decent strategy right now for a lot of investors looking for income.

Stipp: One dividend-payer that Morningstar readers really like is Realty Income. They announced a $503 million acquisition that could support their dividend in the future.

Glaser: Realty Income actually is one of the few undervalued dividend-payers that we like right now. I mentioned there weren't a lot [of them] in the marketplace, but it doesn't mean there aren't any.

Realty Income announced an over $500 million acquisition of a diversified portfolio with industrial and retail and some distribution assets from another REIT.

This will really help support the cash flow coming in the door to Realty Income, and as a REIT, that cash flow is then going to turn into potentially another dividend increase next year, which I think is something a lot of investors will be looking forward to, particularly given that Realty Income's yield already is fairly attractive.

Now one of the reasons that the stock has come down so much is fears of rising rates. As rates rise, that obviously impacts real estate investment trusts, and is going to impact their cost of financing and could potentially have an impact on cash flows in the future. But Josh Peters talked about Realty Income this week in a video. He thinks a lot of that's already baked in, and that, yes, rates are going to rise, and yes, it will impact them, but at this price, you'll be able to withstand those changes.

It does look like a decent place for investors who are looking for yield, and it's a well-run company that will be able to continue to produce that income.

Stipp: Jeremy, thanks for joining me, and Happy Holidays to you.

Glaser: You're welcome Jason.

Stipp: Happy Holidays to you, too. Thanks again for watching the Friday Five. I'm Jason Stipp for Morningstar.

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