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Key Factors for Dividend Growth

Fri, 27 Dec 2013

2013 was a satisfying year for equity-income growth, and DividendInvestor editor Josh Peters outlines how investors can position their portfolios for future growth.

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Video Transcript

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. At the end of the year, many investors take a moment to look back at their performance and think about what could be on tap for next year. Josh Peters, editor of Morningstar DividendInvestor, is no different. We're going to talk about how he looks at his portfolios' performance and some of his expectations for 2014.

Josh, thanks for joining me, today.

Josh Peters: Good to be here, Jeremy.

Glaser: When you look back over the last year, how do you measure a performance? Is it just how your portfolios performed versus a benchmark like the S&P 500, or do you look at it a little bit differently?

Peters: I'm certainly not ignoring those traditional comparisons, such as how did my portfolios do relative to the S&P 500 or perhaps, more accurately, relative to high-yield dividend index like the Morningstar Dividend Leaders Index or the Dow Jones U.S. Select Dividend Index. But those are just tracking market price changes for the most part.

And as an investor, you don't really have much control over that. I don't even try to predict where the market is going to go. Instead I'm making assumptions that it's the dividends that we're receiving that are actually creating the value for our portfolios, the combination of both the dividends we're receiving and the growth of the dividend rates over time.

So I figure, why not put the horse in front of the cart for a change and think about how I'm driving value, getting value created for my portfolios through dividend increases, and then the other two factors that we can talk about in a bit that increase our portfolios' income, and then looking ahead to see what kind of dividend growth we have on tap for our portfolios in 2014.

That's providing the underlying baseline that I figure the market eventually recognizes and capitalizes into the market value of the portfolios. But I don't have to guess at what the market is going to do in the short term.

Glaser: Looking back over the last year, what did income growth look like?

Peters: It's been a pretty satisfying year, and just to recap, I have specific targets that I work with for both accounts. In my Builder portfolio, which is the traditional growth and income account, I look for a dividend yield from the account as a whole of 3%-4% along with long-run dividend growth coming specifically from dividend increases from our portfolio holdings of 6%-9% a year. In 2013, we started off with a yield in the 3.6% area. We didn't have any dividend cuts, so we met that objective.

As for income growth that 6%-9% figure, I thought, would be in the top half. My estimate originally was 8%. Actually it came in at 9.5%. So, even though it hasn't been a lot of the higher-yielding stocks that have grown their dividends the fastest here in 2013, it's been mostly the companies with very small dividends and lots of room to grow their dividends remedially that have generated the biggest dividend increases. Our pretty conservative collection of holdings did well against that benchmark in 2013, too.

As far our Harvest portfolio, we're really looking to maximize our income without sacrificing dividend safety, getting dividend growth from all of our holdings as well as good diversification even within that high-yield space. I'm looking for dividend yields in the 4%-6% range along with dividend growth of 4% to 5% on average over the long run. That account really beat its target for income growth.

We started out with the yield requirement met. Again, we had no dividend cuts. That's always the top priority every year, every day, every minute to avoid stocks that are going to cut their dividends, but the growth came in at 7.5%. That was well above the 4% to 5% target and the 5.1% that I saw at the beginning of the year.

Realty Income was a huge contributor there. They made a very large acquisition at the beginning of the year, and it led to 20% dividend growth for the full year. That's well above the 4% I would see in a typical year. Top holding Magellan Midstream Partners also just continues to astound year-after-year, with this low-to-mid double-digit growth that they have been on. In fact, last year was more than 20%. This year was 14%. These are adding a lot of additional income to the portfolio, yet the yields are still well above-average.

That's helped the Harvest have a particularly good year in terms of income growth, and that's in a year where its returns like the Builder fell short of the S&P 500. I see the underlying progress as being very strong for both accounts in 2013.

Glaser: Other than dividend increases, what else can contribute to income growth?

Peters: There are two other primary factors. One is just changes to the portfolio over time. If you sell a stock that has run up and maybe you bought it at a 4% yield, and now it just yields 3%. So if you sell it, and you buy something else that yields 4%, that's adding income to your portfolio. I go through a process where I separate that effect out from the actual dividend increases that are announced by the companies themselves.

And then dividend reinvestment [is the second factor]. It's not something that everybody in is in a position to do. Some people need to withdraw their dividends in order to meet living expenses or other financial obligations. But if you're in a position to reinvest your dividend income with add-on purchases as we do for both the Builder and the Harvest portfolios--every share I buy pays in more dividend--that is adding to our annualized income growth, as well.

Atop that 9.5% contribution just from dividend increases in the Builder, we had another couple of percentage points that we got from reinvesting dividends. The same in the Harvest, and that's rounded out to low-double-digit growth in income for the full year. Over the long run that total growth of income is what I expect the market value of the portfolio will correlate with.

Glaser: Looking ahead then, what are your predictions for that income growth next year?

Peters: The Harvest looks like it's in great shape. I'm seeing another year of 5% plus income growth through dividend increases there; we'll reinvest a bunch of income, too. It's doing great. The Builder on the other hand looks like it might be a little bit soft, at least with the current makeup of our portfolio holdings, principally because Kinder Morgan Inc., ticker KMI, Philip Morris, and Intel, three of the holdings that we have in the Harvest, they're looking at kind of a tough 2014.

I don't know if Intel is going to raise its dividend at all. KMI has already forecast a subpar year for dividend growth. Philip Morris hasn't talked explicitly about its dividend increase in 2014. But earnings are under some near-term pressure. Some of their individual markets that are facing some turmoil. They're spending more on product development, which I think is good for the long run, but currency is also had a headwind as it often is.

For Philip Morris, I think that will turn around. For Intel, I kind of wonder if maybe I can do better somewhere else, and it's exactly this kind of a review and even budgeting process going forward that helps highlight areas of the portfolio where we might be able to improve our growth of income going forward. KMI is kind of in the middle. I think the shares are quite cheap right now based on the potential for still-high single-digit dividend growth over the next couple of years. But it is becoming a more complicated story as the company as an overall organization really has grown so large that it gets harder and harder to move the needle with their growth projects.

So, there are some areas that need some attention, but this framework--thinking about adding to our portfolios' income growth through dividend increases, through dividend reinvestment, and periodic changes in the portfolio--gives us the framework to manage some of the portfolio positions that might not be doing so well and keep the overall portfolio on track.

I would say, 7% income growth through dividend increases for the Builder, too. I mean, that's within our 6% and 9% target. I just like to be in the upper end of that range, if possible, and it's possible that some of our other holdings will surprise on the upside.

Glaser: It sounds like dividend investors should focus really beyond just what's happening with price return, but also look at how their income stream is growing over time.

Peters: Yes. The underlying force that is going to determine where the stock price is going to be five to 10 years from now and beyond, that's probably going to be dividend growth for these higher-yielding names. Like I said earlier, you get to spend the dividend right now. It's a short-term return that's always positive, and most of the time you can count on it as long as it's not at risk of being cut. You can use that to meet your short-term financial objectives, and you let the long-term piece, the capital gains piece that you can't predict, take care of itself.

Glaser: Josh, thanks so much of joining me today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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