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By Jason Stipp | 01-25-2011 11:24 AM

Dividends for the Long Haul

Dividends can help investors for the whole length of a retirement investment plan, not just in retirement, says Morningstar's Josh Peters.

Jason Stipp: I'm Jason Stipp for Morningstar. It's Retirement Portfolio Week on Morningstar.com, and today we are sitting down with Josh Peters, equity strategist and editor of Morningstar DividendInvestor. He is going to talk a little bit about how to think about your income streams and dividend payments as you transition into retirement.

Thanks for joining me, Josh.

Josh Peters: Good to be here, Jason. Good week going on here. There is some big, big topics to start looking at.

Stipp: Certainly and thanks for joining me today.

One of the things that I think people will tend to think about as they approach retirement is, there is this pile of money that they are going to have, this number, this amount of money that they need to retire. Is that a consistent way, is that a good way to think about your needs in retirement, and would you think about it in terms of a dividend portfolio that way?

Peters: Really, no. I think when you are looking at equities especially--in a retirement strategy, they really should be there to produce income just like your bonds, or your CDs, your cash instruments, anything else in the portfolio that is there to generate income. It's not really about the size of the pile. That's hopefully a happy byproduct, but to me, even within an equity strategy, you have to be thinking in terms of how much income is my portfolio of stocks throwing off?

And hopefully, the closer you get to retirement through dividend reinvestment, the dividend yields of the stocks themselves, and addition from your savings, that is the number that will grow without ever taking big retreats.

Stipp: So, a question for you, because I think a lot of folks think dividend-paying stocks are going to be something I invest in later in life when I am in my 50s or 60s, but that's not necessarily the case. Maybe it would pay for younger investors, who tend to look at the small growthier companies, the ones that probably don't pay dividends. It might pay off for them to check into dividend-paying stocks?

Peters: I don't think it's a one-to-one relationship at all when it comes to age. When it comes down to looking at smaller companies or growthier companies, more aggressive investing, that should really be a reflection of the investors' own personal taste.

The way that I like to look at it is that you can run your portfolio in a passive way, where you are really trying to leverage off of the work done by others, principally the managers and employees of the companies whose shares you own, and your return comes back to you hopefully in the form of a good and growing dividend payment.

Or it can be a very active enterprise, where you are essentially running a business with your portfolio. You spend a lot of time digging into the details trying to find that next Microsoft, trying to find that next Amgen. Those are two very, very different things. And frankly, the latter, investing, running your portfolio as a business almost like a venture capitalist is very hard for most investors to do, and most investors who try are really going to wind up just speculating.

Even if you are very young, it could be said that the losses that you might have in a portfolio from mistakes or just bad luck--they cost more when you are younger because that's all those years that it could have compounded in a safer, more reliable strategy that you've missed.

So, I think it's better to think in terms of what kind of equity strategy can help me reach my ultimate objective, and if your ultimate objective is not a number in terms of the size of the pile that you retire with, but an annualized income stream--so let's say instead of thinking in terms of $1.5 million or $1 million, you are thinking in terms of $30,000 or $40,000 or $50,000 a year worth of annualized income, dividends are going to help you along that way, the whole length of your investment plan.

And, I think perhaps the most important thing is that they help you track your progress in a way that isn't going to be sensitive or at least nearly as sensitive to what's going on in the market. As long as your income is continuing to grow--dividends reinvested, dividends increased from the companies themselves, again letting the companies do the work as opposed to having to work for it yourself--and additions to your savings. That is a way to really monitor your progress and keep you on track to the goal that is going to provide that portfolio paycheck.

Stipp: And if you can focus on that, if you can focus on that income and what the dividends have been doing, maybe you pay a little less attention to what that stock price is doing, bouncing around everyday?

Peters: It helps keep you in, and it really forces you to think in terms of the business. Even a passive investor should be thinking at least in terms of principles like becoming a partner in the business--in this case a silent partner, minority partner--but you want to find management teams that treat you well. You want to find an inherently good business that will do a good job earning a return on your capital over the long run, and you want a fair share of those profits.

When you start looking a higher-yielding stocks that are in a position to at least continue to pay what they are paying now--I'm not really interested in any situation where a dividend might be vulnerable to being cut--and that dividend growth rate is going to round out a nice total return and really fire up that compounding machine, those are the kind of companies I think you want to own for most stages of your life.

And when you let them compound, and you are letting the companies do the work, and you can look and say, "the market dropped 5% today, something really bad happened in Greece or Spain or whatever, but Johnson & Johnson didn't cut its dividend, McDonald's didn't cut its dividend, NSTAR one of my favorite utilities, didn't cut its dividend. Those are all still on a trend toward higher and higher income to me as a shareholder over the long run. Then I can still go out and have dinner. I don't have to think about how much this drop just cost me as if that loss is permanent.

Stipp: Last question for you, Josh: You run two portfolios in the DividendInvestor newsletter. My question for you is, depending on what your time horizon is, would you suggest that an investor look at a different kind of dividend-paying stock, a different kind of dividend situation? Would you say that based on where you are in your investing life and how long until you need the money, you should maybe tilt the portfolio towards one kind of dividend-payer over another?

Peters: I think this in a lot of ways comes down to personal preference even more than it does time of life. Now, at the latter end of the savings plan as you're getting closer to retirement, I think the sort of principles that I espoused in my Dividend Harvest portfolio, the higher-yielding of the two portfolios, really make a lot of sense.

What I am trying to do with that account is really try to maximize the income that you can generate from a portfolio of stocks, but I'm not going to take just anything, because a yield of 15% is probably really dangerous, really risky. You're not going to get the income or even save your capital.

So I subject it to three constraints, which is I want only safe dividends; I want dividends that can rise over the long run at lease as fast as inflation, so I'm preserving the purchasing power of my income; and third, diversification, make sure I'm not overexposed to just one stock.

I think a lot of investors are going to over-diversify to the point where they don't really even know what they own anymore, but you need at least some protection against some sort of disaster that could strike just one company or one industry and take your whole dividend stream in addition to your capital down with it.

Now, that type of strategy could also work very well for a younger person, especially in a qualified account because they have the opportunity to re-invest all that income that they are getting--about 5.5% give or take, the yield of the Harvest Portfolio now. They are reinvesting that over all those years. I look at that as, if anything, more certain than the growth part of the equation. You don't necessarily know how long a business is going to be able to grow at a high rate that will provide you with a good total return, the capital appreciation, and the growth of income over the long term.

For a 35-year-old person to look at owning some utility stocks, by all means. If you can find one that is priced appropriately, has a good business that can compound the earning power of your capital, here is a way to do with that can provide a good return, probably without as much uncertainty as looking at something that doesn't pay a dividend at all or it's very low.

That said, sometimes you get situations, and we have a whole other model portfolio devoted to this, called our Dividend Builder portfolio, where there is a positive trade-off. And the way I like to look at it is this. Let's say I want to earn 10% total return. To me, that breaks down into yield and growth. Yield, let's say, is 5%. The growth of the income that you're getting, the growth of the dividend payment on a per share basis is 5% over the long run.

Those two together reinvested, compounded, assuming the share price goes up as the dividend goes up, which is usually a fair assumption to make if your time horizon is long enough and the business is stable enough, that gets you to that 10%. But what if I can take a 3% yield and get an 8% growth rate or a 9% growth rate, so that the total return has actually gone up because I'm not getting as much dividend income. There are companies like that--and where you find them is where you have really good allocators of capital, where the businesses are really profitable, and where keeping a little bit more money in the business actually generates that much more down the road even accounting for your time value of money.

One company I like a lot for this--not really cheap right now, in fact I think it's a little bit expensive, but I think it's a good name to keep in mind--is McCormick, the big spice and seasons manufacturer. Symbol there is MKC. The stock has been yielding less than 3% now for a while because the stock price has gone up, but this is the kind of company where if they are paying out 30%, 40% of earnings as dividends, 45% of earnings as dividends, but keeping the rest of that and generating very high returns internally, either by making very good acquisitions or just growing the base business where they have very strong competitive advantages, a $1 of forgone dividend income today might mean about $1.10 or $1.20 or $1.30 down the road, even in real terms, even adjusted for the time value of money.

So those are the companies where if you don't need the income right now because you don't need to live off of your portfolio's income immediately, you can take a look at those perhaps as a younger investor, let them compound. Maybe you get to the point where down the road, because you've had a higher total return from these types of businesses, you don't even ever need to sell them. You just cash the paychecks that you get at the end of the line, and they are much, much bigger than what you've got when you just started.

Stipp: Josh, thanks so much for the portfolio perspective on dividend income investing, and for joining me here today.

Peters: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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