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By Jeremy Glaser | 08-10-2011 11:23 AM

Four Dividend Picks for the Sell-Off

In a low-growth, low-interest-rate world, Morningstar's Josh Peters thinks investors should focus on high-quality, dividend-paying stocks.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. As stocks have sold off some dividend yields are beginning to look more attractive. I'm here today with Josh Peters. He's the editor of Morningstar DividendInvestor, and we'll see what names he is taking a closer look at and his thoughts about the sell-off.

Josh, thanks for joining me today.

Josh Peters: Good to be here even if only by phone.

Glaser: So, Josh, we've certainly seen a pretty substantial sell-off and a lot of volatility across the stock market. Can you briefly just talk to us a little bit about what you think is driving that volatility?

Peters: Well, isn't it amazing how they call it volatility only when stocks drop in a haphazard fashion? They call it volatility if the market goes up 1,500 points in a spastic rally; volatility being cover for "You're losing money," I guess. I think that right now, in the last week, emotions have really taken over, and the ghosts of 2008 are coming back to haunt investors, especially on trading desks, hedge funds, and institutional investors.

I don't think you're seeing ordinary people rushing for the exits, but there are a lot of people who got hurt very badly when things started to go wrong in the fall of 2008 and they just are totally unwilling to say, "Hey, there are some stocks now that are cheap. There are some bonds that are cheap. There are some opportunities to make money here that weren't there before."

You haven't seen that greed start to kick in yet. We're just running on fear. It is very unpleasant. There is a, "Here we go again" type of aspect to it, but the underlying facts as pertained to the corporate sector of the U.S. economy really couldn't be more different. When I look at balance sheets, even bank balance sheets are in so much better shape now than they were three years ago, that I think it's an apples and oranges type of comparison. I would much rather have the opportunity to invest in strong corporations now as opposed to sticking my neck out back three years ago.

Glaser: Yeah, certainly three years ago, one of the big stories at least in the dividend world was just the number of cuts from so many different companies in which people really thought were safe dividends or that wouldn't see those big cuts. So you're not expecting any kind of large cutbacks, large conservations of capital from some of the high-quality names that you're looking at?

Peters: I'm really not. I've been checking this. When the market starts to drop like this, the first thing I do is I go back to the well and I say, "OK, well whose dividend might be unsafe, whose dividend might be cut? Where is there actual fundamental risk that actually should force me to take some protective action and try to defend my capital?" And I'm really not seeing much by way of dividends at risk. A big part of it is because in perhaps the most vulnerable sector, the financial sector, I mean, the dividends really haven't come back yet. There's not really any reason to go back and start cutting again when there's barely any yield there anyway.

You look outside of that, and most of the dividend growth that we've had has come from companies that have had very low payout ratios, so they had a lot of room to grow their dividends. They tend to have pretty good cash flow and very good balance sheets. You can't discount the possibility that fear grips even corporate boardrooms, and you have nervous Directors starting to think about reducing dividends in a couple of one-off individual cases that I can't even figure out what they might be right now. But for the most part, the dividend stream in the aggregate that's going out to U.S. investors right now is, I think, still very strong, and it can handle, I think, even a modest recession before you might see another outbreak of dividend cutting. I mean, it's not like what we're looking at now is going to force Procter & Gamble to cut its dividend. That's just not realistic. If the last crash didn't do it, that's certainly not the type of dividend that you have to fear for in this type of environment.

Glaser: So we heard from the Federal Reserve that interest rates are going to stay low for at least two years which is the first time it has really put a timeframe around what that extended period could really mean. What does mean for dividend investors?

Peters: Well, when I read the Fed statement, it was a remarkable document with just how depressing it all was. But you mentioned the action line which is, "We expect the economy to stay weak enough that we're going to hold interest rates to basically zero through mid-2013." When you start thinking through that, that's unusually clear by the standards of Fed speak, but I think it's even easier to interpret it. If you want to have some shot at actually coming out ahead over the next two years as an investor, this to me points right in the direction of high-quality, well-capitalized, high-yielding stocks in defensive sectors. It'd be hard to imagine a better or a more clear prescription for it.

They are saying the economy is going to be weak. That's going to be bad for cyclicals, it's going to be bad for low-yield stocks, it's going to be bad for any kind of company that really depends on a vigorous economy or at least a decent economy in order to generate a good total return for their shareholders. If the economy stays weak on a relative basis, relative to cyclicals and less-defensive stocks, you have the opportunity to buy companies that don't need a whole lot of growth in the first place in order to pay their dividends, in order to grow their dividends, and provide the outlines of a good total-return prospect.

Now, you could say, well, if the economy is weak, maybe the stock market just goes down and down and nobody is going to benefit. It's just a lose-less strategy to favor defensive names, but then you have to look at the other part of the equation, which the interest rate policy, holding interest rates to basically nothing. The Fed is essentially saying, there will be no return for anybody who is unwilling to take risk or at least something that looks and feels like risk. And that in itself is kind of misnomer because even if the economy stays weak, that doesn't mean that we couldn't have a burst of inflation at some point during the next two years where all of a sudden that zero percent, that nominal that you're collecting on a two-year note, turns into a negative number in terms of purchasing power.

So, there, too, you have to think about all the different angles and really the different ways we are kind of boxed-in as an investor. There is no easy ways to make money. There is not even necessarily any easy ways to preserve capital, but I think that it's the high-quality stocks, it's the Procter & Gambles of the world, the AT&Ts, that give you the best shot at actually being able to help preserve your purchasing power and wring some real return out of your portfolio over the next couple of years.

Glaser: Josh, let's take a look at some individual names that you think are suddenly attractively priced. Could you talk about some companies that are on your radar screen right now?

Peters: I just mentioned two: Procter & Gamble and AT&T. I think both of them are very well-prepared to maintain their current dividends. In the case of P&G with a yield in the mid-3% range; I mean, historically that's very attractive for that stock. It's still a phenomenal enterprise. Now that it's an $80 billion company, I don't think that has diminished its ability to produce a good total return for investors going forward. It has lots of things it can do in the organization to keep the dividend growing that doesn't depend on rapid economic growth.

As for AT&T, I mean, it's sitting still with the T-Mobile merger. We don't know quite where that's going to go. It's possible that we won't see AT&T raise its dividend this year, but the company has a phenomenal track record going back to the divestures of the Bell System of raising its dividend every year. I think it's a very high priority for AT&T to keep that commitment for shareholders going forward. You look out over the next couple of years, I expect that dividend to continue to grow at a good rate. And these are, I mean, they are the go-to names. They are defensive. You don't expect the business to fall apart in rough times. They've got very good balance sheets.

If you want to be a little more opportunistic, let's say, and look at some less-household names, two I'd mention are Health Care REIT, ticker symbol is HCN, and Spectra Energy, ticker symbol SE. The latter is a big natural gas pipeline operator, again, a very steady business. It's basically a giant utility in terms of the economics of the way the business behaves. The stock has come down a lot in the last couple of weeks, even though it's a relatively defensive business. The yield is back over 4%, a little over 4%. The dividend, I think, grows at 4%, 5%, 6%, or maybe even 7% going forward. That's I think a very sound total-return prospect, especially in a zero-interest-rate environment.

Health Care REIT will get you an even better yield at this point in the mid-6% range, and this stock just got clobbered like other health-care REITs got clobbered after Medicare announced some changes in reimbursement rates to some of the tenants that these healthcare REITs actually provide real estate to. But when you start picking that story apart, I mean, a lot of it was just a reversal of some previous increases. We're not seeing this putting large numbers of tenants into financial distress, and these are not the actual skilled nursing home operators themselves. I mean, they have got layers of margin of safety between what happens in terms of reimbursement rates and what is happening to the dividends. So, it's a dividend that we think is very secure.

Health Care REIT has grown up. It's been around for a long time. It's been through bad cycles/down cycles in health-care spending before, and it's maintained its dividend. It's a business of the balance sheet and a business model that's built to last, that's built to deliver. So, I think at this point that stock, though a very conservative company, having come down so much in this environment I think makes it actually a very good opportunity.

Glaser: Josh, thanks for the picks today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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