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By Jeremy Glaser | 01-19-2011 03:32 PM

A Dividend Investor's Guide to Earnings Season

As earnings seasons kicks into high gear, Morningstar's Josh Peters gives his advice on what investors should watch closely.

Jeremy Glaser: For Morningstar.com, I am Jeremy Glaser. With earnings season kicking off, I thought I'd sit down with Josh Peters. He's Editor of Morningstar DividendInvestor to take a look at what yield-focused investors should look at when they are reading these quarterly reports.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Josh, as investors get ready for the flood of earnings releases that's coming in the coming weeks, what are some tips you have for them for how to read these releases, how to read these conference call transcripts, how important are they to dividend-focused investors?

Peters: Well, I do think that they're worth paying attention to. Having dividends really be the center piece of your investment strategy, both in terms of how you are picking your stocks and in terms of the total returns that you are trying to get from owning them over time. I mean, it's a much slower process. Earnings come out once a quarter and dividends are usually paid once a quarter, but dividends are very slow to change.

Most companies will only change their dividend rate once a year, most of the time it's an increase, but it's something that is not going to get the same amount of attention from the marketplace as these quarterly results.

So, I think, the first place where that I look at them is just whether it's really good or really bad. As far as the market is concerned you should just kind of take a deep breath and say, am I really picking up on something that's going on about the long-term dividend paying nature of this company or it's just the expectations game where analysts and the companies sort of circling each others, they didn't get all the numbers right by the beat that Wall Street usually wants. It can really be a circus out there.

Glaser: If you are focused on the long-term then what are some of red flags or canaries in the coal mine for the fact that there might be some problems, there could be some dividend cuts down the road?

Peters: Well, in terms of dividend safety, what I am looking for in quarterly reports really is more dividend coverage or which you might call a payout ratio. It can be a little bit tricky to look at the payout ratio on a quarterly basis because some businesses are seasonal, but if I am seeing a process where over a series of quarters, earnings are coming down on a trailing 12 months basis the outlook doesn't suggest that this is going to turn around soon, and you're getting to the point where the current dividend rate is getting up into 80%, 90% of earnings, maybe over 100% of earnings, then you might have to start thinking about a dividend cut becoming a real possibility. The good news is the kind of environment we're in right now we're not seeing much of that.

Glaser: One of the more valuable things that comes out of quarterly earnings that a lot of companies do conference calls with management after they release. What are some of the things you look for when management is describing the state of the business?

Peters: Again it's really coming down more to long-term factors than anything else. I like to see some comments made about the dividend, which to me if nothing else is going to emphasize that management is thinking about the dividend, that it's an important part of their strategy for rewarding shareholders.

When you see a management team that talks about the dividend a lot, of realty income, ticker symbol O is a great example there. After a while, you'll see they are really running the business as it means to the ends. The business is there not to serve itself or to serve management, but to provide the funds in order to pay dividends. If you listen to one of Realty Income's transcripts you'll find a lot of discussion about the dividend.

In some other cases, I have read transcripts from some very large companies whose quarterly dividend payments might be hundreds of millions of dollars and it doesn't even really get mentioned. It doesn't mean that management is necessarily totally taking it for granted because they are in fact devoting the resources to pay these funds, but it also might tell you that maybe the investors that they are speaking to are really thinking much more in terms of this quarter's earnings, earnings for the next three-month period. They are not thinking about the dividends that they might be able to collect over the next 5 or 10 years.

So, in that case, I'm listening for those signs about what's really going on with the underlying trend of the business. Is company becoming more competitive, more productive, more profitable over time or are debts starting to go up faster than rest of the business? Our margin is under some pressure. Is there some reason to think that they are not going to be able to sustain the kind of growth they have been in the past?

It's important to keep one quarter in perspective, any company can have a hiccup and the real world just doesn't move in a straight line. But at some point you want to be able to anticipate or maybe the trend is turning against you before it becomes obvious to everybody and might start to mess with your dividend growth or even the safety of your dividend.

Glaser: So, it sounds like when these quarterly releases come out, investors should really not freak out about small changes, really stay focused on the long-term and rely somewhat on management comments to just see what the future of the dividend maybe, what the future of the company is?

Peters: I have to admit. I'm really disappointed or discouraged by how much emphasis so many investors, mostly institutional investors and your fast money traders, put on these quarterly earnings releases as if they are really the be all and end all, and its self reinforcing. Companies strive very hard to try to beat the estimates that are out there in order to make investors happy, but what are they doing, they are catering essentially to the wrong types of investors, not the people who are going to be holding the stock for the long haul, probably not the kind of people who are interested in dividends, but really a very fickle crowd that comes and goes.

So I'd prefer that a company, if being bigger and better and being able to grow the dividend faster or provide even just a safer dividend over the next couple of years might mean spending a little bit more, investing in the business now and perhaps taking a little bit of an earnings hit. I'll take that trade, because I want a partner with a management team that's looking out there a little bit further.

So, if a company is determined to run itself just to produce quarterly earning's press releases, that's probably not going to be the kind I'm going to invest in. Fortunately, dividends are giving you real earnings and for most companies that pay quarterly, the real earnings report you should be paying attention to is the one that says, 'Company declares dividend,' and then you find out when you are getting paid not just when the company is posting a profit on paper.

Glaser: Josh, thanks for insights today.

Peters: Happy to be here. Thanks.

Glaser: For Morningstar.com, I'm Jeremy Glaser. To see all of the latest earnings news and read earnings call transcripts visit Morningstar.com/earnings.

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