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By Josh Peters, CFA and Jeremy Glaser | 09-24-2013 01:00 PM

Earnings Prep Points for Dividend Investors

Expectations are muted for the upcoming earnings season, but investors need to focus on underlying company fundamentals and not on one quarter's worth of results, says DividendInvestor editor Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. What should dividend investors be watching out for this earnings season? I'm here with Josh Peters, director of equity income strategy for Morningstar and also the editor of Morningstar DividendInvestor, to get a sense of what he looks for when his companies in his portfolios report third-quarter earnings.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start with some just general expectations you have for the third quarter. When you look across the companies that you own, what are some of the broad trends that you're expecting to see in terms of economic growth?

Peters: I think we're going to have pretty muted expectations both for the third quarter and the fourth quarter. I remember looking at consensus earnings data for the S&P 500 in the middle of last earnings season and seeing that apparently there were a lot of analysts who were looking for big double-digit increases in earnings by the fourth quarter of the year. That certainly doesn't look to be panning out. The economy isn't really accelerating. Economic indicators might have a little bit of a positive tilt to them, but they're still very much mixed.

What we saw coming out of the great recession period back in 2009 is that companies initially were able to recover their earnings and grow them very quickly by cutting costs, and of course, revenue was coming back, as well. But now, with companies' having maxed out their cost-cutting opportunities for this level of economic growth, we're kind of constrained. It's going to be pretty much, I think, low-single-digit type of revenue increases. Maybe you get a little bit better than that out of per-share earnings if companies are buying in shares, but it's certainly not the kind of environment where you want to get excited and be trapped with high expectations.

Glaser: Do you expect any major announcements of increases to dividends or new buyback programs, or do you think that companies are going to be more cautious?

Peters: Across the market, I think, companies are generally kind of cautious. We've seen a lot of dividend increases, but for the most part they've been the kinds of companies that you expect to raise their dividends every year. There haven't been a whole lot of landmark changes in terms of dividend policies. We're seeing that the dividend payout ratio of the market is moving up this year, assuming that earnings estimates aren't too far off. Maybe a mid-30s type of percent now of earnings are being paid out as dividends as opposed to 30% a year or two ago. I think that marks progress. But I'm not seeing any big change in terms of the trajectory there.

Overall, I think this is the kind of environment that actually favors companies that can do a lot with a little. I'll use Clorox, one of my favorite portfolio holdings, as an example. This is a name where you don't really look for more than 3% or 4% annual revenue growth even when the economy is booming because people are only going to use so much bleach and only going to use so much charcoal, but they're able to see good revenue resilience in the downtimes.  It's really, what's the gap between that 3%-4% rate of long-term sales growth and getting a double-digit return? A lot of it is just internal execution. Can they keep their profit margins high, convert almost all or all of those reported profits to cash, and pay out the good dividend yield, which obviously is not a growth piece but it adds into your total return? Do they make share buybacks and acquisitions that are intelligent uses of the cash flow that they keep that kind of add a couple percentage points to growth?

Clorox is exactly the kind of company that is built for this low-growth environment that we have now, where what starts out as very modest top-line revenue growth turns into a low-double-digit return when you include the dividends and other things that factor into dividend growth.

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