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By Josh Peters, CFA and Jeremy Glaser | 10-10-2013 02:00 PM

Why Moats Matter for Equity Income

An economic moat is one of the best tools to identify the stability of a company's profit stream and long-term dividend-growth potential, says DividendInvestor editor Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. How much should dividend investors care about economic moats? To get the answer, I'm here with Josh Peters; he is the editor of Morningstar DividendInvestor and also the director of equity income strategy. Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Why should dividend investors care about economic moats, or sustainable competitive advantages? What impact is that going to have on dividend investing?

Peters: The first thing you have to remember about dividend investing is that dividends are paid out slowly, though, relentlessly, and they really add up over time. But if you're going to actually buy a stock for its dividend, then this is going to be probably a five-, 10-, or 20-year-type of relationship. That means you have to think about their earnings potential and growth potential of the company, five, 10, 20 years, or longer into the future.

Now most of Wall Street focuses on those short-term news events. What will [the companies] make this quarter? Will they beat estimates? Will they raise forecasts? But again, if you're hanging around for the dividend over the long run, then you have to think about the long-run earnings power, and that is almost entirely going to be shaped by the company's competitive position in its industry. What's the industry structure like? Can the company actually preserve a good level of profitability and be able to grow in its field over the long term without competitors coming in and slashing away prices and ruining the game for everybody.

So, to have an economic moat and to be able to identify what it is that protects this business and its profits and its future growth potential from competition, is absolutely essential. It may not seem like it has a lot to do directly with dividends, but it really does.

Glaser: Would you buy a company then in your portfolios that didn't have a moat?

Peters: I never have, and I don't think I ever will. In fact I've sold stocks in a couple of instances where we've downgraded the moat rating in some cases to none, where we weren't confident in that long-run dividend outlook anymore. I remember one case many, many years ago when I thought that Tuesday Morning, the off-price retailer, had an interesting story. It just started paying dividends. If you look up to the business, the preceding decade, it had good returns on capital and good growth. But we had started to see that that story was turning, and we changed our minds and downgraded the moat rating to none. In fact, the dividend that they paid the previous year was the last dividend that they paid; now many years later, they still haven't paid anything. So, looking at the company, that company in particular, through the lens of competitive advantage prevented us from making a very large mistake.

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