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By Josh Peters, CFA | 04-17-2014 02:00 PM

3 Questions for a Solid Dividend Portfolio

As part of his portfolio strategy, Morningstar's Josh Peters examines dividend safety, growth, and total return of the investment and prefers companies with midlevel yields.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's Beat the Market Week, and we're looking at investors who have managed to outperform the market over time. I'm here with Josh Peters. He is editor of Morningstar DividendInvestor, and in that role he manages two real-money portfolios. We're going to talk about his strategy and why it has been so successful.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start with how you started to become focused on dividends and dividend investing. What about this part of the market attracted you to it?

Peters: You always hear that owning a share of stock is owning a small piece of the business. But most investors frankly don't really treat it that way or seem to believe it, and a lot of companies frankly don't seem to act like they're shareholders or actual owners and partners in the business with them. But dividends are what bridge that gap. They really connect you directly with the underlying results of the business.

What you find is that companies that pay dividends tend to outperform, particularly on a risk-adjusted basis over longer periods of time because they tend to be more mature, have better established businesses, and stronger finances, and the dividend helps anchor the price of the stock to some sense of value. There is less chance of making a really bad mistake in terms of valuation.

And then finally, the income is so practical. For retirees, certainly who are making withdrawals from their portfolios to have this income that's flowing into your accounts, that doesn't depend directly on whether the stock market is going up or down. That's hugely valuable. But younger people, too, people who don't necessarily have withdrawals coming up anytime soon, can benefit from this strategy, as well. You can reinvest your dividends, and you get the opportunity to allocate the capital as opposed to the companies taking all of those opportunities away from you as an investor and hoarding their cash and calling all the shots.

Overall, I think it provides a very strong investment strategy especially for individual investors.

Glaser: When you're actually building a portfolio of these stocks, though, is it just a matter of looking for the highest yields and buying those? How do you actually go about evaluating these firms to decide which shares you'd like to buy?

Peters: Well, my favorite companies tend to be sort of in the middle of what dividend investors look at anyway. The yield of the S&P 500 is still historically low at about 2%, but there are stocks out there that yield nothing, certainly many like a Google or Berkshire Hathaway. And then there are dozens of companies even in this low-interest-rate environment that seem at least to offer yields of 10% and up.

I don’t like the really low yielders because obviously then I'm not getting the income, and that comes first. I don't like the really high yielders either because that is the market expressing that dividend is not likely to be safe. There is no free lunch, and if you see something that looks like it yields 10% or 12%, 20%, chances are that dividend is either just inherently structurally very risky or that the market is already pricing in a significant cut to the dividend.

So what I like are companies that yield say 3%, 4%, 5%, maybe 6%, but are also able to maintain good dividend growth over longer periods of time. The Dividend Drill process that I use to analyze individual companies, it works right off of this math. The first question is, "Is the dividend safe?" The second is, "Will it grow, which combines the growth potential of the company with the willingness of the management to pass that growth along to shareholders in the form of higher dividends?" And then I ask, "What's the total return?"

I figure if I pay an appropriate price for a stock, hopefully a cheap one, but at least a fair price for a good company, then the dividend yield plus the long-term dividend growth rate should roughly approximate my total return because as that dividend rises, the stock price should follow it up certainly not in lockstep, but over a longer period of time we're going to have that correlation. And in this type of process, you're connecting the analysis and the companies that you choose right back to your individual investment goals.

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