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

Peters: Time to Tighten Portfolio Standards

Few dividend-payers are trading at attractive valuations now, but current conditions require investors to prioritize a stock's quality and avoid future dividend cuts.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He is editor of Morningstar DividendInvestor and runs two real-money portfolios as part of that newsletter. We just talked to him about what his strategy is and how he's used it over time. And we're going to talk about some of the issues that he's facing today and how dividend investors should confront this somewhat-difficult investing environment.

Josh, thanks so much for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start by looking at interest rates. What impact do interest rates have on dividend investing generally, and where do you expect rates to go in the next, let's say, five to 10 years?

Peters: I try not to make too many forecasts, especially macroeconomic forecasts in this business. It's not always good to put things down on paper that you know are going to be wrong, which is how I would characterize almost any sort of macro prediction like that.

But it's not too hard to look at the situation and say the basic direction ought to be up for long-term interest rates. I think of a normalized type of 10-year Treasury yield being in the 4% range perhaps, plus or minus, call it 2% inflation plus 2%, maybe 2.5%, type of real-return premium. Historically that's been kind of a normal range.

Short-term interest rates starting from zero really have nowhere to go but up. But we really don't have any idea when this might happen, and it could take quite a while. Federal Reserve policy continues to be extremely accommodative or lax, depending on your point of view of the situation.

I think the Fed wants to err on the side of caution in that they don't want to withdraw their stimulus plans until they're sure the economy can stand on its two feet. I think that's what they want to do, is withdraw those stimulus plans and start to normalize interest rates. But every year now for I think five years, it seems we start the year, thinking the economy is going to grow faster, and it doesn't happen. Maybe this year it's just the weather in the first quarter, but economic growth, this idea that it's going to accelerate, seems to be sputtering again.

What this has created for a situation right now is that interest rates ended with the 10-year Treasury yield at about 3% at the end 2013. Now it's back down to 2.6%-2.7%, and you've seen a lot of outperformance by higher-yielding stocks. Utilities, telecom, and staples, have moved up. And the thing that makes me cautious here is that you still want to have in the back of your mind that interest rates are going to go up eventually, and if you're going to buy a stock for the long-term that pays a good dividend, you want to keep valuation in mind.

I don't want to buy utilities or REITs, for example, that are priced as if a 10-year Treasury is going to yield less than 3% forever when chances are eventually it's going to go up, maybe 4%, maybe at some point it'll be 5%. Back in the early 1980s, it was 15%. You have to get, I think, some sense of valuation and try to price your stocks according to the idea that interest rates will go up over the long run.

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