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By Josh Peters, CFA | 11-14-2014 11:00 AM

Peters: How to Avoid a Dividend Cut

Morningstar's Josh Peters shares his strategies for assessing company-specific and macro-related risks when constructing a dividend portfolio.

Note: This video is part of Morningstar's November 2014 Risk Management Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He's the editor of Morningstar's DividendInvestor newsletter and also our director of equity-income strategy. We're going to talk about how he thinks about risk in the context of a dividend portfolio and also how he thinks about the risk environment in dividends today.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start with what risk means to you in the context of dividend payers. How do you think about risk when you're assessing a potential income investment?

Peters: I view risk the same way I view return. It's just on a parallel model. When I think about what I'm going to get out of a stock, I think in terms of is the dividend safe, which gives me the yield that I'm looking at. Will the dividend grow, which translates into dividend growth that should encourage capital appreciation as well as a fatter paycheck over time. Then, you take those two factors together, the yield term and the growth term, and that suggests what my total return is.

Thinking about risk, the number one risk that I think about is "What are the odds that this dividend gets cut?" And if you get a dividend cut, you're not going to get the income you expected. And chances are, especially if you get into that situation early, you're going to have a large capital loss as well because it's very difficult to recover from a dividend cut. So, avoiding dividend cuts is the number one factor.

Second, you have the risk that you could own a stock and the dividend growth turns out to be a lot slower than you expect. You typically don't wind up with big capital impairments in these situations, as long as the dividend yield was reasonably high to begin with. But you can end up with a pretty poor total return over a number of years.

Sysco (SYY), the food distribution company, is an example where I bought the stock with a yield around 2%, expected double-digit growth, and watched that growth rate just dwindle and dwindle into the mid- to low single digits. And over the years and years that I owned the stock, before finally letting it go in frustration, I really hadn't made much of a total return beyond the dividend yield itself. So, growth is something to pay attention to.

Then, regarding that third question, "What's the return?" When you think about yield and growth and that combination and what that suggests for your future total returns, you also have to consider valuation very carefully. It's not the biggest threat, I think, just because most high-quality higher-yielding stocks are not prone to be as wildly mispriced as deep cyclicals are or very speculative emerging-growth companies are. But you don't want to pay too much or else your total return is going to suffer even if the dividend is safe and grows as fast as you expect.

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