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By Josh Peters, CFA | 05-18-2016 11:00 AM

Peters: Strong Dividends Are the Edge in a 'Fluffy' Market

With valuations looking stretched across the board, investors would be well served to hang on to high-quality firms with consistently growing dividends, says Morningstar's Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters, the editor of our DividendInvestor newsletter. We're going to take a look at valuations and where he sees the state of dividend payers today.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, you wrote recently that so far this year it's like we've had an entire year worth of volatility. Where does that leave us in terms of valuations after these big swings?

Peters: Well, for dividend-paying stocks, the high-yielding ones, the defensive ones that a lot of people have been craving in this uncertain environment, it hasn't just been a year's worth of volatility, it's been a year's worth of total return. The portfolio that I'm responsible for that's the centerpiece of Morningstar DividendInvestor has been up at some points over 10% year-to-date. To me, that's a very good year and to compress it into four or five months is a little--it gives you a little bit of whiplash and it really has been a function of rising valuations. You're not getting a lot of underlying earnings and dividend growth right now anywhere in the market. I still think of 5% as a pretty good number for dividend growth and earnings growth if you can get it. So, if stock prices are up that much more, it just means you're paying more for every dollar of corporate earnings, more for every dollar of dividends and that's a finite source of return.

Glaser: So, when you look at where current yields are today, both in your portfolio and across the market as a whole, do you think that we're going to see lower returns?

Peters: I think we have to, and it's really just a matter of how does that actually shake out. I think there is a lot of people in the market today, looking at the market today, Jack Bogle is one prominent example, Bill Gross would be another, who are looking at today's valuations, looking at low economic growth, low inflation and saying, gee, you just can't expect those double-digit returns that you've had in the past. Start thinking in terms of single-digits, maybe mid-single digits, maybe low-single digits.

And if you have a long enough time horizon that maybe is what you get between point A and B. But I think with that you also have to assume that there is going to be plenty of volatility. It's not just going to be a nice gently sloping line up. It's going to have a lot of ups and downs along the way. So I think you want to think very carefully about the kind of risk that you need to take in order to get those historically mediocre returns. My attitude is, if the returns are low, take as little risk as you possibly can in order to get them rather than taking more risk to try to get that outsize historic return.

Glaser: So taking lower risk, does that mean getting more of your total return from dividends? Does it mean looking for more stable companies?

Peters: Both. I think having a dividend-yield-rich strategy is a gigantic edge in the pursuit of higher returns from here. I mean, the S&P 500 as an index still yields only a little over 2%. The portfolio that I manage is closer to 4%. So, there I've got a 1.5 or almost 2 percentage point built-in advantage that I start every year with on Jan. 1. If nothing else changes, I should collect that much more in income. Now, the idea has always been while the companies that pay the higher yields aren't going to grow as fast, I don't think that's necessarily the case. In a lot of the data that I've looked at shows that maybe the highest-yielding companies are the ones that are going to be cutting their dividends or maybe have no growth, but those higher-yielding companies don't just pay the bigger yields, they also tend to provide just as much of growth and a lot less of risk.

So, this is a really sweet spot in the market historically. And I think that will continue to apply. Yes, low interest rates have inflated to some extent the value of higher-yielding stocks, but they are going to at least provide you with steady cash flows that you're not going to get in other areas of the market. Furthermore, low interest rates have affected the valuation of everything. I mean, it's not like I'm seeing all these cheap stocks that I just choose not to look at because I'm not willing to sacrifice dividend yield or take on more risk, it's just nothing is really cheap out there right now. So, this idea that you want to try to minimize your risk and learn it to settle for perhaps a little bit lower return as you would have expected historically, if you can build in the advantage of a big dividend yield that might be the best thing that you can do right now.

Glaser: And you still see that as a better alternative to say going into cash, you don't think valuations are so high that it's not worth not being invested?

Peters: There is a point where any stock, even great dividend-paying stock, could become so overvalued that cash is preferable. So, you need to keep that as a part of your opportunity set. But I don't think at this point we're at that level where you want to start thinking in terms of--I'm going to raise cash in anticipation of finding better bargains later on. I mean, it's not something I rule out. But if I'm sitting in cash right now, I earn no income at all and I'm really making this leap of faith that not only will the market get cheaper, which at some point it will, but that it will get cheaper soon enough that I'll be able to get back in and then I'll know what to do when that happens. That's just a tall order. So, I think in most cases, it's better to hang on to high-quality companies with really secure cash flows, really stable and predictable and consistently growing dividends than it is to try to dart in and out even when valuations do look a little fluffy.

Glaser: Josh, thanks for joining me today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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