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Seeking the Best Dividend Bets

Jeremy Glaser

Jeremy Glaser: Hi. I'm Jeremy Glaser with Morningstar. I'm here today with Paul Alan Davis of Schwab's Dividend Equity Fund. Hi, Paul. Thanks for joining me today.

Paul Alan Davis: Thank you for having me.

Glaser: A topic on a lot of people's mind has been dividends. We've seen a lot of high-profile companies like General Electric cut their dividends, stalwarts that people thought would be producing income forever. Can you talk to us a little bit about how at Schwab you use your process to try to find which dividends are going to be sustainable and where you want to put your money to work?

Davis: Yeah, a lot of people tend to think of dividends and start their search with dividends. What we do is we use our Schwab equity ratings model that looks at 3,200 domestic companies and looks at fundamentals, valuation, momentum, and risk, and comes up with an overall score on all those companies. What we're doing is we're looking for quality companies that will do well over long periods of time. So we're not looking for turnarounds. We're not looking for the big growth stories. We're looking for the best candidates in each sector. So if you're looking for dividends, a lot of people get portfolios that are very skewed towards financials, telecom, some of the staples. What we do instead is we put together a portfolio that has coverage in each of the sectors and each of the industry groups to make sure that we have the best stocks and the highest dividend payers in those categories.

In constructing a portfolio like that, we have a yield that exceeds the S&P 500 by between 50 and 100 basis points, and if you look at the long-term track record, we've been able to do a pretty good job of managing dividends in that space.

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Glaser: So, when you take a look right now in the marketplace, I think one of the things we've heard a lot at the conference is that opportunities abound. There's a lot of very cheap stocks, there's a lot of cheap bonds. There's just a lot of places to put your money. What sectors do you think present the most attractive valuations right now?

Davis: Using our Schwab equity rating process, we always look to that, because that's taking 19 factors on each of the stocks on a weekly basis, and from a bottom-up it's kind of boiling up to the top and coming up with the best stocks. Where we've seen values lately, it's been kind of a hodgepodge. Not necessarily all economically sensitive stocks, and not necessarily all defensive stocks. We're seeing values in consumer discretionary, in the financials, in health care, and also in technology.

So two more defensive sectors and two more economically sensitive sectors. Where we have underweights would be in the energy and industrial space. So in the technology space, which has been really good this year, some of the larger-cap names that we have held for a long period of time, Hewlett-Packard and IBM, still look like good dividend plays.

Glaser: So if you think that HP and IBM look like good values, are there any other individual stocks that you guys have been looking at that have purchased that you think could produce some good dividend growth over time?

Davis: Yeah, we have been in the financial space, because financials make up dividend-paying benchmarks like the Russell 1000 Value about 20% of the benchmark, you can't help but own a good chunk of financials, and sometimes you have banks. We've been underweight some of the banks, and last year, when we do a lot of our attribution, much of our success came from avoiding the AIGs and the Washington Mutuals, avoiding some of those stocks, and we favored the larger-cap safer big banks. So J.P. Morgan has been a long-term holding, Goldman Sachs, Morgan Stanley, some of the firms that don't have a lot of the legacy problems that some of the other banks do. Much like Bank of America, we've held underweights there or have not held that stock. So looking for safety, we know that it's going to take some time to get through this and to grind through all of the leverage that is out there. So we prefer to hold the bigger safer companies like those.

Glaser: So if you look at a company like J.P. Morgan or Goldman Sachs that have kind of slashed their dividend in an effort to raise capital, to maybe pay back TARP funds or just to produce a cushion, is that a capital allocation decision that you're happy with, or do you think that the banks would still be better-served paying that back out to shareholders?

Davis: As far as the dividends, I think we had expected that there would be dividend cuts. Your dividend rate is just your dividend divided by your price, and when the price declines, your dividend percentage goes up. So we had expected when we saw some of the dividends in the 10%, 15%, 20%, we had expected them to cut. As management meets with their boards, the boards are going to say, "Hey, we have a longevity concern here. We want to make sure we are continuing business, so let's cut the dividend." And we did expect to see that. In terms of the companies, if the dividends are more at a reasonable rate of 3%-6%, those are adequate dividend yields for us.

Glaser: So do you have a red flag where when a yield gets over a certain percentage, you start to get nervous?

Davis: I would say around 10%. There have been a few areas where dividend yields approached 20-25%, and that definitely sends up a red flag. Not necessarily because we're concerned that the company can make those payments, but just whether the appetite for boards will be to pay that significant dividend in the future. So not necessarily that those companies are going to go under, but just that there would be some changes.

Glaser: Great. Well, thanks so much for talking with me today.

Davis: Thank you.

Glaser: I'm Jeremy Glaser with Morningstar, thanks for watching.