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What Makes a Dividend Stock Tick

Jeremy Glaser

Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com. I'm here today with Josh Peters, editor of Morningstar DividendInvestor, to find out exactly what makes a dividend stock tick. Thanks for joining me, Josh.

Josh Peters: Happy to come around and talk about my favorite subject.

Glaser: Which is dividend stocks.

Peters: Is dividend stocks. That's pretty much what I eat, sleep, and breathe.

Glaser: So what exactly should investors be thinking about if they're going to invest in dividend-paying stocks?

Peters: I think that the main point is you don't want to think just in terms of yield, although yield is very important. You don't want to think just in terms of growth, whether that's growth of the dividend, growth of earnings, growth of the share price. You want the yield and the growth, yield and growth both, in other words.

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And that's a concept that we call total return. Total return is what really adds up and compounds for investors over time. You can't think strictly in terms of price appreciation carrying the day. It's got to be that combination that works for you.

Glaser: So how can you find dividend-paying stocks that are going to give you that good total return over time?

Peters: The way I like to think about it is that it's a mix. I think it's pretty common for most investors in stocks to think in terms of a 9%, 10%, 11% average total return from their stocks. This is kind of what we were brought up in the stock market to expect. It's kind of in line with the long run averages, no one year perhaps, but it's kind of a baseline expectation for going forward.

What I do is I think in terms of whatever I'm not getting from yield then I want to get from growth or vice versa. So let's take a stock like Johnson & Johnson, for example, which yields right about 3%. If the dividend can grow 8% a year, I can add that 3% dividend yield to the 8% dividend growth rate and anticipate an 11% average total return.

The way that works is that not only is the dividend growing and providing more income, but historically as Johnson & Johnson's dividend has gone up, also has its stock price gone up. So its capital gains over time are correlated to the dividend, correlated to earnings as well which pay the dividends.

So these two factors, it really simplifies the process. Three plus eight equals eleven. This is that I have some room to expect. And then if you add in a little additional principle margin of safety, you might think in terms of, "Well, I want to earn at least 9%." So from Johnson & Johnson, as long as it grows 6% a year, I don't need the eight if it grows 6% a year, plus the 3% yield, then I'm earning a decent total return.

Glaser: What do you think the ideal mix between yield and growth is?

Peters: I think it's going to be different for different investors. If you have the opportunity to get a lot more growth in exchange for taking a lower yield, if you're relatively young, you have a long ways to go to save and invest before you get to retirement, then lower yielding stocks might make more sense. Johnson & Johnson, perhaps a good example.

3% is not the kind of income yield that a lot of retirees are necessarily going to find attractive, but if that dividend grows 8% a year, it's going to double ever nine years. And presumably, stock price should follow along. It's got a lot of ways to compound in advance of eventually starting to cash those dividends out and using them for paychecks in retirement.

If you're looking for current income immediately, then a stock like Realty Income is one that I find more attractive. It's a real estate investment trust, very simple business. It's a landlord, long-term leases to single-tenant retail properties. The dividend deal there is in the 6% area, a little better than 6%. Dividend is not going to grow anywhere near as fast as Johnson & Johnson. I think maybe 4% to 4.5% a year.

The overall total return is a little lower than Johnson & Johnson might offer, but that cash portion that you can use to fund your lifestyle in retirement is much larger, less growth but a lot more yield. So in that type of situation, you can almost see yourself matching up different types of companies' total return profiles to their own investment needs.

Glaser: Sometimes it seems that investors are valuing yield over growth and sometimes it's vice-versa. What do you think the market investors are thinking right now?

Peters: Well, I would say that in a market overall that yields less than 2%, you've got a lot of people expecting a lot of growth. I mean, historically, per share dividend growth rates have been maybe 5% or 6% a year. You tack that on to the 2% yield to the S&P 500, you're looking at a pretty poor return from the stock market overall.

That being said, a lot of investors now are starting to think more in terms of income. Stock market isn't shooting up quite the way it was earlier in the year in the most vigorous part of the rebound rally. Interest rates still very, very low by historic standards, and people are starting to see dividend yields and saying, "Yeah, it's better than what I get at the bank."

And this is where I always seem to be leaning against the wind. I really emphasized dividend yield up until the last couple of weeks saying here's an opportunity to get a much more predicable return, compared to all of the wild volatility we're had to put up with on the stock price side and the growth side of the equation.

Now we're starting to see a situation where investors are bidding up the higher yielding stocks without necessarily paying attention to their growth prospects. Higher yielding drug companies, for example. Bristol Myers, Merck, they're moving up faster now than Johnson & Johnson and Abbott Laboratories.

They yield 4%, 5% instead of 3% for Johnson & Johnson and Abbott, but J&J and Abbott are going to grow much faster going forward. You may not get any dividend growth out of Merck, Lilly or Bristol Myers at all. Johnson & Johnson and Abbott Labs are offering a much better overall total return prospect, even though their yields are lower, because they're going to generate double or triple the amount of growth.

Glaser: Investors should definitely keep an eye out for that then.

Peters: Yeah, and it all comes back to the same bottom line. It's not just yield. It's not just growth. It's both.

Glaser: Thank so much for talking with me today, Josh.

Peters: Happy to join you.

Glaser: For Morningstar.com, I'm Jeremy Glaser.