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Do You Need an Investment Umbrella?

Jeremy Glaser

Jeremy Glaser: Do you need an investment umbrella? I'm Jeremy Glaser with Morningstar.com. I'm here today with Morningstar DividendInvestor editor, Josh Peters, to see exactly what an investment umbrella is and what's on the horizon for investors coming up.

Josh, thanks for talking with me today.

Josh Peters: Good to be here, Jeremy.

Glaser: So do you see a lot of dark clouds forming over the investment horizon?

Peters: Well I'll tell you, it's not a bad idea to carry an umbrella if there's a meaningful possibility it might rain. I think a lot of the clouds that have been hanging over the American economy over the last two or three years are perhaps lifting. We've got some kind of economic recover underway.

But the bigger, broader picture is that stocks are still not cheap. Whatever you think of the economy's long-term growth prospects, how things may have changed in the post-bubble environment, what you can say is that relative to history, price earnings multiples are still relatively high against average earnings, and dividend yields certainly are very low compared to past norms.

So I think it pays to think not in terms of it's going to rain, there's going to be bad economic events, bad stock market events, but to try to think proactively in terms of ways to insulate yourself from the worst effects that you might have to experience if worst comes to worst.

Glaser: So if it does start to rain, what are some of the umbrellas, if you will, investors could keep in their toolkit?

Peters: I think one is to look for stocks with lower price-to-earnings multiples, where you have better earning power and you're paying less for it. I actually priced out one of my two model portfolios, my Builder Portfolio. It's trading at quite a bit lower PE than the market overall.

So I'm not making a bet on as much earnings growth. I'm not having to take the same level valuation risk as the market overall in holding this particular basket of stocks. I like that, to look at it on an account-wide basis.

Dividend yields also, above average dividend yields I think are a very valuable umbrella. Here you have a source of return that's in cash, it's always positive, you never have to give it back. This is a reason dividend yields will provide you with a reason to go on owning and finding some reward in stocks, even if valuation multiples are contracting, even if economic growth disappoints.

And with those higher dividend yields, you don't need so much growth. Your dependence on having a big economic recovery or vigorous long-term economic growth is lessened. You're better prepared for what could be a more difficult environment. If you own a stock like say Altria Group with a 7% yield, maybe 3%, 4% type of growth from a stock like that will make it very rewarding to own. You don't need double-digit growth in a situation like that.

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Glaser: What else should investors keep in mind?

Peters: Well I think another good idea is to keep your expectations for total returns relatively modest. The way I think about total return is that I'm getting a dividend yield. Let's use Altria for an example, 7% dividend yield up front. If the dividend grows 3% to 4% a year, then chances are the share price should go up 3% to 4% a year-although actually I think it could probably grow more like 5% to 6%. You add those two figures together, that's your total return.

How you may fall short is if the stock price doesn't keep up with the dividend, or if perhaps the dividend doesn't grow as fast as you expect. So it pays to keep your expectations relatively modest.

I think expectations are certainly more modest on the part of investors today than they would have been at the end of 1999 or 2000 after such a wonderful decade for stocks. But I think you want to think in terms of how do I meet my objectives financially from a portfolio that might only have a total return of 4%, 5%, 6% percent over the next decade because if valuation multiples contract just back down to where they have been historically, that might be all you get.

And here's the ultimate umbrella: again, it turns out to be dividends. Let's say, using Altria again, if they continue to pay that dividend, continue to raise it, there is cash flow that you're getting directly from the business. It doesn't matter if the stock price doesn't go up so much. You've got a rising stream of income that you can use to meet real world investment needs.

Glaser: Josh, thanks so much for sharing your insight with us today.

Peters: Happy to be here.

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