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An Inflation-Beating Dividend Stock Pick

Jeremy Glaser

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. I'm joined today by Josh Peters, Editor of Morningstar DividendInvestor to take a look at the potential of rising interest rates in the future. What impact that could have on dividend paying stocks.

Josh, thanks for joining me today.

Josh Peters: Jeremy, good to be here.

Glaser: So I know it's kind of difficult at this point to talk about rising interest rates, rates have been at almost historic lows for a long time now. But with the economy and the recovery really starting to look like its truly taken hold, it's only a matter of time before the Federal Reserve begins to raise interest rates. And a lot of investors aren't sure what kind of impact that's going to have on their dividend paying stocks. Can you walk us through what some of the first and second order impacts of that will be?

Peters: Yeah, I mean, I think it's not that hard to at least think about where interest rates might go, when you are starting at zero. I mean, obviously interest rates are notoriously difficult to forecast. Fed policies could be kind of a black box, even as more open the Fed has become here in recent years, especially under Chairman, Bernanke. But when you are starting with zero, it's not really a matter of – if or how much you don't just – when and how much.

So, I think that the Fed is going to, in all likelihood, want to keep interest rates low. They control the short-term interest rate, you know, have a peg close to zero. They can keep it there almost indefinitely, if they want to. I think they are going to want to keep that there. They may even continue as they have announced buying with their plan of buying in $600 billion worth of longer term treasuries to try to keep the long end of the treasury curve down, which is more relevant to things like mortgage rates and business borrowing costs.

They are going to want to do that until they see real conclusive evidence that the economy is off the mat, it doesn't necessarily need the crutch anymore before they actually start to take this crutch away. But before that happens investors are going to anticipate higher interest rates and people are going to have to reorganize some of their thinking.

One of the top things that I am afraid of is that a lot of people have moved into dividend paying stocks, just because rates on CDs and treasury bills and money market funds have been so low. If that's the case, they have traded something which is really just supposed to be a store value for a long-term investment that may be they didn't mean to make.

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That long-term investment doesn't have any sort of guaranteed return of your money, let alone a return on the money. So, you have to be willing to make a much longer-term commitment and write out some volatility, if you're owning those kind of stocks.

At this point if you've been using dividend paying stocks as a substitute for money that's really supposed to be in cash you got to start to think about making a change there.

Glaser: For people who want to position their portfolios who do want to be there for the long-term, how can they position their portfolios to deal with the rising interest rate environment?

Peters: I think the number one thing that you want to remember is that interest rates are important, inflation is even more important, especially if you are retired and you are looking to maximize the current income yield of your portfolio.

It's possible to go into the marketplace and say if you are going to use preferred stocks or junk bonds, to try to get yourself 6%, 7%, 8% type of yield, and that's fine, you know, it's actually very good, if inflation stays close to 0% below 1%. If inflation starts moving up 3%, 4%, 5% all of the sudden your real return is eroding pretty quickly. The purchasing power of your income is dropping. The market value of your portfolio is probably dropping even faster, because it's having to reprice to a higher inflation and interest rate environment.

That's why I think that even as I would try to avoid making short-term investments in dividend paying stocks, I actually want to have long-term investments you know which I would define as five years plus in dividend paying stock, specifically because of the threat of higher inflation in interest rates. I want to find companies that are able to pass-through inflation to their customers, increase their revenues, increase their profits even if it's only a nominal terms and then provide me with faster growth to my dividend so that my total return remains solid.

Glaser: So it keeps you from losing ground even if price levels keep going up or if you are paying more for that money?

Peters: Exactly, exactly. And I think that's exactly the way you have to frame it too. I mean, the portfolio is not about generating a dollar figure it's about maintaining a certain standard of living. And so that means inflation and trying to find hedges against inflation is a big part of the picture.

Glaser: Now there is lot of investors who are really concerned that interest rates are going to go to the moon as the Fed tries to keep inflation under control, so they might be looking at these long-term dividend paying stocks but are still worried. What would you say to that kind of investor?

Peters: Well, inflation and interest rates actually go to the moon. I mean, that's just going to be a very, very difficult environment. Although if you go back to the 1970's especially in the latter half of the decade dividends on a real basis were able to continue to grow, they were recovering early on from the '73, '74 recession or when you started to have that double-digit inflation in late 70's early 80's, I mean dividends were actually keeping up.

Now, is the time when dividend yields were relatively high, so you could still get a really good fundamental total return after inflation, it took inflation and interest rates coming back down before the market just exploded with the sort of pent-up capital gains that those earlier returns should have had at the time. So, we move into a really uncertain environment, you know then it's kind of trying to minimize the evils.

Glaser: What are your options then?

Peters: Well, I prefer not to think in terms of catastrophic outcomes. I tend to think in terms of manageable changes in the outlook. Let's say, now we are talking about inflation moving from 1% to 2% or 3%, maybe even a little bit above the Fed's target. Long-term interest rates of 10-year bonds goes from – having gone from 2.5% to 3%, now it's at 5%.

What do you do? If that's a primary concern then there is, I think, two pretty good recommendations that follow; one is, still look for those higher yielding stocks, but average in. Wait and see if perhaps some higher yielding stocks become a little bit cheaper and yields go up a little bit more combined with some dividend growth in the mean time, you might be able to get – secure a better costs, better yield on costs by waiting.

Now, there is nothing wrong with choosing to average in and look for opportunities on DIPs, that's not the same as trying to go all in or all out in a market timing strategy.

The other thing that I would look at is trying to find situations that are more driven by dividend growth perhaps than high current yield. One of my favorite names that falls in this category, one of my favorite names period is Paychex, the small business payroll processor.

Now, a lot of people look at its four plus percent yield and say that's looks really great, but what about that 90% payout ratio. Doesn't that mean the dividend could be cut? Actually, Paychex is a business that is so efficient with its capital, needs to reinvest so little in order to grow that it gears itself towards 75% payout ratio even under normal times. They have no long-term debt, a lot of cash, very good cash flow that covers the dividend even better than earnings does. There is plenty of reasons to think that the dividend is safe.

If we start thinking about growth, Paychex's earnings are really driven by three factors; one is, small business employment because they charge per check; the second is, how much are they able to charge for a check. We think Paychex is a wide moat business it's hard for customers to just switch easily payroll providers on a dime. So we figure that they'll be able to raise prices at least as fast as inflation; and then the third is interest rates. They actually make money, interest income on the funds that represent uncashed payroll checks. So, it's essentially money that is free to them. It's called float.

These three forces are all cyclically aligned in that. If the economy is picking up and yet maybe that comes with higher inflation in interest rates, but Paychex's earnings probably start to grow pretty fast and the dividend probably starts to grow again. It probably won't be the very rapid growth that it's had in the past, but the last two years the company hasn't raised its dividend. I think next year or even as early as next year if the economy cooperates, we can start to see Paychex's dividend rise again.

Glaser: Josh, thanks for the Food for Thought.

Peters: I know quite a lot to think about, certainly uncertain times, but I think dividends are at least a very good way of framing the discussion when you are trying to make decisions about your portfolio.

Glaser: From Morningstar.com I'm Jeremy Glaser.