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Watch for Warning Signs When Chasing Dividend Yield

Jason Stipp

Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.

Jason Stipp: I'm Jason Stipp for Morningstar. As yield seekers continue to scour the market for income, utilities and telecoms and other sorts of companies have been bid up. Surprisingly, though, some of their yields still look relatively attractive. So, are they a good bet for investors? Here to offer some insights is Pat Dorsey, president of Sanibel Captiva Investment Advisers.

Stipp: Pat, thanks for being here.

Pat Dorsey: Howdy, Jason.

Stipp: So we were looking at Verizon today; we were looking at AT&T today. The yields are not so bad, considering what you are getting elsewhere at about 5% or so. However, these stocks [have Morningstar Analyst Ratings of 1 or 2 stars] which indicates to Morningstar analysts that they are overvalued. So what should I think if I am looking for income, those yields don't look too bad, right?

Dorsey: The yields don't look too bad, certainly relative to 1.5% Treasury yield right now or a 3.5%, maybe 4% yield on an investment-grade bond. But of course, when you're buying equities you have little bit more fluctuation of principal than you do in buying bonds, and I think that's the risk in making these very tight decisions with regard to yielding equities and saying "Gee, I'd rather have the 5.5% yielding equity relative to the 4% yielding equity." Well, the thing only needs to go down 1.5% for that argument to suddenly become nil. And as we all know, the equity markets can serve up quite a lot of volatility. So, I really think as an income investor you need to think about the total return that you're going to get off a security, not just the headline dividend yield.

Stipp: So at this point because you're basically having to reach for yield or overpay for that yield right now, you are actually giving up what could be some capital gains if you had looked for an asset that was more attractively priced.

Dorsey: That's exactly right. And I think, last year for example you saw utilities up 20%, or 18% maybe. It was the single best-performing asset class in the S&P 500. Now it's not like utilities started off 2011 as dirt crazy cheap, and it's not like they grew earnings by 20%. It's because people decided to pay a lot more for them at the end of year than they did at the start of the year. That's always a little bit of a warning sign. I think that as an investor you need to be thinking about risk and the price risk you're taking, and you want to make sure you're not taking too much price risk in reaching for that higher yield.

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Stipp: I don't mean to paint all income-producing investments with the same brush. In fact, we have a very high opinion of dividends and the role that dividends can play for investors and what that means about the company's discipline and things like that. But I'm wondering if you are an income investor and you are attracted to some of the fundamentals that are behind a dividend-paying stock, are there any good opportunities out there? How do you find them if investors have been searching for yield so aggressively?

Dorsey: Yeah, I would say use a rifle, not a shotgun first for all. You are certainly seeing individual companies, for example, National Grid which I know has been a Morningstar favorite for some time. It's a U.K.-based utility. It's still very attractive, much more attractive than almost any U.S.-based regulated utility. But it's not going to be in a big basket of U.S. utilities that you buy in an ETF because it's not a U.S. utility. Or you have companies like Kinder Morgan, Kinder Morgan Inc., KMI, which is a C corporation that pays a dividend. You don't have any K-1s to file. But it's pulled back from $38 to $33 per share. It has a 4.1% yield with a very high dividend growth rate. And as you and I've talked about it in the past, I think, dividend growth tends to get undervalued relative to current yield. Those are areas you can look at, but again those are a little bit off the beaten path. MLPs like Amerigas or Magellan Midstream again [are] a little bit more off the beaten path. But I think with the usual suspects, so to speak, of big regulated utilities, consumer staples companies there is some reasonable price risk there, probably a little bit less so with AT&T and Verizon, but you're certainly not getting those things at a bargain right now. 

Stipp: And Pat, you mentioned to me also, as individual investors or investors who are investing for specific goals, specific objectives, you can look at something that might be relatively good, but relativity isn't necessarily where you need to end your discovery.

Dorsey: Yes. The last time I checked the college bursar doesn't expect relative performance when you're paying your kids' tuition, right. If you're short, you're short, that's that. And so I think that's something that individual investors really need to keep in mind because with all the folks you're seeing on television, money managers at large fund companies, analysts at sell-side shops, they are paid on relative performance by and large, not always, but by and large. And as an individual, what you need is absolute performance, not a relative performance. So the fact that Yield A is relatively better than Yield B, that's not the relevant question. The relevant question is, "Am I getting paid for Yield A relative to the risk that I am taking?" It's not what is it relative to something else. [This is] not the best analogy, but you saw this in late 1990s with people going on the relative thing saying "Relative to other companies at 40 times earnings, this company gets cheap at 30 times." That argument didn’t work out so well.

Stipp: All right, Pat, well thanks for some very important tips for income seekers today and keeping the bigger picture in mind and for joining me today.

Dorsey: Thanks for having me, Jason.

Stipp: For Morningstar I'm Jason Stipp. Thanks for watching.