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Are Dividend-Payers Overvalued?

Kathryn Spica, CFA

Kathryn Spica: Hi, I'm Kathryn Spica for Morningstar, and I am joined today by Meggan Walsh, portfolio manager of Invesco Diversified Dividend.

Meggan, thanks so much for being with us today.

Meggan Walsh: Thanks for having us.

Spica: To start off, there's been a lot of talk about people rushing into dividend-paying funds, and there was a strong run in 2011. Are dividend payers overvalued today?

Walsh: I certainly think you can make a case that there are pockets of overvaluation within the dividend-paying universe, but I think that would be universally true across all 10 economic sectors of the broad market as well. So, we think it's a little imprudent to make the blanket statement that dividend-paying stocks are overvalued. We see opportunities in all 10 economic sectors today.

Spica: Could you talk a little bit about some of the opportunities that you see in some of the dividend-paying sectors. Specifically, utilities and consumer staples are being parts of your portfolio. Where are you seeing value in those sectors?

Walsh: Sure, they are big parts of our portfolio. But right now today, we're very positive on the consumer staple stocks. Traditionally, they've had the ability to pass through inflation to the tune of 1% to 3% of price realization. For investors that are worried about inflation going forward or protecting inflation in their portfolio, we think consumer staples are a great place to start. They're traditionally run very conservatively by management teams. Conservative meaning great allocators of capital on their balance sheet. So, when we look at the valuations for consumer stables, we think they're very attractively valued here, particularly in this part of the earnings cycle when we're more worried about the durability of the margin profile of the more cyclical areas of the economy than we are of the defensive areas of the economy.

Spica: So, you avoid some of the cyclical players in the energy space. Could you talk a little bit about how you look at that sector as well?

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Walsh: I can. We traditionally look at energy stocks. We try to evaluate what we think is the marginal cost of production for each company within the energy sector, and we like to see a company that can, of course, earn its cost of capital across a full market cycle. The energy sector in particular has had a huge increase in their capex spend versus the other sectors. So, we've seen a threefold increase in capex spend for the energy companies. But at the same time, we haven't seen an improvement in their return profile, and that is because it's been such an expensive environment for them to be participating in--both from a labor-cost perspective, but also from a technology perspective. So, we just don't see the opportunity set in energy stocks that many of our competitors do today, and mainly on our view of what they will earn over a full market cycle in terms of ROE.

Spica: And another area that you're different from your competitors is your view on banks. So you avoid some of the larger money centers and favor regional banks. Could you talk a little bit about how you look at the financial sector?

Walsh: We have traditionally looked at the financial sector like any other sector we have in this cyclical space, and that is, we look at the normalized earnings power across a full market cycle. So, in the same of the banks, what we do is we look at a line-by-line basis of each of their business lines and try to determine what we think is the full market cycle ROA for that individual bank. So, we were more attracted to the traditional spread lenders, the regional banks, particularly coming out of the '08 downturn, because we thought that the business lines there were not over-earning, versus the money center banks we thought were continuing to over-earn in many of their areas of business, such as securities lending and securitization markets. Now, those estimates have come down dramatically. So some of those banks are starting to look more attractive to us as well.

But broadly we still think that financials, particularly banks, have an improving return profile off of the bottom, but we still think there's opportunity for margin expansion. So we still see fairly good upside in that space.

Spica: There's been a lot to talk about how regulations could affect financial companies. There's are a lot of macro issues that might be affecting your portfolio and dividend-payers in general. Could you touch on some issues--the fiscal cliff, for example, or Europe--some of the larger issues and how those are affecting your portfolio today?

Walsh: It's been a very difficult environment for most investors to think about granularity around your portfolio. So, when we think about the fiscal cliff, … we try to evaluate what's embedded in the stock prices, and we do think that the fiscal cliff issues are pretty well vetted by the marketplace today.

So, we look on a stock-by-stock basis, of course, the obvious area I'd point to within our portfolio is the defensive names--so Raytheon and General Dynamics are two stocks that have been under tremendous pressure as people try to estimate the pullback in defense spending. And then beyond the defense space, I would probably say I'd point to financials, because there's a lot of concern of what the regulatory regime will look like even after the Basel III implementation and after we get through the fiscal cliff. But broadly speaking, we think the fiscal cliff is pretty well explored, which means that most of it is probably already in the stock prices.

Spica: How about for Europe as well. Are concerns in Europe or worries in that area affecting your portfolio?

Walsh: Of course we talk to the management teams as much as we possibly can to see what kind of visibility they are seeing in their end markets, and we go through the earnings periods and try to pay a lot of attention to leading indicators and where we might be seeing concerns, and I would say on a broad-stroke basis, most of our companies are seeing weakening demand in Europe, and that's probably not a surprise. But it is starting to be reflected in the out-year estimates, and we still think the out-year estimates are probably too aggressive as it pertains to the European end markets.

Spica: Any other attractive areas where you are finding a total return approach, the approach you follow on your fund, is really going to pay off going forward?

Walsh: I would say even within consumer discretionary there's probably a handful names that we're very attracted to that have been under pressure because of fears about rising input costs, particularly around gas, and what that means for the consumer. So, I would point to consumer discretionary. Away from that, the traditional areas like paper products that we think have been under pressure, again, because of rising inflation, we think on a normalized basis look pretty attractive. So there's always opportunity. Although for us, we think the opportunity set is certainly less broad than it was two years ago. So we're spending a lot of time in just trying to find defensible businesses where we think the margin profile is sustainable, and we're trying to make sure we're not paying for peak earnings.

Spica: Thanks, Meggan. Thanks very much for joining me today.

Walsh: Thanks for having me, Kathryn.