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High-Quality High-Yielders Still the Best Game in Town

Jeremy Glaser
Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many high-yielding sectors have hit a rough patch in the market recently. I am here with Josh Peters--he's the editor of Morningstar DividendInvestor and director of equity-income strategies at Morningstar--to see if it's opened up any opportunities. Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So let's talk a little about performance. I know you don't focus too much on short term, but what have we seen over the last couple of weeks in terms of higher-yielding sectors? What do you think is happening out there?

Peters: I think we're riding down a mountain we never should have climbed in the first place, to be honest. I've honestly become more bullish on a very long-run outlook, not just for dividend-paying stocks, but for all stocks, and starting to feel like the sins of the bubble in the late 1990s have been paid for. So I'm really not that surprised to see that the stock market is up here again this year after having been up the year before by a pretty good margin.

But when we got to the first quarter and you see the S&P 500 is up 15% or so, and it's high-quality, high-yielding stocks that are actually leading the advance, with returns more in the neighborhood of 18%, 19%, 20%, like my own portfolio's had--OK, this isn't really how it's normally supposed to work. Normally, a market is up a lot in a short amount of time. You expect this defensive low-beta, high-yield, boring stuff to underperform; that's just their nature. And then they outperform, they hold up much better in the big down markets.

But there was some momentum factors I think that came into the market. I mean, people were just getting on a train they thought was leaving the station, not knowing that this is a train that you're supposed to ride for 5, 10, 20 years. This isn't about a short-term dividend trade, as so many people in the financial punditry have referred to it.

So when the market started to turn and you saw a little blip up in interest rates, I'm not that surprised that we've seen the higher-yielding, higher-quality stocks actually leading to the downside, because they probably hadn't deserved to get as high as they had earlier in the year.

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Glaser: So does this help to make valuations more attractive? Or has it just gone from extremely overvalued to just overvalued?

Peters: No, I think we're back in a position now where values are pretty attractive. When I look across my portfolios, I recently made a change, having previously looked for what we call 4-star and 5-star stocks, and now I'm really reflecting the emphasis on quality that has worked so well for us. I'm happy to pay up to our fair value estimates, a fair price for a very high-quality stock, echoing Buffett's views on investing as they've evolved over the years. So, I've gone from--with the policy change, the come-down in the market, and some fair value estimate increases that we've had for some of our companies--I've gone literally from as few as 3 or 4 buy-rated stocks out of 36 to around 30. And it didn't take a whole lot of moves because, again, I didn't see the stocks as being that overvalued in the first place, and they have come down, yields have come up, they've gotten a bit more attractive.

But you have to really place this in a relative context. Interest rates have moved up a little bit, but they are still very, very low. And when I look at the valuations, even among REITs, which I think are the most interest-rate-sensitive sector going forward, they're starting to get that discount of what will the normalized interest rate environment will look like. Utilities are even farther along in the process, 4% or 5% yields on utilities. That's not incompatible with a 4% 10-year Treasury rate. We're still only at 2%. So to me, the best relative value prospect in the market is still these high-quality, high-yielding, almost bondlike stocks, and that's where I want to continue be in now. I think the portfolios are telling me that there's lots of opportunity.

Glaser: What are some of your favorite ideas right now?

Peters: Well, one name I just added, that honestly I've wanted to own for years and even when I had the chance, I kept blowing it, is Southern Company, one of the very largest utilities, fully regulated utilities in the United States. I would also argue one of the best. It has outstanding regulatory relations in the four states it operates in: Georgia, Alabama, Mississippi, and Florida. They earn some of the highest returns on equity in the country of any regulated utility, but yet the cost of power to their customers is below the national average.

So here you have a situation where a well-run utility that has good incentives, good working relationships with regulators, everybody wins--customers win, they get better lower costs, and shareholders win with better returns. Now, yeah, utilities got I think overpriced here earlier in the year, but they came back down and now just recently I was able to buy Southern Company right at its average P/E, its average dividend yield, and its average price to book multiple over the last 16 years. We've had some very high interest rates over the last 16 years, as high as almost 7% on the 10-year Treasury. I'm very comfortable paying that kind of a price for something like Southern Company here.

Glaser: What's another name you like right now?

Peters: Another name that's come back into buy territory for us is Clorox, certainly a classic household name, being so dominant in some pretty small categories like bleach and like charcoal and water filtration. They dominate those niches and they are not necessarily going head to head every day with a huge company like Unilever or Procter & Gamble. They generate a tremendous amount of cash. The top line doesn't grow real fast. This is maybe a 3%, 4% type of top-line grower, but with a little bit of margin expansion over time thanks to the power of their brands and their ability to control costs and continue to dominate their categories with some share buybacks, the occasional acquisition, this is a company I think you can expect 6%, 7%, 8% long-term dividend growth from. And here it's trading at a yield around 3%, not a whole lot of risk. Perhaps you want to hold out for more, but it's a high-quality name that I think you can pick up pretty attractively right now.

Glaser: So for dividend investors, is this one of the best times in the last few years at least to be looking at stocks?

Peters: Well, it's not 2009, it's not 2010. Recently I was just mulling the fact that I bought Altria Group a couple of years ago at about 10 times earnings and a 7.5% dividend yield. In any kind of normal circumstances, you wouldn't expect to be able to get a great dividend payer that cheaply. Now the stock has basically doubled since that point, and you don't have the opportunity to buy it that cheaply anymore. But you have to place everything in a relative context. Your money has to go somewhere, and unless you want to try to time a future correction by holding cash until it happens, your alternatives are the high-quality, high-yielding stocks that I like so much, or you can buy low- and no-yield stocks. You could go buy a Google or an Apple or whatever is popular or whatever you might find, whether it happens to pay a dividend or not. Or you could be looking at bonds where interest rates are still very low even though they've moved up.

When I lay out these choices, I still think that those high-quality, high-yielding stocks are remarkably versatile. They play to a wide, wide degree of different market conditions as well as different investor needs, personal financial needs. So it's not as cheap as it's been in the past, but I think that when you place it against the relative choices that you have, especially for somebody who is seeking that reliable income, it's still far and away the best game in town.

Glaser: Josh, thanks for talking with me today.

Peters: And thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.