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Peters: Pay Up for Quality Dividends

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We recently received a reader email asking if it makes sense to remain fully invested in a dividend-paying portfolio given how valuations have moved higher. I'm here with Josh Peters, editor of Morningstar DividendInvestor and also our director of equity-income strategy, to answer this.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's just start with that basic question: Does it make sense for individuals to be fully invested right now, or should they be keeping some power dry in case there is a sell-off and they could take advantage of those opportunities?

Peters: This question is actually one that's just a little bit beyond my pay grade. In DividendInvestor, we have two model portfolios. In our Builder portfolio, which is oriented around yields in, say, the 3% to 4% range, we try to maximize dividend growth and with that long-term capital appreciation. And our Harvest portfolio is looking for yields kind of in the 5% range but also demanding income growth from all of the stocks that we own.

Those two portfolios, I try to keep them as fully invested as possible. To some points, I've been invested almost down to the last couple of dollars in these two accounts that both have six-figure real money account balances with them. And that's because DividendInvestor is really oriented around picking good individual stocks for income. The only reason I'm not going to try to be fully invested is literally if I cannot find anything to move new cash into that doesn't meet my standards; one of which is, I'm willing to pay up to fair value, our fair value estimates, for high-quality stocks that have good dividend characteristics.

When I'm fully invested, I'm trying to optimize the number of recommendations that I'm able to provide to subscribers, but the message there is not that everybody should be 100% invested all the time in dividend-paying stocks. For most people, I think a high-yield and growing, quality dividend strategy is a very important piece of their portfolio plans or should be, but it shouldn't necessarily be the whole thing.

You want to think for yourself about how much you want exposed in equities, if you want to devote some funds to more growth-oriented investments or even some speculation with a little tiny bit of money over in the corner, or how much you might want devoted to bonds. You don't want to look in DividendInvestor for answers of how much of those different types of other asset classes and other styles you should own. It's essentially beyond the purview of the newsletter.

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Glaser: What are some of the factors individuals should consider when crafting that asset allocation, when crafting the amount of cash they hold? Should valuations play a role in that?

Peters: I think valuations play a role up to a point, and it's most valuable to think about it in a relative context. So, yes, the stock market has done very well here over the last couple of years; 2012, especially 2013, were very strong years, with a lot of price appreciation that was based on rising-valuation multiples: dividend yields that are falling and price/earnings ratios that are rising. There are not as many bargains left out there.

But if you were to sell now, just start departing en masse from the stock market in an area where we think it's within fair value, give or take, do you then move the money into bonds? Well, bonds, I think are something that you own for different reasons than you own stocks. You're looking for preservation of capital, and right now, only a little bit of income perhaps, but they play a different role than I think the real-return engine that equities can be in delivering that total return to your portfolio.

If you own bonds, mostly as just a risk stabilizer and capital-preservation instrument, if you're going to buy more, then there should be a good reason. And that should be because they're cheaper than stocks, but I've a very hard time making the case that a 10-year Treasury even now with the yield having come up a lot in the last year, up closer to 3% now is actually more attractive than owning high-quality stocks that have yields of 3%, 4%, 5% and still the potential to grow those dividends at a good pace over time.

Obviously, a third option is to just sell stocks and move into cash and maybe you hope to buy them back cheaper. Well, you can, but I think then you're kind of moving into market timing a little bit. There's some grey area between pricing the market--which is what I think the best value investors try to do, what Warren Buffett talks about doing, when we don't try to time the economic cycle or the market cycle but are looking at price relative to value--and what's just flat out market timing.

To sell in advance of a correction, say a 10% drop in stock prices, you don't know that it's going to happen. It may be that you sell out after the market's down 5% and goes down another percentage point, but then it goes back up 10%. Those become very, very difficult games to play successfully and by darting in and out of stocks, you lose the opportunity to just let the dividends do the work and maximize your dividend income that way.

I think it's better to think about your asset allocation, including the piece that you have in cash, about what works best for your own financial needs and preferences, what your risk tolerance is, certain cash outflows, and large bills that you have coming due perhaps like a college tuition in a couple of years. You should have that money in cash; it shouldn't even be in long-term bonds. It's exposed to loss there. You know you're going to need to make the withdrawals. The money that you're able to leave there permanently, you can think more opportunistically, but you don't want to upend your strategy just based on a sense that the market's gone up a lot and can't keep going higher from here.

Glaser: If you did want to buy some dividend-paying stocks or wanted to put some of that cash to work, are there any opportunities? Are you seeing anything in the market, or is it more of making the best of a situation without a lot of opportunities?

Peters: I think it is making the best of a situation with some good, respectable opportunities as opposed to lots of bargains. There are really very few bargains that come to mind right now. But when you're in a market where you don't see a lot of high-quality stocks that are cheap, that essentially sets up a choice. You can buy other things that still look cheap, even though they're not as high quality, or you can pay fair prices for higher-quality names. I very, very strongly encourage people to do the latter.

Don't sacrifice your standards in terms of fundamental quality of the business. [Look for] narrow and wide economic moat ratings, good solid dividends that are backed by cash flow on a balance sheet that doesn't have a whole lot of debt, and management teams that are going to support that dividend and actively look to create shareholder value as opposed to just padding their own pay packets. Be willing to pay perhaps a fair price, not over value, but a fair price for that business rather than looking for the outlier bargain even if it happens to pay a dividend because, usually if the stock looks wildly mispriced, the market's picking up on the fact that something is going wrong, and you don't want to be the last person in to what might turn out to be a value trap.

Glaser: Josh, thanks for talking with me today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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