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These Discounted Dividend Payers Can Be Portfolio Staples

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Consumer staples stocks have been under pressure throughout 2014. I'm here with Josh Peters--editor of Morningstar DividendInvestor and also Morningstar's director of equity income strategy--to see if any opportunities have opened up.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: What's happening in the staples sector? Why has it been under pressure so far this year?

Peters: I think a lot of it has to do with what's going on in emerging markets. What we've seen here in the last couple of months is some turmoil in countries like, say Turkey, and now more recently Ukraine. We've seen currency issues, falling emerging-markets currencies. Venezuela could devalue its currency; it's already practically a black market situation there. Argentina has been a problem. You can say any one of these countries shouldn't have a big impact on a giant company like a Unilever or a Philip Morris International, but when a lot of them are going south at the same time, you're getting some pretty stiff headwinds here for near-term revenue and earnings-per-share growth.

Glaser: Are these just temporary factors that you think over the long run will even out, or are these really serious potential long-term concerns about the health of emerging markets?

Peters: I'm inclined to think that this is more of a buying opportunity that, these issues are going to be temporary. Over time you expect that some of these emerging economies are going to have political problems, economic problems, if their currencies are going to depreciate relative to the dollar.

That said, the bigger companies whether it's a Philip Morris or a Coca-Cola, a Unilever that are selling into these markets, these are still defensive consumer goods. They are not so much discretionary purchases that are very easy to simply not make as opposed to buying new cars or building houses when economies are under stress.

It's really been the currency effect, I think, that has hurt the most, and you're seeing a company like Philip Morris that would ordinarily be looking at 10% to 12% type of earnings per share growth. Currency headwinds are still so stiff for them right now that they're looking at EPS probably declining a bit this year.

But what you're getting is still that underlying stability, currency issues aside as well as a very strong dividend, a very generous dividend yielding mid- to high-4% range lately. In fact, I think almost close to 5% on some days for Philip Morris; that should grow at a good clip over the long run. They're certainly going to benefit like most of these companies will from having exposure of these faster-growing markets. But even though it is a very steady business, they put a pretty conservative payout ratio in place. A 65% payout ratio target for Philip Morris leaves room for currency and other issues to hammer profits in the short term by 35%, and yet they still fund the dividend.

So, they're doing exactly what I would expect them to do. The currency headwinds are not always going to be so fierce. Sometimes they're going to turn into tailwinds, and that's when I think you will see a lot of these stories start to recover.

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Glaser: You're not worried then that the currency issue is going to really drive down or really pull down dividend growth, which is something you are looking for?

Peters: Dividend growth obviously is very, very important to these names, but I think what's most important is that you get a consistent long-run outlook. In the short run, I definitely expect that Philip Morris' dividend increase this year--I think the company almost certainly will do one--it's going to be a lot smaller than the low double-digit hikes we have had over the last couple of years. Because again they want to maintain that balance and that cushion, and they want to raise the dividend a lot in a year where earnings have fallen a little bit.

But over time, one of the things you got to remember about emerging markets: When currencies plunge, then maybe you get faster inflation. If there is faster inflation then companies that are producing especially nondiscretionary and consumer items have the opportunity to raise prices faster.

It's a process that has to play out over perhaps a couple of quarters or a couple of years in order to have everything being recouped, but these are not newbies. A company like Unilever or Philip Morris has been operating in these emerging markets for a very long time. They know what they're doing. They understand the risks that they have to take, and they understand the risks that they can control. As long as on an internal basis, you see that they're maintaining their competitive strength, both of these being wide-moat companies, wide economic moat ratings for these names, and you get very generous dividend yields that should not be jeopardized even if the currencies continue to slide here in the short term, I think that's a pretty good buying opportunity. If everybody else on Wall Street wants to chase whatever is hot in the next 15 minutes, give me what's going to be hot over the next 15 years. I'll take that trade all day.

Glaser: You mentioned Unilever and Philip Morris International. Those are your favorite opportunities in this space right now?

Peters: They are two of them. Clorox is another name I like. Clorox actually is mostly a domestic staples company, but they do have some exposure in Latin America. In Venezuela, it looks like they're losing money; Argentina, the currency depreciation has hurt. So at the margin, it's shaving a little bit off of Clorox's near-term earnings-growth potential, but if you're concerned about these emerging markets, Clorox is a good name to consider. It probably won't have as much growth as a Unilever over the long run in terms of the top line. I think that they can make up for that with their high margins, with their really impressive cash generation. You're still looking at this as being a stock that can deliver total returns in the 9%, 10%, 11% range over the long run.

But if you go with Unilever, you've got perhaps some more variability in the earnings and dividend growth from year to year, but I think you do a little bit better with Unilever. I like them both, risk-adjusted I think they're kind of six of one, half dozen of the other, but it's a good reference, I think, when you're considering the emerging-markets exposure. You just won't get as much growth without it over the long run.

Glaser: Josh, thanks for your picks today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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