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3 Questions for a Solid Dividend Portfolio

Josh Peters, CFA

Note: This video is being re-featured as part of Morningstar's December 2014 Guide to Better Investment Picking special report. This video originally appeared in April 2014.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here with Josh Peters. He is editor of Morningstar DividendInvestor, and in that role he manages two real-money portfolios. We're going to talk about his strategy and why it has been so successful.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start with how you started to become focused on dividends and dividend investing. What about this part of the market attracted you to it?

Peters: You always hear that owning a share of stock is owning a small piece of the business. But most investors frankly don't really treat it that way or seem to believe it, and a lot of companies frankly don't seem to act like they're shareholders or actual owners and partners in the business with them. But dividends are what bridge that gap. They really connect you directly with the underlying results of the business.

What you find is that companies that pay dividends tend to outperform, particularly on a risk-adjusted basis over longer periods of time because they tend to be more mature, have better established businesses, and stronger finances, and the dividend helps anchor the price of the stock to some sense of value. There is less chance of making a really bad mistake in terms of valuation.

And then finally, the income is so practical. For retirees, certainly who are making withdrawals from their portfolios to have this income that's flowing into your accounts, that doesn't depend directly on whether the stock market is going up or down. That's hugely valuable. But younger people, too, people who don't necessarily have withdrawals coming up anytime soon, can benefit from this strategy, as well. You can reinvest your dividends, and you get the opportunity to allocate the capital as opposed to the companies taking all of those opportunities away from you as an investor and hoarding their cash and calling all the shots.

Overall, I think it provides a very strong investment strategy especially for individual investors.

Glaser: When you're actually building a portfolio of these stocks, though, is it just a matter of looking for the highest yields and buying those? How do you actually go about evaluating these firms to decide which shares you'd like to buy?

Peters: Well, my favorite companies tend to be sort of in the middle of what dividend investors look at anyway. The yield of the S&P 500 is still historically low at about 2%, but there are stocks out there that yield nothing, certainly many like a Google or Berkshire Hathaway. And then there are dozens of companies even in this low-interest-rate environment that seem at least to offer yields of 10% and up.

I don't like the really low yielders because obviously then I'm not getting the income, and that comes first. I don't like the really high yielders either because that is the market expressing that dividend is not likely to be safe. There is no free lunch, and if you see something that looks like it yields 10% or 12%, 20%, chances are that dividend is either just inherently structurally very risky or that the market is already pricing in a significant cut to the dividend.

So what I like are companies that yield say 3%, 4%, 5%, maybe 6%, but are also able to maintain good dividend growth over longer periods of time. The Dividend Drill process that I use to analyze individual companies, it works right off of this math. The first question is, "Is the dividend safe?" The second is, "Will it grow, which combines the growth potential of the company with the willingness of the management to pass that growth along to shareholders in the form of higher dividends?" And then I ask, "What's the total return?"

I figure if I pay an appropriate price for a stock, hopefully a cheap one, but at least a fair price for a good company, then the dividend yield plus the long-term dividend growth rate should roughly approximate my total return because as that dividend rises, the stock price should follow it up certainly not in lockstep, but over a longer period of time we're going to have that correlation. And in this type of process, you're connecting the analysis and the companies that you choose right back to your individual investment goals.

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Glaser: Can you give us an example of purchase that you have made either recently or in the past that you think kind of exemplifies this process and that's done well for you?

Peters: One that I made recently here is Coca-Cola. This is actually the second time that I've owned Coke in our Builder Portfolio, which has, say, 3% to 4% yields, but faster growth. We also have our Harvest Portfolio, which looks for a little more yield, and a little less growth.

When I last sold Coke back in 2007, the shares yielded only 2.2%. They were kind of expensive. Now a couple of years later the company has continued to raise its dividend, and it has every year since 1963, and in fact, the growth rate hasn't even diminished that much compared with the company's longer-run history. But I was able to buy the stock at 3.2% yield, a full percentage point higher.

I don't think that this is a double-digit growth story, and there's a lot of negative sentiment out there about people backing away from sugary drinks or maybe even diet sodas, but people forget this is a distribution and marketing engine. It doesn't need to just take the Coke in red cans all around the world. It can take any kind of beverage. As long as we don't all go back to drinking tap water, I think Coke is going to continue to grow and continue to capture more share of global beverage volume.

With that I am looking for 7%-8% long-term dividend growth. When I can buy a stock like this with such good, low risk characteristics at a 3.2% yield and pick up the potential for that growth, I'd settle for 5% growth. If I can get 7% or 8% growth from Coke over the next 10 years, I think I'm going to be able to do very well on this stock.

Glaser: What are some of the big risks of the strategy?

Peters: The number-one risk every day, every minute of every day, is that your dividend gets cut. And you have to avoid those dividend cuts well out in advance because typically once everybody realizes that a dividend is going to be cut, the stock has already fallen dramatically.

First Energy, a big utility company, ticker symbol FE, is good example. Shares had already lost a very large chunk of their value before the dividend cut was announced. So you have to look out far into the future and say, "Is this a business that is stable or growing? Is it a balance sheet that can afford some shorter-term problems? Is the commitment of the management team there to preserve the dividend through thick and thin, if their backs aren't absolutely up against the wall?"

Hopefully you don’t buy a business that ever gets that into that bad of a position in the first place. You got to avoid those dividend cuts.

After that I'd say another risk is not getting the dividend growth that you would expect, which has a significant impact on valuation very often. Many years ago, I bought Johnson & Johnson, actually one of my very first purchases. When I bought it, it had yield less than 2% and the company's growth rate then slowed, and that meant that I didn't get that yield-plus-growth type of total return. It was about eight years before I saw any capital appreciation on balance at all. Now the stock being much more reasonably priced, I am getting that benefit.

Another risk that a lot of people worry about, but I tend not to worry about it as much is interest-rate risk. There's this idea out there sort of conventional wisdom that nobody wants the dividend payers unless interest rates are going down. If rates are going up that's negative for bond prices certainly and is perceived to be negative for dividend payers. But I think people overlook the fact that stocks even with good yields are not in fact bonds. And from any dividend-paying stock that you pick you should try to get at least some growth, so that then you're outperforming inflation and hopefully outperforming what you could get from long-term Treasuries, as well.

And yes, I do take some rate risk especially with some stocks like utilities whose growth rates don't change a lot depending on economic conditions. But when I take that rate risk, I also get the income. In fact, I can't get a good rate of income without taking some interest-rate risk, but I'm also limiting my exposure to economic disappointments.

So I feel like I'm getting a two-for-one deal. I'm getting the income and I'm getting less sensitivity in an uncertain economy as the economy is always uncertain. I'm willing to take some interest-rate risk for that.

Glaser: Are there certain market environments that you think this strategy is going to do better in and some where it is going to underperform?

Peters: Last year was a good example; the stock market did very, very well. The S&P 500 returned over 30%. Both of my portfolios, in 2013 lagged the market; they both had 20%-plus gains. But it was one of those years where people were much more interested in cyclicals and more speculative stocks. So-called momentum stocks got really hot at the end of the year. And I'm not going to outperform every year, and I am not even going to try. That isn't even one of our stated objectives.

Instead, I look to manage that stream of income to finds safe dividends that can grow, that can provide the basis for lasting capital appreciation. And when the market kind of flattens out or you see declines in the market, typically these stocks outperform. And on balance between those periods of outperformance and underperformance, the stocks do better than the market. That's exactly what we've been able to do, since inception for our portfolios, is beat the S&P 500 with a lot less risk without even having "beating the market" being an explicit objective.

Glaser: Josh, thanks for sharing your strategy with us today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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