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Peters: Income Picks I'm Adding To

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He's editor of Morningstar's DividendInvestor newsletter and also our director of equity income strategy. We're talking about where he's finding values in the market today.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: It's probably not a big secret to any viewer that the market isn't exactly affording a wealth of opportunity right now. How are you thinking about where to deploy any money you might have in your portfolios--be it reinvesting in companies that you already own, looking externally, holding cash--how are you making that decision?

Peters: It ain't easy. I'll make that abundantly clear. Overall, we think that the market is fairly to slightly overvalued at this point here in the U.S. Certainly, dividend yields are very low. There's this recurring debate. It seems like every day there's someone in the papers or on the web or on TV asking, "Are valuations stretched? Are we at the point of a bubble?" I don't think we are there yet, but the converse is also not true. You can't find bargains. They're just simply not in abundance like they were even a couple of years ago.

So, getting and staying fully invested is kind of tough. Earlier this year, for example, back in March, I took a look at my portfolios and I decided to call out a few names where the characteristics had changed--I thought for the worst. These weren't businesses I really felt comfortable owning for the long term. So, now I've got a pile of cash. How am I going to redeploy it? I hoped to find some new individual stocks to buy to replace those names, but it was just very difficult.

What I did, instead, was look at the remaining names in my portfolio and ask, "What can I add to? What can I do with those names to bring their weights up and my best ideas a little bit? Peter Lynch has pointed out before that the best stock to buy may be the one that you already own. I think the key point is this: You want to make sure you're not concentrating your portfolio so heavily on just one name or just one sector; you don't want to leave yourself exposed to those one-off risks associated with just one sector or just one stock.

It's not a bad thing to go, for instance, from owning 25 stocks to 23 or 21. I think that's better--that's preferable to hanging on to companies that maybe you're not comfortable with anymore--whether it's the valuation or the fundamentals of the business--just because you're trying to maintain some specified number of stocks.

Glaser: Let's take a closer look at some names that you've added to recently--the first being General Electric. Why do you still like GE?

Peters: This is a very straightforward dividend-value proposition. The stock has been yielding over 3% for some time now; that's half again or more than you can get from the market overall. The businesses themselves--especially on the industrial side--I think they're world-class. They're not going to be on fire at every point in the cycle. I think, frankly, they are structured in a more defensive posture. They don't ride the cycles in their fields nearly to the same degree as some other companies might. So, maybe some other companies look like they're doing a little bit better right now; but since 2010, [GE's] dividend has been on a nice recovery track. It was cut back in 2009. That was really painful. But I'm not going to hold that against the stock--with management having just demonstrated both the wherewithal to bring that dividend back and grow it over time as well as the determination to do so.

I think it's pretty reasonable to expect long-term dividend growth. I'd say about 8% per year. And you almost wind up, I think, with bond-like consistency from a company like this over longer periods of time. I know people remember when the stock was worth $50 or $60 almost 15 years ago--back in the bubble days. A lot of people just don't want to hear about GE anymore. They just hate it. I think that creates opportunity. And when you're being paid to be patient--to the extent that you are with GE right now--I'm willing to be patient, even if the stock is not popular.

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Glaser: How do you feel about [GE's] spin-off of that North American consumer-finance business? Do you think a move like that is a step in the right direction.

Peters: I think it's absolutely a step in the right direction; but as a shareholder, you have to recognize it for what it is. It's very easy--as GE proved under previous management--to grow a finance business very, very quickly and book lots of earnings of almost whatever quality you're willing to tolerate.

Jeff Immelt has been slowly--because it's a giant battleship of a company--turning the mix of the business back toward the industrial operations, where we think its moat is widest and where the best long-term return potential is. But as you are shrinking--and they are shrinking the capital services unit--you can't expect to immediately redeploy that capital over in the industrial side at an equal return so that it is earnings neutral.

In the near term, this mix shift--bringing down finance and bringing up industrial operations--it's a drag on growth, especially relative to some of the competitors that don't have financial businesses--like United Technologies, for example. But what you're going to wind up with at the end of this process in a couple of years, according to GE, is a mix of earnings that is 75% industrial and the remaining 25% will be financials, which is going to be there to support sales activity in the industrial business. It's essentially going to shrink GE Capital back down to where it always should have been.

So, I like this hand-off to the industrial units, but I understand that it's a process. And it's a good thing that you can pick up that additional percentage point or so of yield relative to the peer group. I think that makes it an attractive situation, even without that much near-term growth.

Glaser: How about Chevron? Another name you've added to.

Peters: Chevron is interesting. You see so many companies--even large ones--that have hunkered down. They're trying to maximize free cash flow and then maximize the share buybacks or just hoard the cash. What you see at Exxon is that's essentially what they're doing, prioritizing share repurchases with their cash flow. Chevron has been really lucky with the drill bit. They have been really smart and really lucky with it over the years. Now they have this vast opportunity set to go out and develop. Now it's costing a tremendous amount of money, $40 billion a year roughly. But you're going to come out of another period of investment in transition--kind of like with GE, where you're going to have much faster growth in production than you're going to see from its immediate big-oil peer group or super-major peer group. And you're going to get that, all the while collecting a dividend yield over 3%. Chevron is able to do both. They are able to pay the big dividend and continue to grow it, even as they invest heavily for the future to drive that future production growth.

So, I certainly have respect for Exxon as an operator and for some of the other super-majors too. Exxon's strategy, you could even argue, is a little less risky than Chevron's just because if you are buying in shares, you don't have to worry about the future prices of oil for that capital you've deployed. But I like the companies that have both the ability and the willingness to invest for the future. I expect to get a better return on capital through faster dividend growth from Chevron over the long run for that reason.

Glaser: In the utility space, what do you like about Southern?

Peters: Southern, traditionally, has been really the go-to name in regulated utilities. Certainly, it's very large with substantial operations in four states. Even more importantly, they've had terrific regulatory relations in those states. You have a real virtuous cycle where regulators allow them to earn higher returns, frankly, than most utilities get; but Southern then has an incentive to invest more at that higher return. When a utility makes good investments, it should actually cut the cost of power to consumers because the utility profit is a pretty small piece of your bill. If they're more efficient in the rest of their business as a result of having that little more incentive, then it's going to save customers money. So, Southern does have a lower cost of power for its customers than the national average. And that below-average cost of power, in turn, means that regulators can justify the higher allowed returns.

What you've had enter into this process in the last couple of years are two big projects. One of the projects is adding a couple of nuclear units at Plant Vogtle in Georgia. They're gigantic, long-running, expensive projects that they have managed very well so far, but there's still some risk until they are completed. And those two units both won't be done until 2018.

The more problematic project has been a novel plant that would capture and store the carbon dioxide it emits from a coal gasification process in Mississippi. That project was based on untried technology, it's wildly over-budget, and Southern is having to eat the additional costs. They volunteered to cap the amount that they are going to try to recover from ratepayers in Mississippi, as a result; but that's the kind of sacrifice they are willing to make. They don't want to go and litigate the matter in the State of Mississippi if they don't have to or try to force ratepayers to pay for some mistakes and bad luck that they've had. Instead, they want to preserve those relationships with the utilities.

At this point, the latest information we have is that the Kemper County project that we've been talking about should be done next year. I think, once it's done, that's going to lift a cloud that has been hanging over the stock's valuation here. And, through it all, I think you are going to get consistent dividend growth in the low 3% range. It doesn't sound like much--you can certainly find more growth elsewhere if you look--but getting a yield close to 5%, to me, is a pretty compelling total return.

Glaser: Josh, thanks for the update on your portfolio holdings today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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