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3 Dividend Picks for Your IRA

Josh Peters, CFA
Jeremy Glaser

Note: This video is part of Morningstar's February 2015 Tax Relief Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's Tax Relief Week here on Morningstar.com. I had a chance to sit down with Josh Peters--he's the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy. He talked to me about why dividend payers could be a good choice in an IRA, and he also shared three top ideas.

Josh Peters: The advantage, I think, of concentrating your dividend payers in an IRA is that you have the ability to reinvest all of your income, perhaps for decades, before you need to start making withdrawals from the account, and those dividends can be compounded tax-free--not that there's anything wrong with receiving dividends and having to pay some tax on it, especially if you are, in fact, withdrawing that from your portfolio. But in an IRA where you can reinvest, I would say to look at situations that perhaps are going to take a long time to play out but have a very good chance of playing out effectively and where valuations at the beginning of your investment here would be most attractive.

I would start with [General Electric (GE)]. This is a name where, honestly, I worry about having eggs thrown at me when I pitch it in front of audiences. The stock has had a really rough 15 years of going down and then going down and then rebounding and then kind of going nowhere here since the crash. But what's going on behind the scenes is that CEO Jeff Immelt and his team are radically reshaping the portfolio of businesses that are paying these dividends.

It's going from more than a 50% position in financial services accounting for the earnings that, in turn, fund the dividend back prior to the crash to a 75%/25% split in favor of their industrial businesses. And that's where their moat is widest, where the company is most efficient, where it's going to generate the highest incremental returns on capital. This transition has been kind of a drag because you take money, repatriate capital out of financial services, and look to redeploy it in your industrial business. There is a little bit of a timing mismatch. You're not immediately going to replace all the earnings, but GE has grown its dividend every year through this transition, and now that they are looking at 2016 being the year where the mix levels out, I think you are going to have faster earnings growth and, with that, faster dividend growth.

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And upfront, here, this is one of the stocks in a market that's kind of pricey that trades at a big discount to our fair value estimate and offers a dividend yield that, some days recently, has been pushing up toward the 4% mark. It's not going to turn around in terms of popularity overnight, but I think it's going to serve people very, very well over the next 10 or 15 years as opposed to the last 10 or 15.

My favorite opportunities are the ones that are sort of tangential. I own Chevron (CVX) and Shell (RDS.A), but at the same time, a much lower price of oil is certainly going to take a toll on dividend growth from these companies. In fact, Shell probably won't raise its dividend at all this year. So, I like to look, perhaps, in some areas like midstream energy and pipeline and storage operators.

Spectra Energy (SE) is my favorite among those names right now. Most of the business at the SE level is actually its master limited partnerships, Spectra Energy Partners (SEP). I love SEP. It's a pure play on natural gas transmission with very, very reliable cash flows and a good backlog of growth projects. Spectra Energy Corp., ticker symbol SE, has some other businesses, some gathering and processing, that are a little more sensitive to energy prices as well as a utility up in Canada. But these assets eventually, I think, when you look down the road, are likely to be spun off or otherwise monetized. And even with them in the mix, I think this is a company that can generate high-single-digit dividend growth over the long term, even if energy prices stay relatively volatile. And here is a name that yields over 4%. So, I'm not making a bet here that oil prices are going to snap back immediately. It's much more of a play on consumption, frankly--that people in North America are going to continue to consume natural gas. I think that's a pretty good bet.

Echoing with the theme of transition and transformation at GE, I like Procter & Gamble (PG) for some of the same reasons. The biggest drag on the company's results here lately has just been currency, which is hurting just about every multinational company that's out there. That has, frankly, set them back a little bit relative to the goals that they had hoped for for profits by this stage. But I really like the fact that they are becoming a leaner organization. They are trimming out the second- and third-rate brands in their portfolio to concentrate on a smaller core number of brands that can get a lot more attention, a lot more R&D and marketing focus, a lot more of management's attention. And with that tightening up, I think it's going to have somewhat of a negative effect on sales just because, as they sell off some of these ancillary business lines, business won't be as big as it was before; but it should be more profitable, it should generate more cash, and that sets the stage for faster growth over the medium- to long-term time horizon.

The stock right now yields a little over 3%. For a business this high quality, this defensive, I think that yield is pretty attractive and the stock continues to trade at a discount to our fair value estimate. Most of the companies that I look at in staples are now looking kind of expensive. P&G is sort of an outlier there. And if I'm going to look at something for my IRA--something I want to own for many, many years, maybe decades until I need to tap that capital--initial valuation is a pretty good starting point, if it's low, to jump off and have good subsequent returns.

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