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Dividend Investors: Time to Rethink Tech Stocks?

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters--he is the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy. We're going to look at tech stocks and how dividend investors should think about them.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, let's start with talking about the tech sector as a whole. It's not one that's known traditionally for paying generous dividends. Do you think dividend investors should even bother taking a closer look at tech names?

Peters: I think it's always a good idea to have an open mind. And certainly for your traditional income-oriented investor who is probably going to have a lot of staples stocks, a lot of utilities, a lot of REITs, it's nice to have that option for diversification to get into some other sectors of the economy. But what you have in those traditional dividend-paying areas of the market that you don't necessarily have in tech is a long-run stable state of reliability, whereas in technology, business models are going to have to change faster--and maybe or maybe not successfully--in ways that General Mills (GIS) just doesn't face. I'm pretty sure that Cheerios are going to be the same 50 years from now as they were 50 years ago as they are today. You can't really say that about tech companies.

Glaser: So, do you think that it's OK to just ignore a whole sector or does that kind of throw off your portfolio?

Peters: Well, some people--especially institutional investors or people who are being measured closely against benchmarks in the matter of a year or even three months at a time--if the tech sector takes off and you have no exposure to it, then you're probably going to be left behind. But I prefer to think of it in terms of what kinds of income characteristics do these companies have, are they meeting my income objectives--both above-average yields, which tech stocks still as a whole do not offer, as well as income growth. We've seen a lot more dividend increases in tech over the last couple years; but still, the yield of the sector overall is about 1.5%--well below the market average as well as my usual minimum of 3%.

So, if you can't get what you're looking for from a dividend perspective from these companies, I don't think it's essential to own them. The way I like to look at them is this: Most of them, despite having very high profit margins in a lot of cases or gigantic hordes of cash, are cyclicals. So, I'm not sure that I would look at an Intel (INTC) or a Microsoft (MSFT) that much differently than I would look at a General Electric (GE) or in Emerson Electric (EMR) or UPS (UPS).

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Glaser: Let's look at an individual tech company, then. How about IBM (IBM)? It's a favorite of Warren Buffett. They recently increased their dividend. Do you see anything interesting there?

Peters: This one is interesting, in part, because Warren Buffett is chairman of Berkshire Hathaway (BRK.A) (BRK.B), a company that doesn't pay a dividend--which I have no problem with. This is the only case where I don't mind if a company doesn't pay a dividend because Warren Buffett can, in fact, be expected to reinvest all of his company's earnings profitably. I wouldn't say that about any other company in existence.

But he had also said, when he started buying IBM, that he loved the buyback program and hoped that IBM's share price would go down over time--not forever but at some point along the way--so that the company could get more shares repurchased for the same amount of money, and that would effectively increase Berkshire's stake in IBM that much faster as a result.

Well, the share price has slipped; you've actually had a change in the capital-allocation policy at IBM. This year, buyback spending is at a 10-year low, but the dividend was just raised another 18%. Now, the stock yields 3%--that's, I think, a pretty good yield. So, there, I have fewer qualms about the dividend policy and the capital allocation of IBM than I've had in years.

The problem is that, operationally, I still like to have growth in the business as well as a reliable outlook--five, 10, or 20 years out. And with IBM right now facing a lot of technological changes [such as cloud computing, the outlook is uncertain]. Cloud computing is something I barely even understand. I have an idea in my head of what cloud computing is, but I'm much more comfortable with regulated utilities and food stocks and things like that. [However,] I understand that there's a threat and that IBM may have to go through a period where it gets smaller until it has reformed itself around the new technological landscape--and it might be less profitable when it gets there--and is then able to start growing again.

So, with that, our fair value estimate now carries a Morningstar Uncertainty Rating of high. Even though we still think the company has a wide economic moat, it has a negative trend. These are signs that suggest that even as dividend policy has gotten better and the yield has become more generous for IBM, the business is now no longer as reliable as an income investor would want it to be. So, you've had these two pieces moving in opposite directions. You really need to have both a good business and a good dividend policy in order to expect a dividend-paying stock to do well.

Glaser: Another company that has been increasing its return to shareholders is Apple (AAPL). Do you think that there is a case in the future in which you could see Apple as a solid income holding?

Peters: That's even harder to envision, actually, than IBM. And I'm a huge fan of all things Apple. I don't think I'm going to go for the [Apple Watch], but I've got in my house multiple iPads, iPods, iPhones, and a giant iMac on my desk. I'm just Apple through and through. But as an investor, I look at their situation and say, "They've been on a terrific roll. They've got huge market share in smartphones and incredibly high profit margins, but can these things last?" And there are a lot of reasons to think that Apple is doing the right things in order to maintain a competitive edge and to be able to preserve the edge that it has developed here over the last couple of years; but compared with a food company or a utility or Johnson & Johnson (JNJ) even, I just can't have the confidence that they will be as or more profitable five years from now as they are today. You have to have that underlying confidence in the resilience of the business. [You need to have confidence] that you're not going to have something that's very hard to predict--changes in technology and consumer preferences, let alone Apple's current status as a hit factory.

You need to be able to have a lot of confidence that that can last for a very long time. Put it this way: Apple, right now, yields 1.7%, give or take; if the dividend didn't grow, you are looking at more than a 50-year payback at just the current yield to get your original investment back through dividends--not that the dividend won't grow. I think Apple's dividend will grow. But just as a frame of reference: Over a 50-plus-year time horizon, I have no idea what Apple is going to look like. General Mills yields more than 3%. You could think of it as a 30-year payback--again, with no growth, and I do expect dividend growth. Thirty years from now, I'm pretty sure there's still a packaged-food company with a solid portfolio of brands throwing off a lot of free cash flow that they return to shareholders with dividends.

Glaser: Josh, thanks for talking with me today.

Peters: Thank you, too, Jeremy.

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

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