Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Josh Peters, the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy, recently made some trades in his Dividend Select portfolio. He's here to share some thoughts about them.
Josh, thanks for joining me.
Josh Peters: Good to be here, Jeremy.
Glaser: Can you start by telling us a little bit about your philosophy and how you decide when it's time to execute a trade or when you want to make a move in your portfolios?
Peters: I try to stay fully invested as much of the time as possible. To me, you look at cash as, one, an asset-allocation decision, which is something that is more or less independent of what's going on with individual stocks in your portfolio. You just want cash as part of your general financial plan or security blanket--that kind of thing. Or, two, it's something that you back into because you've sold some stocks that you had to get rid of essentially for defensive reasons--because you just didn't feel like the dividend was safe or you weren't comfortable with the valuation--and you had nothing to replace it with.
So, at times, I have held some cash for that reason. But in my model portfolio, I want to show how I would invest all of the capital that is available for me to work with. Within that framework, it turns into a pretty simple process: Does my least-favorite current holding match up better or worse than my next-best new idea that I don't yet own? I look at valuation, especially our price/fair value ratios, which can indicate that perhaps a stock I own is expensive and I can replace it with something that's cheaper. I look at dividend yields. Those are very important. I typically don't want to sacrifice dividend income in order to make a trade, if I can avoid it. And finally, I look at growth potential. The ideal trade, for me, is to get a higher-quality business at a cheaper price that pays a higher yield and will grow its dividend faster. That kind of opportunity doesn't come along very often; usually you have to give something in order to get something.
[It's better to look] at it in that framework. Rather than thinking in terms of stocks are high or stocks are low or needing to sell this or buy that--making a lot of independent decisions--instead it's better to pair things up. I think that helps you make better decisions for the portfolio and keeps the portfolio on track as a machine, if you will.
Glaser: Let's look at some of those changes, then. One is that you sold Clorox (CLX) and bought Compass Minerals (CMP). Why did you make that swap?
Peters: That was not actually an easy one on the sell side because Clorox is a business that I really admire. Both of these businesses carry wide economic moat ratings. In the case of Clorox, you have an incredible brand portfolio. They really dominate small niches like bleach or water filters. They own Kingsford. Can you even name the number-two brand of charcoal? But they've had trouble growing the business because it's mostly in mature markets like North America. The foreign exposure that they've had has been in Argentina and Venezuela, which has not really helped on the growth front at all. They generate a lot of cash flow, but the dividend has grown faster than the earnings. Now, the dividend growth has slowed down, and that started to make the stock look expensive. It traded above our fair value estimate and got up to where it was 24 or 25 times earnings. I felt that, even for a very defensive, stable business, this is kind of a rich price.
Compass is a name that I'd owned before and was one of our most successful investments from the last decade. It's the dominant rock-salt miner in North America and also a business that throws off a lot of free cash flow. But it's much more variable since the bulk of the salt goes for highway de-icing, and you might have a dry, warm winter that doesn't need a whole lot of de-icing salt. And then the next winter could be very wet and cold and icy. So, there is that variability in the business. That, essentially, was what I was taking [in this swap]--more variability in the cash flows and the earnings behind the dividend.
But I was able to pick up a higher dividend yield. I also expect that Compass can grow its dividend somewhat faster, in part, because they have something that Clorox lacks, which is the opportunity to put a lot of cash back into the business that will yield a good return. Clorox generates a huge amount of free cash flow because there's just not very much to juice the growth. You can't sell a lot more bleach in existing markets. You can tweak the products here and there or maybe charge a little bit more, but there's not a whole lot of advantage there.
Compass has a very good story in cost-reduction projects at its mines, where they can put capital in and increase their earning power and earn a very good incremental return. There, I expect a couple of percentage points a year, at least, or more of dividend growth over the longer term. And here is a stock that we thought was reasonably undervalued as opposed to Clorox being overvalued.
So, I did have to give up a little bit in terms of variability. But even considering that, is Compass a riskier company? Variability is not the same as risk. Weather has a tendency to mean-revert over a couple of years. And its franchise, I think, is very secure, in part, because of the cost advantages of their mines. So, their earnings are quite durable, if you want to think about it over the space of a couple of years--even if there is more year-to-year variability. That might mean a little more variability in the stock price, too. But adding up all the other advantages that weighed in Compass' favor, I felt like the time had finally come to make the swap.
Glaser: Another move you made was selling GlaxoSmithKline (GSK) and buying Enterprise Products (EPD). What drove that?
Peters: That one was motivated--to an even greater degree than in the first case--by wanting to get out of Glaxo. It was not easy to sell a business as high quality and that, frankly, had treated me as well as Clorox, but Glaxo has actually been one of my worst calls over the last couple of years. Their earning power has really deteriorated, and they haven't been able to maintain their respiratory-drug franchise. It's come to the point where, this year, even their core earnings--the prettiest, most dressed-up version of their earning power--are not likely to cover the dividend rate.
Now, they're hoping to improve on that next year and get some growth in future years, but these are all promises, and I don't have a margin of safety protecting that dividend in case something additional goes wrong. And it's not impossible for a pharmaceutical company or a big health-care company to cut its dividend. Pfizer (PFE) did it; many years ago, Schering-Plough did it. It can happen. I don't think that's the most likely case; but when the yield on the stock got well into the 5% range, this is the market saying there's not a whole lot of confidence here in, certainly, the growth of the dividend--which, as management says, is on hold--and maybe even the stability of the dividend. There is not a cushion there for much more to go wrong for Glaxo. And hopefully, everything that can go wrong has gone wrong, but I like to preserve that safety margin.
Enterprise is a very, very different business, being an operator in midstream energy. It really has an outstanding set of infrastructure assets. You might almost think of it as the Mississippi River, which drains water from all over the midsection of the country and brings it down to the Gulf Coast and Louisiana. Enterprise's pipeline system does the same, only for natural gas liquids, picking them up from all the different places that they're being produced in the United States and draining them down into Texas and Louisiana where they're used in chemical manufacturing or exported.
Now, there is going to be some more variability in this business, too, but what I have here that I didn't have with Glaxo was a margin of safety. Enterprise tends to cover its distribution by about 1.4 times--call it a 70% payout ratio, give or take. So, they can afford some of the variability that is inherent in the business and the sensitivity to the commodity prices. They can have that happen, and they can continue growing this distribution at a nice, steady 5%, 6%, or 7% type of pace. We think 6% annual growth is likely over the next couple of years. And it's been beaten up. It's a much cheaper stock. Even though we sold Glaxo at what I thought was a little bit of a discount--which I wasn't thrilled about--I was was able to buy Enterprise quite cheaply relative to our fair value estimate. The best part of all is that, in this kind of a market, let's say you buy a stock with a 4.5% yield, and the story starts to go south. The stock price goes south, and now you are selling it at a 5.5% yield--that's essentially what's happened with Glaxo.
So, how can you replace 5.5% with something that is better? Usually, as you go up in yield, beyond a certain point, the quality of the business and the security of the dividend get worse and worse. But in the case of Enterprise, the panicky selling that we've seen in some corners of the energy sector has unfairly beaten up what we think is one of the highest-quality operators. And one of the few. I'm still pretty skeptical of many midstream energy companies. I think before the cycle is over, we're going to see some partnerships and other companies in midstream energy--not even just oil producers--cutting their dividends and distributions. But Enterprise is on very strong ground and, at the price I paid, I almost matched what I was getting from Glaxo.
So, I didn't have to take a hit on income; yet I picked up, I think, in quality. I picked up growth that, I think, Enterprise can provide even in this tough circumstance--as opposed to Glaxo saying it's on hold at best. And I've gotten that margin of safety restored on the cash flow to protect the dividend.
Glaser: Josh, thanks for sharing your thoughts on these trades today.
Peters: Thank you, too, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.