Where Dividend Hunters Should Take a Peek (and a Pass)

Christine Benz: Hi. I'm Christine Benz for Morningstar.com.

A healthy dividend is attractive, but not every company with the juicy dividend yield is worth biting on. Here to discuss where he is spying dividend opportunities in the market, and also some key areas where he is taking a pass, is Josh Peters. Josh is an equity strategist and also editor of Morningstar DividendInvestor. Josh, thanks for being here.

Josh Peters: Good to be here, Christine.

Benz: So let's just set the stage, Josh, and talk about some of the key sectors where dividends are concentrated?

Peters: It's really remarkable how lopsided the dividend income is in the U.S. stock market. Within the S&P 500, which has a yield a little bit over 2%, you've got a 100-odd companies that pay nothing at all, and then you've got a group of 26 companies that actually account all by themselves for half of the total dividend income of the index, about a $106-$107 billion out of $213 billion total. These top 26 companies are actually kind of hard to ignore if you're going to start out on a dividend investing strategy.

Benz: So one of the key areas where they are not is in the tech sector, but then let's move on to some of the areas where they tend to concentrate, and the telecom sector has historically been one, and currently some of the richest dividend yields in the S&P 500 are there. So let's talk about that area and whether you are finding any hint to buy there?

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Peters: Telecom has just been a tough area for me to really be convinced of the total return prospect. I said total return prospect, not dividend yield alone. I think no matter how you are trying to use dividends in an investment strategy, you really need to keep the focus on total return. A big dividend that doesn't ever grow probably isn't going to work real well for you. A tiny dividend that grows very fast probably isn't going to work that well for you, either. You really need that combination of yield and growth.

Now for AT&T and Verizon, two largest companies by far, and for some of their smaller rivals like CenturyLink or a Windstream, you've got very good yield, 6% and up, but I'm really kind of unconvinced still about the case for growth.

In order to buy a stock like that, I'm going to have a really good degree of confidence that the dividend is going to grow at least as fast as inflation. If it doesn't, I might as well go buy a corporate bond. And in the case of telecom, you just haven't had an expanding pool of revenues and of services. It's been very slow to grow. It's very capital intensive. The company's payout ratios have been very high, and then it makes me wonder, can I really get better than a bond-like return since I am taking stock-like risk?

Benz: So yield piece is there, the growth not so much. Another sector I'd like to discuss is health care, another historically rich source of dividend yields. You do have a couple of positions in your portfolios in J&J and Abbott, but you're passing on some of the higher-yielding companies in the sector. Can you talk about why?

Peters: Again, it's kind of odd you know that I picked the lower-yielding stocks in this particular group that is known for its yield, but it really comes back to that focus on total return. If you look at the top four of the six companies, domestic companies--Pfizer, Bristol-Myers, Eli Lilly, and Merck--their dividend growth prospects are really quite poor, because their earnings growth prospects are quite poor. All four of them are facing significant patent expirations over the next couple of years. You know that a certain amount of revenues are going away. Now they've been investing very heavily, working very hard to try to create new products to fill that gap, but those are uncertain sources of revenue, so you really don't have a lot of confidence in how exactly it's going to shake out.

In the meantime, a lot of the money that isn't spent already on these companies' dividends will probably go to pay for acquisitions of smaller drug discovery and biotech firms to try to just keep the business steady, keep it from shrinking.

Now you contrast that with Johnson & Johnson and Abbott Labs, yields are a little under 4%, as opposed to almost 6% in some cases for some of these stocks, but their growth prospects are much better.

I'm not going be at all surprised if these companies can grow their dividends at 8% to 10% a year over the next five, maybe even 10 years. They've got better diversity, they are already passed some of their patent issues, and they can allocate capital into a wide range of different opportunities. I really look at those as being the superior long-run total return prospects that might actually generate more income, five or 10 years out, than these higher-yielding stocks because of that superior dividend growth.

Benz: Okay, good to know. So, last I want to briefly touch on the technology sector. And even though that has historically been a stingy sector when it comes to dividend yield, some of the big bellwethers do pay at least some yield, but you're not particularly keen on them. Let's talk about why.

Peters: The contribution of the tech sector actually is meaningful, but it's only because the companies are so large. Intel, Microsoft, and IBM are huge, huge companies, so they pay out billions of dollars a year in dividends; it's just not a lot in relation to their stock prices. Even the best dividend yields in the tech sector tend to be kind of in that 2% to 3% range.

Intel is at the high end of that, actually above the high end and kind of the 3.5% area. And it is interesting that you have a world class business with a good balance sheet, dominant competitive position able to provide this kind of yield. I just worry about the cyclicality. Intel is kind of in 2010 what U.S. Steel was in 1960 or 1970. It's enormous, powerful but very cyclical, and you need an extra margin of safety, which I mean a cheap price, in order to feel comfortable for it.

Some of the other companies, just where is the beef? A 2% dividend yield, even in an environment where interest rates are low, is just not going to do a whole lot for me. And it's not because they can't pay out more; I'd say IBM and Microsoft are perfectly capable of doubling, maybe even tripling, their dividends overnight without having to pass on any internal growth potential. They are simply choosing not to do it. I think there is still very much a stigma associated with dividends--for old fogies, companies that don't have creative and talented people, don't have dominant markets, don't have high levels of profitability. Some of these new economy companies have all these things, they are actually in a better position to pay big dividends, they just can't seem to grow up and do it. I'd love to think at some point they might, but in the meantime let's see what happens with tax rates--if the taxation on dividends goes up. It's no coincidence that Microsoft started paying dividends back in 2003.

Benz: Josh, thanks for being here. It's instructive to hear about what you are not buying as it is about what you are buying. So, we appreciate your insights.

Josh: It's been my pleasure.

Benz: Thanks for watching, I am Christine Benz for Morningstar.com.