Peters: Fed's Giving Caffeine to the Jockey

Jeremy Glaser: I am Jeremy Glaser with Morningstar.com. What does quantitative easing mean for dividend investors?

I am here with Josh Peters, editor of Morningstar DividendInvestor, to answer this question.

Josh, thanks for talking with me.

Josh Peters: Good to be here.

Glaser: So, quantitative easing has been all the news for the last couple weeks now. People are getting very excited about the Federal Reserve's plan to buy a huge amount, $600 billion worth, of long-term government securities. What impact is this going to have on an average company that's just a dividend payer?

Peters: Well, I don't know that it's going to have that much of an effect on individual companies. I think, an analogy for this perhaps is that the economy is a tired race horse, maybe even asleep at this point. But instead of giving caffeine to the horse, we're giving the caffeine to the jockey. We're injecting a huge amount of money into the financial system, but there is no guarantee that those dollars are going to get back out into the real economy where they start to circulate, borrow, spend on consumption, on increased productive capacity; there's just not a whole lot of demand right now.

So, what we might wind up with instead, and in fact most of what the impact has been to-date ever since the Fed started leaking word that they were considering this kind of strategy back in the summer, is that asset prices get inflated. Bond prices go up, which means yields go down, and the stock market had gone up more than 15% in less than three months.

Glaser: That's certainly not helpful for dividend yields. Should we think about the potential for future inflation, we're putting a lot of new money into the system, are you worried that inflation could eat away at long-term investor returns?

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Peters: It is a real concern. The near-term inflation outlook I would describe as actually being pretty stable. If you're going to have a big surge of money supply growth, it's not necessarily going to translate into dollars walking around on Main Street right away, and in the meantime what do we have? 9%-10% unemployment, a lot of spare productive capacity in the economy, and this isn't really the 1970s. I mean, American industry is really much more competitive both with companies within an individual industry and among companies around the world that it's not so easy to just raise prices; you really have to have the competitive dynamic to permit prices to go up.

That said, once the economy starts to get on to a stronger footing, which is going to happen at some point I think, then that opens up a really risky type of outlook. We could have inflation go up. I mean, the Fed wants inflation to go up, but just a little bit. We could have inflation get out of control on the upside, or if the Fed overreacts in trying to contain the inflation it's trying to create, we could have another crash. It's really hard to get comfortable with that longer-run outlook. And I'd say once you start talking three, four, five years out, the picture starts to get really cloudy.

Glaser: We're walking that tightrope then between having just enough inflation and having way too much inflation. How should an investor think about positioning the portfolio to accommodate for all that uncertainty?

Peters: Well, I mean, as I see it, there's two directions you could go. One is you just pick one: say, I think inflation is inevitable or I think deflation is what we're headed for--a Japan style decade. If you think that deflation is the risk, then even buying long-term Treasury bonds at 2.5% starts to make sense.

But if you think inflation is the risk, then maybe you want to go and speculate in commodities just as long as you don't mind eating that gold or copper that you put into your portfolio.

What I would really like to do instead is try to stay down in the middle, and to me that really is high-yielding dividend-paying stocks that can provide some dividend growth in a wide variety of environments.

The way I think about it is that stocks in general are real return instruments. If the companies that back them have some pricing power and ability to pass inflation on to their customers, they should be able to raise their dividend growth in nominal terms as inflation goes up--you keep the real dividend. This works best, though, with companies that have strong balance sheets, that have strong competitive positions. Things like brands or patents that give them some ability to raise prices--even though inflation goes up, it doesn't mean everybody will be able to raise prices. Then in turn, and this is really the critical link, is that shareholders get to participate directly in the real returns of the business through the dividend.

Glaser: It seems to come back to competitive advantages a lot that companies having an economic moat lets them get that pricing power, lets them get greater returns seems to be an investment strategy that works for the long term?

Peters: And also to defend on the downside. The same basic competitive dynamic that lets a company raise prices in normal times--maybe not really fast, but gives it some ability to raise prices--is the same thing that might be able to prevent them from having to cut prices if deflation comes to pass.

So you have to think about managing both sides of the fence, and you have got to realize you're not going to be able to really control the market value of your portfolio all that well--if we started looking out at a wide range of outcomes, but if you're interested primarily in income, and that's what I think almost all investors will be at the end of their investment strategy, then the opportunity and I think the imperative is to really think in terms of that real dividend return that you can get from some of your better companies.

Glaser: Do you have an example of that?

Peters: One of my very favorite companies is actually one of our top holdings, a company called Magellan Midstream Partners, symbol is MMP. We think the company has a wide economic moat. It is a partnership, which means there are certain tax consequences associated with owning it, but pipelines are very, very strong business from an economic point of view. I mean, they are really monopolies in most of the areas that they operate, not unlike regulated utility, but in the case of pipelines, even though they are regulated, the prices and profits are regulated to a certain extent, pipelines like Magellan's that carry refined petroleum products and crude oil and other liquids actually receive automatic price hikes that are tied to the Producer Price Index. So there's a direct link between the inflation that the economy is going to experience and their revenues and their profitability. If inflation starts to ramp up, Magellan Midstream, which we think actually even as it is can raise its distribution may be 7% a year over the next five years, should be able to just grow its distribution that much faster.

That doesn't mean that the price of the units will necessarily go up faster. Inflation tends to be bad for valuations of all financial assets, just look back at the 1970s, but if you're buying this chiefly in search of a good real return through income, even though we think the units are a little bit pricey today, it's still a very good hedge against inflation.

Glaser: Josh, I think inflation is something that we're definitely going to be keeping a close eye on. Thanks for talking with me today.

Peters: Well, hopefully, enough people will be watching it so closely it will be like the pot that won't boil.

Glaser: For Morningstar, I am Jeremy Glaser.