The Biggest Dividend Story

Jeremy Glaser: For Morningstar.com I'm Jeremy Glaser.

It's Ideas Week, and we're taking a look at some our best ideas for the end of 2010 and into 2011.

I am joined today by Josh Peters, editor of Morningstar DividendInvestor, to give us his take on the dividend market next year and what some of his best ideas are.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, let's just take the broader picture first. Where do you see dividend increases in general, and how do you see dividend stocks performing over the next 12 months?

Peters: Well, it kind of breaks down into high-yield, low-yield. What we've had this year has been actually quite good performance from some of the higher-yielding stocks, because interest rates have been low and continuing to drop, at least up until very recently, and that has made income streams more valuable just about everywhere you find them.

People have chased some of the higher-yielding stocks into territory where they still provide above-average yields, but the total return potential down the road may not be so great. If the economy continues to recover into next year, we might see yields on 10-year Treasury bonds, which have already gone from 2.5% to 3%; maybe they head up to 3.5% or 4%.

I wouldn't expect to see a whole lot of outperformance by higher-yielding stocks in that kind of environment. In fact, since most of those stocks are pretty conservative businesses anyway, they are not going to benefit a lot from an economic recovery. They may be in for some underperformance. I don't think that's a reason to sell them, because I don't know what's going to happen; I want to guard against short-term problems, and I also want to think long-term, but I wouldn't be thinking in terms of big outperformance.

I think the biggest dividend story is going to come from what are now some very low-yielding stocks in the banking sector. Probably in the first quarter, we're going to see the first major round of dividend increases from the big banks in this country that have returned to profitability, have now acceptable capital positions, are continuing to grow their capital. I am not exactly sure how large they will be, but in terms of growth, will the dividend double or triple, could it quadruple? I mean we are looking at a significant comeback, whatever it happens to be.

Glaser: So, if you are thinking about individual best ideas, what are some that are on your radar screen?

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Peters: Well, I might start by saying that, I think the best ideas that I have really aren't for 2011. They are for 2021 and 2040--perhaps not the kind of investments you would hold forever, put in a drawer and forget, but thinking beyond just one year.

The top name that I would look to buy on a sell-off, especially if it was just a matter of some modest increase in interest rates bringing some higher-yielding securities down, would be Magellan Midstream Partners. It is one of the larger master limited partnerships, carries refined petroleum products up and down the middle of the country.

This is a great business for a lot of reasons, not the least of which is that its regulation provides for pass-through of inflation automatically to customers, who are actually shipping products through their pipelines. That means that if inflation starts to pick up, interest rates go up, a lot of higher-yielding stocks might start to look less attractive. Guess what, Magellan's going to be able to raise its distribution that much faster. The distribution should grow faster than inflation in almost any scenario that I can imagine. It doesn't mean it's a risk free business; it doesn't mean that it's even a buy right now given that the price has moved into the mid-$50s, but if it comes down into the mid-$40s, again, if nothing else changes about the business for the worse, then that'd be, I think, a terrific opportunity to look for in 2011.

Glaser: For an investor that, for whatever reason, doesn't want to be in the MLP structure, what's another name that might be good for them?

Peters: It's a good point, because of the tax characteristics, MLPs aren't for everybody, but another name--yields are little bit lower here, but still lot more generous than I think it probably should be, is Abbott Laboratories, symbol (ABT).

If you look at big pharmacy--the Johnson & Johnsons, the Bristol-Myers, Mercks, Pfizers--you tend to think in terms of, "there is not a lot of growth here and there are a lot of patent expirations," especially beyond Abbott and Johnson & Johnson. Abbott really has the best growth prospects of the group. It's a lot like Johnson & Johnson in the sense that it's very broadly diversified; it's unlike Johnson & Johnson in the sense that it's not such a big company that's going to find it just so, so difficult to grow.

The stock has come under tremendous pressure, given that it's such a conservative business in the first place, over about the last six weeks because people are worried about its top drug, which is about a quarter of sales, a drug called Humira. It treats rheumatoid arthritis and some other diseases. It's grown a lot, it actually doesn't have a patent issue, where the expiration of the patent at some point is going to create just a massive cliff in revenues, like say for Lipitor at Pfizer. It's a biologic drug, which means that even the manufacturing process has to be approved by the FDA.

Now there is the potential that Humira is going to face more competition. It already faces Remicade from Johnson & Johnson, among some other drugs. Pfizer is working on a new drug that unlike Humira, which is an injection, will be a pill. It could take some growth potential away from Humira, but there aren't really signs that the drug is so much better than Humira that it's going to cause all sorts of doctors all over the world to suddenly change their prescriptions.

If you take this issue, which is meaningful, but if you back away and you think about the other drivers behind Abbott's growth, its stent business, its nutritionals business, its baby formula business is part of that--my family is actually a customer at times. You've got the potential for high-single-digit, maybe even low-double-digit growth in earnings and dividends; it's all we've seen over the last couple of years, I would expect it to continue.

Here I think you're looking at a stock that yields now about 3.7% to 3.8%, with a 10% growth rate for the dividend. To me, that's just a terrific bargain, and really what you're just betting is betting against the idea that their number one product faces a real serious treat; we just don't see it.

Glaser: And then finally, Josh, if you are interested in playing that potential of increases in bank dividend, what bank do you think is the best bet?

Peters: Still have to go with Wells Fargo. You've already seeing Wells earnings improve substantially. I believe they only lost money in one quarter during the crisis; they've had actually a very consistent profit record. And when they brought on Wachovia, they brought on the potential for a lot of growth. As now this even bigger national franchise under Wells' superior management and strategy can start wringing a lot more value out of Wachovia's branches--picking up market share, selling more products to the same customers. Wells is too large to go out and make another huge acquisition; it may not make any acquisitions going forward, but we think it has a lot of potential to improve on the value it's generating already, which is already better than most of its peers.

It's going to create a lot of capital, as it continues to generate very large profits, and as profits only get bigger, as credit losses eventually start to run off, any improvement in the economy certainly would just add to the picture. Wells probably is capable of raising its dividend to $0.80, maybe even $1 a share on an annualized run rate by the end of next year.

And now, you are looking at a yield of 3% or maybe 4% on the stock. So, there is a lot of risk, obviously, with any of these names, and the yield right now is under 1%. You don't buy it for the current income, but you are buying what we think is very high-quality dividend-paying potential, and we think that in 2011, we're going to start to see that potential turn into reality.

Glaser: Josh, thanks for your picks today.

Peters: Thank you, Jeremy.

Glaser: For Morningstar.com, I'm Jeremy Glaser.