Dividend Picks for Your IRA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Morningstar DividendInvestor editor Josh Peters to look at some dividend-paying stocks for your IRA.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: So, from the big picture does it make sense to be holding dividend-paying stocks within a qualified account like an IRA?

Peters: I think it absolutely does, when people are in contribution mode, and they have a good 20, 30 years, perhaps before starting to make withdrawals from their accounts, they might be thinking growth, growth, growth, growth. Well, that's actually not the right answer. Just as if you are in retirement, income, income, income isn't the whole answer either. It's always going to be total return.

If you do have that long time horizon toward retirement, you shouldn't try to figure out what's the next Apple, what's the next Google, trying to chase some high-growth stock. Instead you should figure out how you can get a combination of both growth and a decent dividend yield that can grow over time and allow you to compound that total return. How can you get that working for you early, so there is a lot more money there at the end of day.

Glaser: Do you have any specific securities that might work well in an IRA?

Peters: Well, if you think about my universe, I mean a lot of the time I am really looking to maximize the current yield, but subject to some constraints. I still want the dividend to grow, I still want it to be safe, still want some diversification. That's really my Dividend Harvest strategy in DividendInvestor, one my two model portfolios.

But really if you are thinking about IRAs and having that long-time horizon, then something that's more along the lines of my Dividend Builder model portfolio is kind of what I have in mind. And there my mental model is, I still want a good dividend yield, got to remember the S&P 500 only yields about 1.8% right now, so a 2.5% or 3% yield is actually quite good by market standards.

What I am more concerned about, though, than the immediate amount of income is what is the company doing with the rest of its earnings. To use an example, a company like McCormick, one of my favorite businesses, stock is a little expensive right now, but I think it's definitely one to watch. Ticker symbol is MKC. They typically are going to pay out maybe about 40%, give or take, of their earnings as dividends.

Well, that's going to give you right now yield that's in the mid-2% range or so, but what about the rest of the earnings, the other 60% or so of earnings that aren't being paid out? In McCormick's case, they have the opportunity to reinvest a lot of those earnings into what we think is a wide-moat business, where they have the opportunity for small incremental investments in the business, whether its new products, expansions of capacity say in emerging markets, to get a really strong bang for the buck, a very high return on those incremental capital dollars.

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They've also done a very good job making acquisitions, like Lawry's Seasoned Salt and other Lawry seasonings a couple of years ago. They bring a business like that in. They pay what we think are generally reasonable prices for their acquisitions, but they just then combine the manufacturing, the selling, the marketing, distribution of those products in with their existing systems, they turn out to be a lot more profitable.

So, in this case where if McCormick, let's say, paid out a 100% of its earnings as dividends, maybe the stock would have a yield of 5% or 6%.

But by leaving about half or a little over half of the earnings inside McCormick, I am going to get a pretty favorable trade-off. I might get, I think, a 7%, 8%, 9%, maybe even 10% earnings growth on a yearly basis in exchange for not getting that three percentage points of additional yield. So, this is the kind of situation that I look for when I have more time to let my capital compound through total return.

Glaser: What about using an MLP in an IRA? I know a lot of investors have been turning to that structure for getting some yield, but I know that there might be some tax consequences there.

Peters: Yes. MLPs actually could make very good compounding vehicles for retirement income, even if you have a long way to go. You might not think in terms of something of the 5% or 6% yield as being that growth vehicle. But they definitely can be a total return vehicle.

Just to use one example, one of my favorites, Magellan Midstream Partners, ticker symbol MMP. Right now, its yield is pretty low by historical standards in the mid-5% range. But we expect the company to raise its distribution 7% a year over the next couple of years.

So, now you have a pretty big yield, pretty good growth rate, and the company is really able to get, again, a lot of bang for its buck on the incremental dollar it can invest back in the business, because the business itself is inherently profitable.

The problem, of course, has been that you should not own MLP units directly in the IRA structure. If you do, there is a chance that your IRA could literally have to file its own tax return and pay tax at a pretty high rate, in which case the whole benefit of the MLP structure avoiding that double taxation is erased.

Glaser: So is there any way to get those returns of the MLPs without having to invest directly in the units?

Josh: Yes, there are, and this is one area where perhaps Wall Street innovating isn't a bad thing. Now I would tend to be pretty skeptical. I agree with Paul Volcker when he says the only good financial innovation in the last 30 years has been the ATM.

But this is one case where I think a specific product, the exchange-traded note structure, actually does a fairly good job, because it's able to catch all of those allocations of MLP income and essentially turn those distributions into just ordinary income.

Now they do charge a management fee, but there is no extra layer of taxation. So, in total return terms, compared to some of the other open-end and closed-end fund products that are available now for MLPs, I think the ETN structure is actually more efficient.

There is one big drawback, which is that it's an exchange-traded note, which means technically it's a bond that's issued, in this case, by J.P. Morgan Chase. But, if you're comfortable with the credit risk of one of America's strongest and best run banks, then I think this is a good way to access those total returns and let that compounding really work for you in the MLP sector.

Glaser: So do you have a particular ETN that you think would work for investors?

Josh: Of the ones that are out there, they are all pretty similar, but I tend to favor the J.P. Morgan Chase issue that tracks the Alerian MLP Index. Ticker symbol there is AMJ. And the current yield is kind of low by MLP standards historically, but again when you're looking at MLPs, you're also usually seeing a big growth component relative to the yield, at least, you know in a lot of cases mid-single-digit type of growth that can really round out a nice total return from these kind of assets.

Glaser: Josh, thanks for your picks today.

Josh: Thanks for having me on.

Glaser: For Morningstar, I'm Jeremy Glaser.