Don't Fall Victim to the Next Dividend Cut

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He is the editor of Morningstar DividendInvestor and also the director of the equity-income strategy at Morningstar. He will be hosting a free webinar on Tuesday, Feb. 26 on dividend-investing strategies.    

Josh, thanks for joining me today.

Josh Peters: Thank you, Jeremy.

Glaser: So, let's talk a little bit about dividend investing. If it makes sense for people looking for income right now, with the stock market looking pretty fully valued, does it still makes sense to look at those dividend-paying stocks as an alternative to bonds or to other areas that people might be looking for cash?

Peters: I think it does. I mean there are a lot of people who are concerned about some higher valuations in this area of the market. I'll be the first to admit, you look at the multiples on, say, packaged-food stocks, tobacco stocks, utilities, and REITs in particular, they don't really look that appealing. But we're also in an environment here where I think we're going to be looking at a combination of low economic growth, low corporate profit growth as a consequence, and low interest rates for very long period of time.

So, you have to consider your opportunity set and the way I look at it is, you can go into bonds and lock yourself into very bad relationships with issuers, very low-yield relationships with issuers for many, many years that can really clobber you if inflation starts to move up and interest-rates start to move up. You could just sit on cash, but of course every day you sit in cash, you earn nothing, and you are losing purchasing power because of inflation. And you can also go back into equities, with just the same-old buy-low/sell-high strategy that works until it doesn't.

And one of the things especially for people who are coming back to the stock market--the risks have gone down, maybe the road ahead is not going to be so rocky as the last 10 or 15 years--do it right this time. And that is get back to the understanding that even stocks are principally about the dividend income and the growth of the dividends over time. It's not just a growth story. It's not just a capital gains story. It's about the income and the capital gains that are encouraged by the growth of that income over time.

So if this is a strategy that works to suit your financial needs, your eventual desire to retire and be able to fund your retirement from a 401(k) plan, for example, then this is not a bad time. In fact, it's a great time to make that strategic choice and start to migrate your portfolio in that direction.

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Glaser: If you are not terribly worried about valuation, what would keep you up at night in terms of the stock market?

Peters: Looking back over the eight-plus years of portfolio performance history at DividendInvestor, I found that there's been some times where I paid more for a stock that I would have liked to in hindsight. Johnson & Johnson is my classic example. I bought that on Day 1 back in January 2005. The stock has only gone from about $66 to $76 here in eight long years. I paid too much at the beginning. The growth was slowing, the multiple contracted, the dividend yield went up because the dividend was going up so much faster than stock price. But I didn't get clobbered. I had some mediocre results, but I didn't get clobbered. 

What really clobbers you in this area of the market is not valuation so much as dividend cuts or risks that are starting to really accelerate around the dividend cuts. You don't need to look any further than to just look at CenturyLink, the big superregional telecom company last week coming really out of the blue, cutting its dividend 26%. The stock dropped 23% the day after that was announced. That's what you really want to avoid. And one of the key factors here, both with CenturyLink and with Exelon, another big dividend cut announced here recently, is look and see when was the last time they raised the dividend. A growing dividend is one that's much less likely to be cut than one that's been flat for a while and that's maybe starting to become kind of burdensome. That's what really helped keep me out of those two stocks in particular.

Glaser: Other than a history of dividend increases, what else should investors be looking for to avoid dividends cuts?

Peters: Yeah, you want to look at the balance sheet; you want to make sure that you don't have a tremendous load of debt that potentially could stand between you and your dividend income. R.R. Donnelley, the commercial printing company is pretty good example there; it's a cyclical business, but it's one that also loaded down with a lot of debt. The dividend yield certainly looks very high right here, but I don't know that it can really survive another recession.

Another factor you want to concentrate on is the management team. How committed are they really to paying that dividend. Looking at CenturyLink last week, it occurred to me there are really two kinds of companies. There is the kind of company that looks at paying a good dividend really as a privilege and an honor and a duty. And then there are other companies that see all this cash going out the door, and management says, "You know what, this is just another expense. Why don't we try to minimize this expense just like we'd minimize any other expense, and then we, the management team, have more money to play with ourselves."

So you want to find that commitment, and it's not always real easy, but when you do see that dividend record where the dividend grows every year for five years, for 10 years, or for 50 years in some cases, you know then with the much greater degree of certainty that the dividend is important to management. They are planning ahead so that they can continue to pay and raise that dividend. They are not swinging for the fences in the kind of business decisions they are making. It doesn't guarantee the dividend won't be cut. In fact I think Pitney Bowes, another company that's had a long history of raising its dividend is pretty likely a dividend-cut candidate here this year. But in most cases, you're going to get I think a good sign, a positive signal that this is a company worth investigating. Get to know the growth factors, get to know the balance sheet, get to know the economic moat, the competitive conditions that will help support your dividend over time.

Glaser: So it sounds like a portfolio of possibly fairly valued but companies with stable dividends and potentially growing dividends might be a better option than sitting in cash or in some fixed income right now?

Peters: Yes, and you've got to remember, it is a matter of relative choices. Your money is going to sit somewhere. If you are stuffed with long-term bonds in your portfolio, I'd say they are overpriced; they are underyielding. And even fairly or perhaps even fully, in some cases, priced dividend-paying stocks might actually be the better alternative when you start looking out over the next five, 10, or even 20 years.

Glaser: Josh, thanks for talking with me today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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