Measuring the Success of Your Dividend Portfolio

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters--he is the editor of Morningstar DividendInvestor newsletter and also director of equity-income strategy. We're going to talk about how he picks metrics to measure his performance and how that helps him manage the portfolio.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start by talking about how you pick the way that you measure your performance, measure the portfolio. A lot of people think about maybe looking at it against a benchmark or something like that. How do you think about the success of your portfolios?

Peters: Benchmarks are important. To be able to compare your returns over a long period of time against, say, the S&P 500 is not a bad idea because that's sort of a default option that you can get with very low cost. If, over a very long period of time, you're taking just as much risk as--or more than--the S&P 500 and not getting as much return, then maybe you should just index. So, for active managers everywhere who are sort of under siege, that is what you have to do. You have to add some value either with less risk or more return or preferably both.

Fortunately, that's what we've been able to achieve in our first 10 years with the DividendInvestor model portfolio strategy, but that's actually not how I manage it. I figure to really achieve the best results you have to start by thinking, "What is the desired outcome?" And for the portfolio I manage, the number-one objective is to generate income that can either be used to fund withdrawals for people who are in retirement and have living expenses to meet or for people who like the strategy and want to reinvest that income to drive future income growth so that they've got that much more income available to them when they retire.

So, my preferred metric for looking at the performance of our portfolios is to look at the annualized income it throws off. So, if I have 200 shares of XYZ that pay $1 per share annually, then that's $200. I add up that value for each position in the portfolio--have 27 individual stocks in the portfolio right now--and that comes up with a single number that expresses the income of the portfolio as a whole. It's a little over $17,000 now for a portfolio that's worth $440,000 or $450,000. So, that correlates to about a 4% yield right now. But the yield itself--half of it is a function of the stock prices. The market could be high or it could be low--that's going to influence the yield.

What I really figure I have some control over and what I want to manage and measure the progress of is that $17,000 today. Is it $18,000 or $19,000 next year? Is it $21,000 or $22,000 year after that? Or am I having dividends cut or not getting the dividend growth I expect and, therefore, my income is stagnating? So, to me, that's really the most powerful indicator of whether or not we are moving in the right direction. And historically, we've had a very close correlation between the market value of the portfolio and the annualized income.

So, you might think of it as our yield has been pretty stable over time and as we've grown our income, that in turn has helped push up the value of the portfolio. That's where you get your total return. Total return is always the bottom line. The question is, "How do you achieve the total return that you're looking for?" To try to compete, head to head, with a benchmark--saying, "I'm going to try to beat the S&P over the next 12 months"--that's a very different game. It's a very difficult game, and it doesn't even necessarily serve your personal investment objectives directly.

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Glaser: If that's the metric that you're really looking at, what happens if you have a portfolio holding that's currently producing a fair amount of annual income, but you're worried that they might have to cut their dividend or that there is going to be low growth? What kind of options do you have if you have a holding like that?

Peters: That's always a tough one, because I try to look very carefully at every stock before it goes in the portfolio and run it through a whole battery of tests to make sure that it meets our standards. I always want to have companies that are protected by wide or narrow economic moats. I don't like highly leveraged balance sheets. I want a payout ratio that provides both for a generous yield as well as excess coverage--a margin of safety for the dividend, if you will.

A couple of years ago, I thought GlaxoSmithKline (GSK) fit that bill. When I bought it, they were paying out about two thirds of their earnings at the time. So, I figure a third of earnings retained--that's a pretty good coverage. You could have earnings come down by a third, and they can still afford the dividend.

Well, that's not what you want to have happen. Unfortunately, that is what has happened now. Between a lot of different factors--the most important of which has been the hits that they've taken to their big respiratory drug, Advair--their earnings have now declined to a point where, this year, management expects the dividend to be right in the neighborhood of earnings. In fact, earnings might fall a little bit short.

Now, they expect it to come back next year and to improve gently after that. They've put dividend growth on hold, but they haven't cut the dividend. So, there's some encouragement from that. But that margin of safety that I want is gone, and this isn't a management team that has shown that it can deliver on its promises--even just in the couple of years that I've owned it. So, at this point, the stock price is fairly depressed. The dividend was still rising until this year; now it yields in the mid-5% range. That's a very tough yield to go out and replace in today's environment. There are a lot of stocks that yield 3% to 4%, but 5.5% is really tough to get with any kind of quality. So, then you have some choices, and I like to relate them all back to how they affect my income stream.

If I just hang on, I know I'm not going to get any dividend growth from Glaxo, but at least the dividends I'm receiving [will contribute to dividend growth in the portfolio]. In our portfolio strategy, we do reinvest our dividends, so it will be able to contribute to dividend growth as long as the dividend is not cut. The problem is that if a dividend cut is coming, the share price is going to continue to decline until that's actually announced. It gets harder and harder and harder to evaluate options that will preserve our income the lower the stock price goes.

So, that's one option. And I'm still holding the stock as I evaluate my choices. But that may not be the best one. [Another option] is to just sell it, wash your hands of it, and buy whatever else is next on your buy list. But today, that's probably a lower-yielding stock, which means I take a hit to my income from swapping out. That makes you wonder whether you should maybe just take your chances on a dividend cut. There, you have to think about potentially taking a larger capital loss down the road--again, a difficult choice.

Another option is to try to replace it with whatever yield is in that range. There, the problem is that most of the companies in that range--in fact, everything I've looked at so far--is just as bad quality or worse, just as dubious, in terms of its overall support of the dividend and ability to grow it. So, that's one tough, too.

The fourth option is probably what I'm going to wind up doing, which is to pair a sale of Glaxo--which, fortunately, is my smallest holding right now--with the sale of a lower-yielding stock, something that yields less than 3%. Clorox (CLX) is one possibility. And now, I've created a pool of capital to reinvest, where I can replace the income of the higher-yielding holding and the lower-yielding holding with a blend of around 4%. That's much more doable in this environment.

I'm still weighing these different options; but again, if you are thinking in terms of the impact of your choices on a stream of income--which, in turn, is going to determine your market value--it gives you a framework for how to replace this with something better that's not just matter of saying, "Well, I think something else can go up faster or something else has less risk." It gives you a richer framework for evaluating your choices.

Glaser: Josh, thanks for sharing your thoughts today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.