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Dividend-Payers Mostly Weather the Pullback

Although utilities took a particularly strong beating and energy continues to look shaky, the overall backing for dividends across most of the market still looks solid, says Morningstar's Josh Peters.

Dividend-Payers Mostly Weather the Pullback

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. What impact will the recent market volatility have on dividend-payers? I'm here with Josh Peters--he is the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy--to look at how the sell-off impacted his portfolio.

Josh, thanks for joining me.

Josh Peters: Good to be here.

Glaser: Could you talk a bit about how the volatility we've seen over the last couple of days has impacted the sectors that have most of the dividend-payers in them?

Peters: Early on, it seemed to be kind of a traditional correction. We saw utilities and REITs and staples hold up better than the market overall. That's kind of what you'd expect. These are lower-beta names. They tend to be less volatile. And then as we got closer to Tuesday--I don't know if I want to call it the first bottom--we actually saw that utilities were the worst-performing group. It seems to me that maybe with these stocks that are counted on for being more stable and certainly pay those nice dividends that a lot of individual investors want, you were seeing people react to a very fast-moving correction in the stock market and saying, "I want out"--even though these are stable names. We saw the price for Duke Energy (DUK), for example, hit a 52-week low, and the yield is closing in on the 5% mark. That, to me, doesn't really make any sense. This is the opportunity, I think, to buy a name like that and make that a cornerstone of your income strategy for the long run.

Glaser: You mentioned that this is a fast-moving market, but did you see any broad areas of opportunity open up? You mentioned Duke. Are there other areas that you think are worth staying on investors' radars?

Peters: It's been a curious market for a while--for a number of reasons. One is this preposterously narrow trading range that we were in all year up until now. Within that range, there haven't been a lot of bargains, and lots of stocks have been trading at all-time highs even though fundamentals for businesses that have a lot of nondollar exposure or exposure to emerging economies and commodities, their earnings were eroding. And yet, the market overall has been hanging out at this very high level. [Then, the market] shocked us with a 10% or greater decline, and there weren't really a whole lot of names that, all of a sudden, jumped off the page as bargains that weren't already relatively attractive [before the correction].

The way I like to think about it is that my best idea is not just whatever stock has gotten the cheapest; my best idea is my portfolio as a whole. And in this move, we saw my portfolio's yield, which had been right around 4% or 4.1%, jump up to 4.5% at the top. To me, that means that from that starting point, I'm likely to collect the benefit of that extra 0.5% of yield almost forever. Certainly, I expect prices at some point will come back; my portfolio now looks undervalued on a price/fair value ratio basis, using our fair value estimates. But I want to earn higher yields, and I want the opportunity to compound faster. Since the portfolio as a whole already has diversification in place--it's spread out among a number of different sectors so that it doesn't have the risk of any one stock--I feel like it's a good time to be sticking with your strategy and being able to reinvest your dividends. And if you're adding capital to your portfolio, it's better to do it at lower prices as opposed to high prices. I never thought during this volatility that this was a once-in-a-lifetime or once-in-a-generation type of opportunity for anything. In fact, it should be more routine. And perhaps if it hadn't moved so quickly, we would think of it as just kind of a routine pullback in the stock market.

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Glaser: The pullback was caused by a lot of things--everything from concern about China to the Federal Reserve. Do any of these concerns lead you to think there could be dividend cuts on the horizon or weakness in the real economy, or are these just things that are impacting the market but not the businesses themselves?

Peters: Nothing new has emerged on that front. I still think that, in looking at the energy sector, you have to be concerned. You want to make sure that you're on very high ground and that you've got companies with very strong balance sheets so that they can afford to have their earnings and cash flow drop significantly for a period of time without having to force a dividend cut.

Outside of that area, we're still at a pretty high level of profitability across the board. Where payout ratios are generally higher tend to be in the more stable industries--like your REITs, like your utilities, like your staples. So, overall, the backing for dividends in most of the market still looks pretty good. The question that arises is, "Does this presage some recession that, even if it starts in China or in some other emerging market, rolls around the world and eventually drags the U.S. down with it?"

This is why I try to stay hunkered down all the time and why the bulk of my portfolio--typically 75%--is going to be in very defensive names like the ones we've already been talking about. I reserve some of my portfolio for more cyclical names. I own Chevron (CVX)--that falls in the cyclical category. Wells Fargo (WFC)--a bank, to me, is cyclical. Industrials are cyclical. But even in those cases, I feel like I'm getting the sufficient protection, as well as long-run total-return prospects, that make owning those stocks worthwhile. The rest of it, I really want to be able to trust those cash flows and trust the dividends and even continue to grow the dividends even in the downturn. That's a standpoint that has served the strategy very well over more than a decade now.

Glaser: Josh, thanks for your take on the last couple of days.

Peters: Thank you, too, Jeremy.

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

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