3 Reliable Dividend-Paying Stocks

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters--he is our director of equity-income strategy and also the editor of Morningstar DividendInvestor newsletter--to look at the state of dividend stocks today and see a few of his favorites.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, let's look at the overall state of where dividend-paying stocks are right now. How have you seen the landscape shifting, say, over the past year or so?

Peters: Well, it's not been the greatest year. The biggest development, I think, for most equity-income investors has been the implosion of the energy sector. This isn't so much a feature of the little E&P guys, the wildcatters, or even some of the bigger names in that sector because they weren't really paying much for dividends to begin with, but we have seen some dividend cuts anyway.

It's been the big names like Exxon (XOM) and Chevron (CVX). People have been worried about if companies as financially secure as these two might be forced to cut their dividends. I don't think they will, but certainly the share prices have come down. We've seen a lot of volatility. The earnings are plummeting. And then the midstream story, especially, has really been hurtful for investors who perhaps weren't discriminating very carefully between the qualities of the businesses they were buying--or worse, investors thought that they were just getting access to a great industry through index products or mutual funds that were just buying all of the MLPs or most of the MLPs because some of them really are utilitylike in their consistency and their profitability. Most of them are not, and they have at least some commodity-price exposure, direct or indirect--and perhaps they have a lot. And many of them have a lot of debt leverage and not much for excess coverage. They can't afford to have much go wrong.

So, that's been the toughest thing, I think, specifically among higher-yielding stocks. But on a relative basis, we're still lagging growth. For the most part, company earnings aren't growing very fast and that little handful of companies that are experiencing a lot of earnings growth right now--some of the social-networking names that are still there or Nike (NKE) or Starbucks (SBUX) or somebody like that--they are not big dividend payers or even dividend payers at all. So, this has been one of those years where being different in pursuit of a different result has gotten you a different result--and it doesn't maybe look that good.

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Glaser: Looking out over the next couple of years, given that earnings growth is slowing, do you think there is going to be a lot of dividend growth? If your total return is going to be really driven by that over time, is there any prospect for growth there?

Peters: I think you actually want to tilt your mix at this point, if you're a longer-term investor, toward thinking about locking up more of that return upfront with the dividend yield. There are certainly fears of interest rates going up over time and the impact that that might have, but historically that's been more of a relative performance drag; it hasn't led to utilities and REITs falling apart and losing a tremendous amount of value. It's that some other stocks in the market go up more.

I do think that dividend growth in the market overall, which has been in the double digits, is going to slow a lot, partly because earnings growth has slowed to actually shrinking. I suppose if you exclude energy and basic materials--well, if you exclude everybody whose earnings are going down, then earnings are going up. [Joking.] But earnings growth has slowed a lot because the economy has continued to be sluggish. It's even worse outside of the United States. I don't know how high profit margins can go, but they certainly are going to have trouble continuing to expand with stagnant or falling revenues in lots of industries--not just energy, not just basic materials. And payout ratios have come up a lot from where they were. I still don't think they are high enough--50% or 55% would be historically normal. We're now in the high 30% range, but we've come up from the high 20% range in the last couple of years--that's dividends growing faster than earnings. That doesn't go on forever.

So, I think you want to think in terms of if I can get a portfolio that yields 4%--that's about what the model portfolio I manage in DividendInvestor yields right now. That takes a lot of the pressure off of the growth and the capital-appreciation component. And if valuations drop--if prices become more attractive and I'm reinvesting those dividends--then I can buy more shares at lower prices and compound my earnings faster. I actually prefer that as a younger investor.

Glaser: So, if you're looking to find some of that higher yield today, where can you look for that without maybe risking dividend cuts, without risking that just being an illusion?

Peters: The funny thing is that there is no real sector that sticks out right now to me as being cheap. I think you have to dig into the level of individual companies in order to start finding bargains. For example, in staples, frankly I think most staples companies are fairly to fully valued right now. But Procter & Gamble (PG) is still in Wall Street's doghouse. People are still impatient about a turnaround that's taking a very long time to turn. I think it's going to work, and I think the company is positioning itself to deliver much better results operationally over the next couple of years. Currency and emerging-markets turmoil isn't always going to be a headwind. At some point, it will be a tailwind for P&G, and you can still pick up that stock at a pretty nice discount to our fair value estimate. But calling out P&G doesn't mean that Kraft Foods (KHC) is a bargain because I think it's actually a little bit overpriced.

Similarly, in REITs, I'm not going to probably ever buy a REIT that yields less than 3%. I think I'd really have to find something extraordinary to buy one that yields 4%, and there are lots of REITs down in that lower-yielding category because people are anticipating lots of dividend growth in some more cyclical areas of REITs. And then you look at the other end of the spectrum, the healthcare REITs that tend to lock up a lot of their income under long-term leases. Maybe they don't have as much growth potential short-term, but Ventas (VTR) or Welltower (HCN)--the old Health Care REIT--are trading at around 5% yields and are still positioning themselves for mid-single-digit dividend growth or better for many, many years to come.

They've gotten beat up because people are worried about excess supply in senior housing. Well, if that's a problem, it's not going to take long for demand to catch up with supply. That's just the demographics. I think the concerns there kind of harken back to some eras where different property types have been overbuilt and REITs have really been hurt. But here, the incoming tide of demand in that area is just going to continue to roll in. We're a long way away from peaking out on the demographic potential there--decades, really.

Glaser: There are still some opportunities then, but be careful with securities selection and try to get paid upfront.

Peters: Yeah, it's a pretty simple formula, I think. Your strategy as a long-term investor isn't going to change a lot from year to year. That's one of the advantages of it.

Glaser: Josh, I certainly appreciate your thoughts today.

Peters: Thank you, too, Jeremy.

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