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Dividend-Stock Deep Dive: Picks for 2022

Dividend-Stock Deep Dive: Picks for 2022

David Harrell: Hi, I'm David Harrell, editor of the Morningstar DividendInvestor newsletter. I'm here with Dave Sekera, Morningstar's market strategist. Dave, you've been market strategist since 2020, I believe. Can you share a little bit of your background and what you were doing prior to that?

Dave Sekera: Well, of course. As you mentioned, I've been in this role for a couple of years now, but prior to that, I've been with Morningstar for about 12 years, and I've had a number of different analytical roles, mostly in the research area, covering both stocks, bonds, specifically corporate bonds. But overall, I'm starting to show my age. I've been in the finance business for 30 years now. And again, at some point in time in my career, I think I've covered just about every security under the sun, whether it's been stocks, investment-grade bonds, high-yield bonds, levered loans, options. So, I think that's given me a pretty good background for the market strategist role.

Harrell: That's great. So, dividends. In 2021, dividend payments were certainly back following the cuts and suspensions that we saw in 2020. I believe according to Dow Jones, total dividends paid by the S&P 500 companies were up nearly $70 billion in 2021 as opposed to the drop of more than $40 billion that we saw in 2020. What's your take on dividend trends for 2022? What do you expect to see?

Sekera: I think, like everything else, the key for 2022, a lot of it's just going to be normalization, whether that's normalization in the markets, whether that's normalization in consumer behavior, normalization as far as our economic outlook. So, again, getting back to dividend payments specifically, what I'm looking for this year is, there's still a few companies out there that I think need to get back to where they were pre-pandemic as far as paying out the percentage of typical earnings in dividends. There's still a little bit of that left to come. But really, what I would expect this year is more for dividends to grow in line with earnings.

Harrell: Now, in addition to increasing dollars devoted to dividends last year, we saw a record number of dollars devoted to buybacks, or firms repurchasing their own shares. Do you think that trend will continue and what are your general thoughts on capital allocation? And is there any possibility that a proposed tax on buybacks, if implemented, would have any effect on capital allocation decisions?

Sekera: It might be easier to answer that second part of your question first. As far as the Build Back Better bill, whether or not it happens in 2022, which contains that language that they may look to have a 1% charge on buybacks. I just talked to our DC policy analyst, recently. We think it's probably under a 50% chance that that ends up getting done with midterms coming up here. Now, having said that, even if it does get done, we're not necessarily confident that that 1% clause would end up making it through to the final stages at the end of the day anyways. With enough caveats there, I guess, the quick answer would be, no, I don't think a 1% charge would be enough in order to change a management's view as far as how they want to allocate capital, whether it's for dividend payments, share buybacks, or for other parts of the capital allocation process.

Now, for 2022, let's get back to this normalization theme. First, I expect management, they're always going to look internally. What kind of capital expenditures can we do that we can grow our own company organically? And I think that's what management is always looking for first. Second of all, then they're going to say, well, if we don't have great opportunities here internally, what is out there externally? So, again, getting back to mergers and acquisitions. What our view is for that this year? I think it's going to be pretty robust. Now, I think, management teams first look for smaller bolt-on kind of acquisitions, but I do think that there's still a pretty good demand out there for larger strategic acquisitions for companies to be able to grow their business. After that, now we get back into what is your typical dividend payout ratio. I would expect most companies will continue to keep paying that same type of ratio that they've paid in the past. From there, when you have excess cash flow, there might still be some companies out there that think they're a little bit over-levered, might use that in order to pay back debt. For the most part, I think, most of that excess cash flow is going to go back for share buybacks this year.

Harrell: Now, I believe on Jan. 4 you wrote a piece for, and you noted that the equity market overall is somewhat overvalued. But you believe there was more opportunity in value stocks than growth stocks in 2022. Now, given that many mature dividend-paying companies land in that value column of the Morningstar Style Box, do you think dividend payers in general should have good relative performance in 2022?

Sekera: Well, it really breaks down to the individual companies and their fundamental performance. So, you are correct, coming into this year, we did think that the market, broadly speaking, was about 5% overvalued. The markets actually sold off a little bit here over the past week and a half. So, we're probably a little bit closer to fair value. Maybe we're only 2% or 3% percent overvalued at this point. But yes, we do think that value stocks are going to have good economic tailwinds behind them this year. We do see a lot of undervalued opportunities for investors in that space, both for high-dividend-paying stocks as well as for stocks that don't pay dividends.

Harrell: And in that report, you wrote about energy, and that's a sector that had a very strong performance in 2021, and at the beginning of the year, it was actually the most undervalued sector. This is also a sector where we see a number of higher-yielding dividend payers. So, what's your thoughts on the prospects for energy stocks in 2022?

Sekera: Well, we still think they're undervalued. But I have to caution that just based on the market movement already this year, the Morningstar Energy Index is up already over 10% this year. So, coming into the year, yes, we thought it was the most undervalued sector, probably by about 15% from a broad sector perspective. At this point, it's probably only like around 5% undervalued. Now, having said that, yes, there's a lot of very good, high-quality dividend-paying stocks in the energy sector.

And really, this is also a good opportunity to learn how to use Morningstar tools. So, in the energy sector, what I would do is, I would go through, pull out using different screening applications, the energy sector, look for 3-, 4-, and 5-star-rated stocks and then also take out those stocks that might have like very high uncertainty. Companies that maybe they're paying a good dividend today but may be more volatile in the future and could be those that you might consider that they might pull back on their dividends in a downcycle.

Harrell: Got it.

Sekera: From there, you can rank them from a price to fair value and then also rank them by dividend, and that helps, I think, give investors a wide choice of different types of stocks within the sector that might fit within the constraints of their portfolios.

Harrell: Great. Now, finally, are there any other sectors or individual names you'd want to highlight either from a current yield perspective or based on their potential for dividend growth?

Sekera: Sure. There's a number of different ones out there, and I think it's interesting to look for different types of opportunities. One that I would highlight right now would be AT&T. So, for me, when I look at AT&T, I think there's actually a hard catalyst there in order to improve shareholder valuation. A new management team, new CEO took over in mid-2020, and he wasted no time in order to really go in and put his print on that company. They've done a number of different corporate actions. Probably the most important, in my view, would be is that they're spinning off their WarnerMedia subsidiary. And we think that's really going to help that company unlock shareholder value as well as really be able to refocus that business back on kind of that communications part of the business that they kind of lost that focus a number of years ago.

Now, I do have to caution investors that we do think that they're going to cut their dividend, and in fact, they're probably going to cut their dividend about in half from where it is today. Now, it is one of the highest dividend-paying stocks under our coverage today. Once it gets cut, it will probably be somewhere close to that 4% range, close to competitor Verizon. But we think that stock is trading at a 27% discount from fair value. And so, in my mind, I think it's kind of the best of both worlds where you're still going to get a good, solid dividend payment, but you're also getting an opportunity of buying a stock that we think is undervalued and should accrete over time for long-term investors.

Harrell: Got it.

Sekera: Other opportunities that I'm looking at today, maybe in the consumer defensive sector, I look at like Kellogg and Conagra. It's interesting. Both of those stocks are rated 4 stars, they are both trading at a very similar discount to our fair value estimate, and they pay a very similar dividend yield today. However, for me, I would much rather look at Kellogg because we do rate Kellogg with having a wide economic moat. And so, when I'm looking at how things could play out in the future, while inflation is running hot today, we do think it will start to moderate later this year. But if we're wrong and inflation is more persistent, I'd much rather be invested in those companies with a wide economic moat, because those are going be the companies that have the pricing power to be able to pass through their own cost increases to their own consumers, be able to maintain their margins, and even if the rest of the market is selling off because of inflation, those are the ones I would expect to hold their value.

Harrell: And as we saw in 2020, the moat does not guarantee a dividend, but I believe at least in that year the wide-moat firms were the least likely to cut or suspend their dividends, whereas your no-moat firms were the ones that were most likely to have to make a cut or even suspend the dividend.

Sekera: Exactly.

Harrell: OK, great.

Sekera: And another one too is, oftentimes investors will look at utilities almost as like a fixed-income substitute, so that would be another sector where I would highlight doing some of these different screens where you can look for those companies that we think are going to be attractive from both a valuation point of view as well as from a dividend point of view.

Harrell: I actually have one last question, and that is, we're certainly experiencing higher inflation these days, and we keep seeing the headlines that the Fed is going to raise short-term interest rates. How might an increase in short-term rates like that affect the prospect of dividend stocks?

Sekera: I guess, maybe the first part of the answer there is, yes, we are certainly seeing inflation run pretty hot these past couple of months. And in fact, according to our economics team, we are expecting inflation to continue to run hot for a few more months before it starts to moderate. But when you look at the average inflation rate for the full year, this year, we're looking at about 3.6%. Having said that, it will continue to moderate in the second half well into 2023. So, then, we're looking for inflation to drop all the way down to 1.4% before going back to more like a normalized kind of 2.2%, 2.3% long-term inflationary run rate.

So, yes, the Fed is definitely going to be raising rates this year. The market is certainly pricing in three rate hikes. I think you also need to make sure you put that into context that we are coming from a 0% interest-rate policy. So, even with those three rate hikes this year, we're still only getting to 0.75% to a 1.00% fed-funds rate, which when you look at a historical long-term chart, the only time we'd ever been there before was during the global financial crisis and never even had a federal-funds rate that low in the past. So, from my perspective, I don't expect increases in short-term rates really to impact those dividend-paying stocks.

Harrell: Got it. Well, thanks for sharing your insight, Dave, and I'm sure we'll be talking again.

Sekera: Great. Thank you.

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