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What No Taper Means for Dividend Investors

Jeremy Glaser
Josh Peters, CFA

Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. What do dividend investors need to know about the Fed’s decision not to taper its bond purchases? I'm here with Josh Peters; he’s the editor of Morningstar DividendInvestor. He’s also Morningstar’s director of equity income strategy. We're going to talk about some of the implications.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Many market watchers were really taken by surprise that the Fed decided not to taper. Were you taken aback at all by Fed chairman Ben Bernanke’s decision to stay the course?

Peters: I have a pretty entrenched process of not making explicit forecasts to DividendInvestor subscribers about near-term changes in interest rates, monetary policy, or any other macroeconomic factor. I think they're just too unpredictable. It's much easier to base your portfolio around longer run trends that you actually have some shot of making good decisions with.

But, to be honest, I really wasn’t that surprised, and I was kind of surprised that everyone else is surprised.  The timing has everything to do, I think, with the Fed’s choice. First, you’re coming up on having a new chairperson leading the Fed here in January; you don't necessarily want to change course on existing policies right in front of that.

Second, we're looking at a government shut-down/debt-ceiling crisis perhaps coming up here shortly. Do you really want to start to tighten policy right in advance of a major fiscal event like that? I know the Fed doesn't think of tapering as actual tightening of policy. They think they're still loosening as long as they're still buying bonds, but everybody else would think of it as tightening.

Then third, you still haven't seen any sort of take-off in the economy. The fact that you've got a key player in the economic recovery today, the recovery in residential real estate, being so closely tied to what's going on with long-term interest rates, you don't want to knock that housing recovery off before it has a chance to get up and run on its own. For the Fed to have decided to wait, get more information, and let some of these other events--like a new chairperson and the fiscal drama--things unfold, I actually think it was a pretty smart decision even if most of Wall Street was either puzzled or hostile to the idea.

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Glaser: What does this mean for dividend stocks then? Are they that sensitive to relatively minor changes in what the Fed's bond-buying program looks like?

Peters: In the short term, yes. You do see that these stocks are competing with bonds for the attention of investor dollars. That's one main reason that these companies' stocks are sensitive to changes in interest rates. Second, if you think about why interest rates would normally go up, it's because the economy is doing better, and at that point you would expect other sectors of the economy that don't pay as large of dividends--cyclicals, growth stocks, and more speculative situations--those are the companies that are going to benefit in a better economic environment. Your food stocks, utilities, telecoms, and things like that aren’t going to benefit so much; these stocks tend to underperform. But this isn’t a normal rate cycle, and I think it's been important and will continue to be important for all investors, especially those focusing on income, to assume that long-term interest rates are going to continue to rise.

Now, we don't know how that will play out or how fast, but I think a normal type of target for planning purposes to think about is a 10-year Treasury bond that’s going to yield somewhere between 4% and 5%. That's kind of a normal relationship to inflation, if you think of inflation running around 2%. Now, when do we get there? I don't know, but hopefully you want to find stocks in this environment that are going to provide those above-average yields, but also dividend growth and valuations that are going to already discount that moving interest rate even though it hasn't happened yet and we don't know when it's going to be done.

Glaser: You mentioned valuation is important there, but are you seeing anything cheap? For a long time dividend stocks have been fully priced. How are you finding cheap stocks that will be able to withstand that increase in rates during the next few years, let's say?

Peters: Well, since the taper talk started earlier this year, things have actually gotten better. We've seen valuations improve a lot, in part because stock prices are falling, in part because dividends continue to grow across the market as well, even among those more conservative sectors. If we look at it on a relative basis, the S&P 500 is back near a record high; it's very close to record highs. Most high-yielding stocks, defensive stocks are not knocking on the door of new highs yet.

I’ll use one name in particular, Realty Income, ticker symbol O, a very longstanding holding of our Harvest portfolio in DividendInvestor. This name soared to what now looks like an almost unbelievable level, up around $55, $56 back in the spring. Once interest rates started to move up and the long-term Treasury rate started to move up, the stock cratered. Nothing had really changed about the company. It hadn’t become shaky, the dividend wasn’t at risk, and the dividend in all likelihood is going to continue to grow at a good rate going forward. But all of a sudden I look, and the stock is at $39. Well, what is $39? For this stock it means about 5.5% yield, instead of a yield just under 4.0%, which is where the yield was when the stock was at its peak price.

A 5.5% yield, that's a pretty good level for a stock like Realty Income. That's about where the stock traded back in 2007 when a 10-year Treasury-bond rate was between 4% and 5% for most of the year. At this point, we’re seeing that the bond market, if anything, has gotten way out in front of the Fed and that the stock market has gotten even further out in front of the Fed and out in front of the bond market in discounting these future interest-rate increases. You can buy good-quality companies like Realty Income now without being vulnerable to long-term interest-rate rises.

In the short run, these stocks could continue to underperform as rates are moving up, but I'm more worried about what the stock is going to be worth, what it's going to be paying me, and what the dividend growth is between now and, say, three, five, ten years from now. On that basis, I'm very comfortable now with the kind of valuation you can get from a stock like Realty Income, and just recently I actually bought more shares for the Harvest for the first time in a long time.

Glaser: How much should investors care about a taper coming, say, as early as October, or something happening early in 2014? Does that kind of timing really make any difference?

Peters: You know what, I really don't think it's going to. Matt Coffina, my colleague, editor of StockInvestor, made the point, in 10 years who is going to care whether the taper started this month as opposed to next month or the month after. I think that you have to just let the market sort these things out from day-to-day, week-to-week without trying to get out in front of it or trying to play Wall Street's game on its own terms.

Instead, think in terms of interest rates are going to go up somewhat to a normal level in the medium term. You want to buy the good companies now that are at attractive prices given that outcome; just hang on to them. Don't get caught up in this game that so many individual investors even get caught up in playing, which is trying to guess what the market is going to do tomorrow or what the market is going to do if there is a taper or if there's not a taper. Those aren’t really the questions that lead to the best long-term outcomes. Instead, spend the most time with the companies themselves. You've got to have a few basic macroeconomic assumptions in order to make some valuation calls.

Like I said, I work with the idea that a long-term Treasury rate is in the 4% to 5% range. I typically think of inflation as being 2.0%, 2.5% over the long run. That's not a terribly heroic assumption. That's essentially where it's been on consumer price index for the last 20 years. But other than that, get to know the companies, get to understand how they pay their dividends and what makes some tick. If you have the ability to pick the best companies that are going to treat you well both in the good times and in the bad times, then when those bad times come, you don't have to sell them.

Glaser:  Josh, I appreciate your thoughts today.

Peters: All right. Thank you, too, Jeremy.

Glaser: For Morningstar, I’m Jeremy Glaser.