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Peters: Time to Tighten Portfolio Standards

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He is editor of Morningstar DividendInvestor and runs two real-money portfolios as part of that newsletter. We just talked to him about what his strategy is and how he's used it over time. And we're going to talk about some of the issues that he's facing today and how dividend investors should confront this somewhat-difficult investing environment.

Josh, thanks so much for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start by looking at interest rates. What impact do interest rates have on dividend investing generally, and where do you expect rates to go in the next, let's say, five to 10 years?

Peters: I try not to make too many forecasts, especially macroeconomic forecasts in this business. It's not always good to put things down on paper that you know are going to be wrong, which is how I would characterize almost any sort of macro prediction like that.

But it's not too hard to look at the situation and say the basic direction ought to be up for long-term interest rates. I think of a normalized type of 10-year Treasury yield being in the 4% range perhaps, plus or minus, call it 2% inflation plus 2%, maybe 2.5%, type of real-return premium. Historically that's been kind of a normal range.

Short-term interest rates starting from zero really have nowhere to go but up. But we really don't have any idea when this might happen, and it could take quite a while. Federal Reserve policy continues to be extremely accommodative or lax, depending on your point of view of the situation.

I think the Fed wants to err on the side of caution in that they don't want to withdraw their stimulus plans until they're sure the economy can stand on its two feet. I think that's what they want to do, is withdraw those stimulus plans and start to normalize interest rates. But every year now for I think five years, it seems we start the year, thinking the economy is going to grow faster, and it doesn't happen. Maybe this year it's just the weather in the first quarter, but economic growth, this idea that it's going to accelerate, seems to be sputtering again.

What this has created for a situation right now is that interest rates ended with the 10-year Treasury yield at about 3% at the end 2013. Now it's back down to 2.6%-2.7%, and you've seen a lot of outperformance by higher-yielding stocks. Utilities, telecom, and staples, have moved up. And the thing that makes me cautious here is that you still want to have in the back of your mind that interest rates are going to go up eventually, and if you're going to buy a stock for the long-term that pays a good dividend, you want to keep valuation in mind.

I don't want to buy utilities or REITs, for example, that are priced as if a 10-year Treasury is going to yield less than 3% forever when chances are eventually it's going to go up, maybe 4%, maybe at some point it'll be 5%. Back in the early 1980s, it was 15%. You have to get, I think, some sense of valuation and try to price your stocks according to the idea that interest rates will go up over the long run.

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Glaser: Overall, do you think that dividend-paying stocks are priced for the 10-year Treasury to be at 3%? Do you see that across all of the dividend-paying sectors?

Peters: I think it depends on the sector. Staples, out of the big higher-yielding groups, I think, is a little less sensitive to interest rates than, say, utilities or REITs because you do have some correlation in their growth potential, their ability to grow earnings and dividends, in the economy. They won't grow a whole lot faster in a better economy, but they might do a little bit better. So there's a little less rate sensitivity there.

Utilities have actually held up very well in the move in interest rates thus far. You consider it was only May of last year when then Fed chairman Ben Bernanke started to talk about tapering the quantitative easing program that we've had in place now for several years, and interest rates moved up very quickly. For a while utilities really underperformed or even lost value. But on balance, it seems like higher interest rates were priced in.

I think that some of the better utilities that have faster growth rates, they're kind of in the fairly to slightly overvalued range. I wouldn't describe them as perilously overpriced for a normalized interest-rate environment, but I don't think this is the best time to be adding capital in utilities. REITs are the area that I'm still the most concerned about.

You still have a lot of REITs, big, premier, blue-chip names that are trading with yields well below 4%. That concerns me because a lot of people think of these assets as having such a close link to Treasuries. Well, if that's the case, then you've got a lot of downside valuation potential, moving from a 3% yield to a 4% yield on a stock, if its dividend rate doesn't go up by one third means that the share price has to come down substantially in order to make that math work. So those are some of the areas where I would be a little more cautious.

Glaser: There are some areas where it seems like the best we can say is that they may be just a little bit overvalued. Are there any other areas that maybe are looking slightly more attractive where there could be a few values?

Peters: Sector by sector, that's a hard call to make. I'm really unenthusiastic about valuations across the market right now. In fact, I'm sitting on some cash in the two model portfolios I manage. I sold some stocks for company-specific reasons a while ago and set about looking for replacements. And it's been very difficult. There's just not much out there that is attractively priced. About the best you can hope for is maybe fairly priced stocks. Some names that I would mention, GE is yielding in the low-3% range now, but I think it still has a good upper single-digit type of long-term dividend-growth potential. You've got some upside from better economic conditions, but that yield being so attractive, I don't think there's a lot of long-term valuation downside from here.

Chevron is another stock that I like. Within big oil, a lot of people prefer Exxon, and I'd say, Exxon is maybe a slightly better company. But Chevron is oriented around exploiting a lot of the growth opportunities that they've developed with a lot of exploration success over the last decade. They're spending a lot more in capital expenditures, but they're going to grow their production. And I think that makes for better higher-quality dividend-growth potential that we can look at with that name. Plus Chevron will pick up quite a bit of yield relative to Exxon at these prices. That's maybe not the full list. Clorox and Procter & Gamble are two household staples names that I like, but the picking is really pretty thin right now.

Glaser: Given the market conditions then, have you made any changes to your Dividend Drill, the process that you use to evaluate stocks. Are you thinking about companies in a different way?

Peters: I'm not really looking at companies differently, but I think you want to perhaps shift your emphasis just a little bit depending on market circumstances. My number-one goal is always to avoid the dividend cutters. That will never change.

I'd say my second emphasis here is to make sure that I'm emphasizing quality, and that I'm not sacrificing quality in order to perhaps get what looked like superficially better valuations. In his final edition of The Intelligent Investor back in the early 1970s, Ben Graham made an observation that I think is just perfect for the kind of environment we're in. He admitted that, yes, there is a risk of paying too much high-quality companies at the top of the market, but he said, an even bigger threat to your portfolio is those second- and third-rate companies that you buy when business conditions are good. They might look a little cheaper, but they're not necessarily going to hold up in that next downturn. 

I'm already thinking ahead, thinking past the current cycle, what's the next recession going to look like, what's the next downturn going to look like and do I have dividends that are vulnerable to being cut? That's what I want to make sure that I've got as little exposure to as possible. It may seem like it's skipping a step. I don't know if the market has already put in a peak. I try not to even get into that business of forecasting bottoms and tops and big shifts in market direction, but I have a sense that having tripled off of the bottom in 2009, we may be closer to the top than the bottom. This is a time to be tightening and raising your standards, not to be cutting them.

Glaser: Overall, right now you'd say then that dividend-focused investors should be a little bit more cautious but it's definitely not time to abandon the strategy and maybe look at non-dividend-paying stocks or other things that might just be less expensive?

Peters: No, I don't think that investing in high-yielding stocks is a decision that you want to make on the basis of market conditions. Certainly, there are some people who do that. A lot of institutional money managers say, "I've got to stay invested in stocks, but I don't want to own cyclicals right now, because I'm bearish about the economy. So, I'll buy the food stocks and the utilities stocks."

Then, that same person will sell them back and try to chase something else, and that's just timing the market. I think that's very, very difficult for, even institutional investors to do successfully and even more difficult for individuals.

As an individual, what I think you want to do is ask, "Is this a strategy that works for me over a series of decades in meeting my personal financial objectives?" And to have that large and growing stream of income certainly doesn't have the guarantee of an annuity but has certain annuitylike characteristics, that I think makes dividend investing something that you decide is right for your personal financial circumstances. You work with, of course, the raw material you're given in the market. You don't want to overpay, even for the good companies if you can avoid it. You've got to be sensitive to valuations; you should be aware of factors like interest rates. But you don't go, I think, from high-yielding stocks back to biotechs just because now biotechs are starting to run again. I think that's just a recipe for being whipsawed all over the place and having a very poor overall result.

Glaser: Josh, I appreciate your thoughts today.

Peters: No problem. Thanks, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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