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Peters: Dividend Outlook for 2015

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Josh Peters. He is the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy. We're going to take a quick look back at 2014 and see what 2015 might hold for dividend payers.

Josh, thanks for joining me.

Josh Peters: Thanks for having me, Jeremy.

Glaser: Let's quickly take a look back at last year. When you look at the performance of your portfolios--and dividend payers, in general--how did they do compared with the broad market?

Peters: Dividend investors had a pretty good year, I think it's fair to say. In general, we're taking less risk. In statistical terms, we have lower standard deviations and lower betas than the market overall. And so when the market does well, has an above-average year--and it was an above-average year for the S&P 500 last year with a total return of 13.7%--it's not unusual to expect [dividend payers] to lag a little bit.

But within that experience, it's really a tale of two camps. There are the REITs and the utilities that frankly shocked a lot of people with how high their total returns turned out to be, close to 30% for these groups--in fact, a little better than 30% on some REIT indexes last year. [In comparison,] the other types of dividend payers, your big multinational, industrials, and staples firms--also very popular with the core of many dividend-paying portfolios--suffered rather poor years. And macro factors explain a lot of these divergences. The higher-yielding stocks, the REITs and utilities with very steady cash flows, they benefited incredibly from the surprise drop in long-term interest rates.

On the other hand, your big multinational staples, a Coke (KO) or a P&G (PG), those names didn't do quite as well because they weren't benefiting solely from economic growth picking up here in the U.S. They have a lot of exposure overseas--emerging markets, Europe--where the economies are not doing as well. And the strength of the U.S. dollar has been a real headwind for earnings and for dividend growth for those names.

So, this has played out essentially in our model portfolios, our Builder versus our Harvest. We've got those big multinational growth-and-income types of stocks; we had a total return of only 4%. Our Harvest, where our REITs and utilities are, that portfolio returned over 22% last year. So, a good overall result, but the best portfolios I think were the ones that maintained a good balance of both types of stocks and not just one or the other.

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Glaser: So, looking to this year then, would you expect utilities and REITs to fall back, to kind of come in a little bit given how much they've run, or will they continue to trade at these kinds of valuations for some time?

Peters: In the short term--and I think of one year as being a short-term time period--it's going to be an interest-rate story. And I don't think there's any good way to predict what may happen with long-term interest rates this year. Even if the Fed starts to raise short-term interest rates, there is no economic law that commands that long-term rates like the 10-year Treasury bond have to see their yields rise as well. It's just a very complicated situation with very, very low interest rates in other parts of the world, quantitative easing on the part of other central banks even though our Federal Reserve has stopped. That's importing deflationary pressure and importing lower-interest-rate pressure here in the United States even though our economy is doing better. So, maybe utilities can hang on to these valuations--and REITs, too.

The one thing I would be comfortable saying is that to have a repeat, another year of 30% total returns from these groups, it would really take a terrific imagination to see that happening. I'd never rule anything out, but you might have to have our 10-year Treasury drop from 2% to 1% in order to have a repeat of last year's performance. So, at the very least, you should be thinking about a lot less, and then the longer out you look--and especially with these dividend payers--you want to own them for years or think about owning them for years to collect the value and the benefit of those dividend checks as well as the growth in the dividend over time. Valuations are, frankly, pretty unattractive in these rate-sensitive areas like REITs and utilities. It might actually make more sense to take some money off the table and perhaps shift it into some of the higher-yielding names in big multinational firms that haven't done so well lately but where valuations are that much more attractive. And frankly, you can get some better yields, pick up income in some of those swaps.

Glaser: How about energy? That's a sector that was battered in 2014. Do you see any opportunities for dividend investors there right now?

Peters: I think there's some opportunity, but I wouldn't overreact to it. Yes, I want to pay a good price or a bargain price when I can for a good business; but in the energy sector, most of the E&P (exploration and production) companies and oil-services companies--the ones that are most directly exposed to the oil price--they don't tend to pay very large dividends to begin with. So, those are not good income vehicles. Then, there are some royalty trusts or partnerships that are set up to pay really large yields; we're already seeing those distributions and dividends get cut. Those are not areas for conservative income seekers to look to participate in energy. They are just much too speculative.

But where I think you can add some names to your portfolios, if you don't already own them, would be a Chevron (CVX) or a Shell (RDS.A) or an Exxon Mobil (XOM)--these giant Big Oil companies, the super majors, that have very strong balance sheets. They can continue to pay their dividends, maybe even continue to raise their dividends in a low-oil-price environment and continue to invest in future production. They are geared to do that. They understand that this is a game for them and their shareholders that's played out over decades. They are not going to overreact or wind up in a pinch terribly quickly in a low-energy-price environment.

And some of the midstream names like Magellan Midstream (MMP), for example, or Spectra Energy (SE). The one cautionary point I would make about midstream is that even though a lot of these firms don't have direct sensitivity to commodity prices, they are going to be influenced by drilling activity. These are the gathering-and-processing companies in oil and natural gas. If drilling activity falls off, which is frankly what you expect when prices plunge, then that's going to curtail some of the growth opportunities and maybe even some of the transportation volumes for some midstream companies that are involved in that area of the business that's closer to the producing fields. I tend to favor the midstream names that are closer to the consumers, because the way we consume energy tends to be much more consistent, much more predictable than the price of energy and the impact that that has on production.

Glaser: Sounds like it could be another interesting year. Josh, thanks as always for joining me.

Peters: Thank you, too, Jeremy.

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

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