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What Impact Will a Rising Dollar Have on Dividend Payers?

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. What impact will a rising dollar have dividend-paying stocks? I'm here today with Josh Peters--he is the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy--to look at this question.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, let's start with what's driving the dollar higher. What are some of the factors that are [causing the] rise against the euro, the yen, and other currencies?

Peters: Well, it's a tribute to American economic strength right now. We've really broken out of the pack and suddenly are having a much stronger economic recovery. Really since mid-2009, we were ploughing along at a low 2% GDP growth rate, and now that's picked up quite a bit relative to the rest of the world, which frankly isn't doing so well. Emerging economies have slowed down; there is more uncertainty; Europe remains moribund--on the verge of a deflationary recession. And with that, you would expect that capital would look to go places where it's going to find more economic growth, and that's the United States.

Then, you've also got very, very low interest rates. We think of them as being very low here; they are even lower in Europe. Lately, you can go out to five years in German bonds and the interest rates are negative. A 10-year government bond--government of Germany--is about 0.5 percentage points. To a German investor, a 10-year Treasury here that we think of as really expensive at a 2% yield actually looks really good. So, that's continuing to attract more capital. And as people want to exchange other currencies for the U.S. [currency] so that they can invest in our securities and our economy, that's driving the price of the dollar up.

So, I think we can take it as a compliment as Americans--give ourselves a little pat on the back. But this isn't really good news for most investors because so many of our large companies have overseas operations.

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Glaser: Let's talk about that potential bad news [as a result of] the stronger dollar. How big of an impact is this going to have on the earnings of some of the big dividend payers?

Peters: I like to look at Coke (KO) as an example. I bought Coke in April of last year--actually the second trip around for our model portfolios. People have really been criticizing the company. They are generating internal operating growth in earnings that's maybe in the 5% range, give or take. A lot of critics think that they can do better higher single digits. I think 5% is actually decent. Anything more than that is gravy. But what's Coke's biggest problem right now? Currency has turned into a 6- or 7-percentage-point headwind, and it's still getting worse, not better. So, all of the internal growth that Coke is generating with its global footprint--so much of it overseas business--is being canceled out as the dollar rises. And the currencies in which it's earning so much of its income are depreciating once they are translated back into dollars.

That, to me, is really the story around Coke. It's the story around Philip Morris International (PM), which has its operations entirely outside the United States. A lot of other staples firms, industrials with global footprints, this has created a pretty significant drag that I think is going to translate into some smaller-than-trend dividend increases in 2015.

Glaser: So, it doesn't sound like these trends are going away--the move toward the stronger dollar. So, if you are going to see potentially smaller dividend increases in 2015, does that change your strategy at all? Do you think about maybe moving toward companies that have a bigger domestic footprint?

Peters: Well, if you've got a well-balanced dividend portfolio, you've probably got some REITs, some utilities, some more domestic companies already. So, those I think are giving you that sort of pro-dollar exposure, as it were, in your portfolio. I don't think you necessarily need to increase that, in part, because you have to balance the current fundamental trend against valuations. REITs and utilities have very steady cash flows that are now very valuable in a low-interest-rate environment; but the valuations look very high if you assume that, over the next couple of years, we're going to see interest rates go back up--which I think is still the most likely case and an important planning assumption for income investors. You don't want to buy a stock today that is priced for a 2% long-term Treasury-bond rate off into infinity. I think you have to assume that 3%, 4%, or maybe 5% out there is coming, and that's going to have a negative effect on valuations.

When you look at the big multinational firms that have yields now that are comparable to in a lot of cases--or even better than in the case of a Philip Morris--what you can get from regulated utilities, yes, you've got some current headwinds. Yes, maybe you're taking a little bit more risk. But I think the valuations are much more attractive, and that is going to have the biggest impact on your long-run total return. It's going to translate into superior results over a three-, four-, or five-year time horizon. The dollar is not going to go to the moon. Eventually, these trends are going to reverse themselves, and I think you want to take advantage of the better opportunities from a valuation standpoint that you have in front of you now.

Glaser: Josh, thanks for joining me today.

Peters: Thank you, too, Jeremy.

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

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