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In Search of Sustainable Dividends

Laura Lallos

Laura Lallos: Hi, I'm Laura Lallos, an analyst here at Morningstar. I am speaking today with Clare Hart, the longtime manager of JPMorgan Equity Income Fund (OIEIX). Clare, thanks for joining us.

Clare Hart: Thanks for having me.

Lallos: I think it would be useful [if you started by explaining] your approach to equity-income investing because it's not about the highest-yielding stocks for you.

Hart: So, for us, in this strategy and the portfolio, the way we do it is, first off, we call it the equity-income fund, and that's on purpose. We're equity, so we're not using fixed income, we're not using derivatives, or synthetics of any kind. It's really about equities, and the income piece comes from the companies in the portfolio. So, we look for what we call quality companies at a reasonable valuation that pay a dividend yield. And we think about it in that order. And so, it's maybe a little counterintuitive to people who say, "If you are running an income portfolio, you must just be looking for the highest-yielding things you can find in the market." And that's not true. We always look for great companies that have yield attached so they can deliver hopefully for us, over time, really strong income in terms of the dividend income--the dividends we get from the companies--but also some capital appreciation.

So, the companies don't pay out every single penny that they have as a dividend; we take some of that money as a dividend and we're grateful for that, but we also are curious about what they are going to do with the money we leave behind for them. And they should--if it's a good management team with a good business, a good company, smart people--invest it so that their earnings grow over time, the book value per share grows over time. These things that should, over time, drive the share prices higher as well.

Lallos: You've mentioned looking at payout ratio in addition to dividend yield as a way to signal that.

Hart: People look at the payout ratio and think, "30% payout ratio--that's great to dividends covered." From our perspective, we can do the math on the dividend to see if it is covered or not; but again, with $1.00 of earnings, 30% payout ratio--relatively low--it's $0.30 for the dividend. Again, we're happy about that, but what are you going to do with the $0.70 I left behind? How are you going to make that money work for me? So, your earnings could grow, your dividend should grow over time as well--so, you get more dividends. But also, I think the low payout ratio is really the compromise you have to make in order to make sure the company has money to invest to grow the business and not squeeze every last penny out for the dividend--because you really shouldn't expect your dividend to grow at all. Then, you have the worst-case scenario: something that doesn't grow with a static yield.

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Lallos: Because of your focus on valuation, your fund is not as full of consumer-staples names, for example, as another income-oriented manager might be invested in right now. But you do like tobacco--that's one area you're interested in.

Hart: So, tobacco is an area, again, we're interested in. Within the portfolio, for example, we have Altria (MO), which is sort of the domestic piece of Philip Morris (PM). And as we think about the changing landscape in tobacco, the company Lorillard (LO), for example, is potentially going to merge with Reynolds (RAI). They're in the process of that. And Altria really has pricing power, and that's a big deal. To really have pricing power in tobacco or any pocket of consumer staples is really hard to come by these days.

People, I think, have historically said tobacco should trade at a huge discount to other staples because there is increased regulation, fewer people are smoking, those sorts of things. But tobacco companies are really good at trying to maintain their shares, being very careful about price and volume, being very careful about that mix. And I think, unfortunately, there are a lot of consumer-staple companies out there that are now living in that world that are trying to learn how to do that.

And I get back to someone like an Altria who, again, has pricing power, is domestically focused. And I know people are concerned about exchange rates and that sort of thing; but for me, it really goes beyond that. And it's domestically focused. I think that other tobacco companies outside the United States are facing the issue of plain-packaging, which is a big deal. If you're a cigarette company that's about the brand and the cache of what people have or are seen holding in terms of the pack or the way the cigarette is styled--if you strip that away, you're destroying all of that brand equity. I'm not sure it's a great place to be. Bring it back to the U.S., we're very careful. Within the United States, we have very specific rules around intellectual property and what you can and can't do in terms of taking away someone's brands and trademarks and that sort of thing. So, we really do like domestically focused tobacco.

Lallos: Obviously, after 2014, traditional income areas such as REITs and utilities are not particularly attractive. What areas are you finding some values in?

Hart: One of the areas that we are spending a lot of time on and that I think many people are talking about is energy. And again, our approach is that we are a conservatively managed portfolio. So, my goal is not to be a closet commodities trader in the portfolio; it's not what we would do. But we look at the energy sector--oil and gas--and we're trying to be as opportunistic as we can. We're trying to own the companies with the best balance sheets and the best business plans that can not only make it through what I'd call a difficult commodity environment, difficult commodity stack in terms of where the price have dropped to--especially for oil, though also for gas--but maybe even take advantage of it.

To take advantage of it, you have to have good assets in place; but more than that, you have to make sure your balance sheet is not overleveraged. You need to make sure that you can potentially [add value] through M&A, not certainly of whole companies but of fields, of assets that sort of thing. So, Exxon Mobil (XOM) I think definitely fits the bill. People would say, "It's a big integrated--how special could it be?" I would say, it's a big integrated with interesting assets--and "integrated" is not a bad thing when it means they own the value chain. That's important. They are not just on the tail like a drilling company, for example. They have the value chains. They have many levers to pull. They are exposed to both oil and gas. And again, flexibility in the balance sheet, flexibility in terms of a low payout ratio can really mean a little extra cash to do some shopping if there are interesting assets out there.

[Occidental Petroleum (OXY)] is another example--it's an E&P. But again, they've sold off their noncore assets. They are in the process of trying to sell more. But as the commodity stack dropped through the end of December, they are very well positioned in terms of the balance sheet. So, it gives them tremendous flexibility. They own more of their land than they lease, so that gives them tremendous flexibility on deciding when they are going to take the commodity and bring it to market.

They are not trying to beat the clock because they just need the cash and are drilling for cash in an un-economic price environment. They are not trying to beat the clock on land leases that are going to expire and they have to get the commodity out of the ground as fast as they can. They can sit and wait.

Those are two examples. Those are the kinds of companies we are trying to find. It's a difficult environment potentially, but they are positioned for it and can maybe even take advantage of it.

Lallos: In general, for income-oriented investors right now who are looking to equities, are there pitfalls they should be avoiding or any advice you have?

Hart: I would say that it's tempting for people to think that valuations don't matter, because I think there are certainly pockets and types of stocks that have a yield attached that are trading strange valuations and maybe they have been for a year or two. So, people feel like, "Well, how bad could it be? Maybe it's a new normal." But I don't think it is. I think the pitfall is to be careful about the yield and really pay attention to what it's attached to. I always say, for the companies in our portfolio, that they have a dividend but don't hold it against them. We talk to the management team. We want to make sure that they have a plan. They are all companies with a plan. It's not just that they are going to show up next quarter and pay you a dividend.

So, I think that's something I would encourage people to think about. Certainly, if you got the dividend check in the mail this time, that's great. But take a look at what it's attached to and try and figure out if that's actually going to be sustainable and can grow. Don't get caught in the situation where you're taking the dividend now but it's attached to something where capital destruction--meaning share-price correction to the negative--is going to take money out of your pocket in the future.

Lallos: Terrific. Thank you so much for talking with us.

Hart: Thanks for having me.

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