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Finding the Dividend Growth and Income Sweet Spot

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Dividend investors spend a lot of time doing research on individual securities, but sometime they spend less time thinking about portfolio construction. 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 some changes he has recently made in his portfolio and what lessons investors can learn from them.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start with some of those changes that you have made to your newsletter portfolios. Could you walk us through why you decided to take the two separate portfolios and combine them into one?

Peters: Just a little bit of backstory: Our performance starts in January 2005, so a more than 10-year track record. Those first two years, we had just a single portfolio--it was called the Dividend portfolio. Then, in 2006, I noticed that a lot of subscribers were looking for us to concentrate on a lot more high-yielding names, which back then could yield 6%, 7%, 8%, or maybe 10% or 12% on some stocks. And so, at that point, we divided the strategy. We set up a new brokerage account because both the accounts were represented by real Morningstar money that had been deposited into a brokerage account and set about having what we called our Builder Strategy--kind of the carryover from the original portfolio--and moved some of those higher-yielding names we owned earlier on into the higher-yielding-focused one called the Harvest portfolio. They used the same basic investment discipline but targeted very different yields.

What happened, though, was that experience taught me the best results are really in the middle. So, where initially that Builder portfolio focused on yields between 2% and 4% but 8% to 10% dividend growth, I found that was actually more than you could reasonably expect over the long-term from most of those kinds of companies that could meet those yield requirements, [and the same was true for] the Harvest portfolio looking for 6% to 8% yields. Now, I wanted at least some growth to offset inflation; but frankly, even in that environment--even more so in today's environment--if you are looking at stocks with those kinds of yields, you are taking too much risk.

So, as I maneuvered these two portfolios over the succeeding eight years, I found they are getting closer and closer together--because I'm finding that the best results are in the middle--to the point where, at the very end, the Harvest yield objective was 4% to 6% and the Builder was 3% to 4%. They were right next to each other. So, at that point, I had to consider whether it made more sense to keep them separate or whether the whole was worth more than the sum of the two parts.

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Glaser: So, what does the new portfolio look like? Did you make any holdings changes? What are the new objectives?

Peters: So, in this one portfolio, I'm looking for yields in the 3% to 5% range. The portfolio, as it's currently constituted--excluding its cash balance--is at about 3.9%. So, we are right in the middle of the target there. We're looking for long-term growth of income specifically through dividend increases from the stocks we own of 5% to 7%; I think we are a little bit below the 6% range on an average basis. So, again, we are kind of right in the middle of that range, which I think is where we want to be.

You might wonder, "Well, does one size really fit all?" I gave that an awful lot of thought, but I think you have to think about it from the standpoint of who is out there and what they are looking for. It's very easy to think in terms of a 70-year-old retiree--they want as much income as possible--and then the younger investor, say, a 30- or 35-year-old--they don't need the income, so why get it? They should go for growth, growth, growth. Again, I see balance, the lesson that I learned over 10 years--one of the many lessons over those 10 years--was that there is a sweet spot that seems to generate the best risk-adjusted outcomes.

So, the choice isn't so much about how much income do you need to generate but how much risk do you want to take in order to get a rewarding total return. If you are that retiree, you might want or even think you need a 6% or 7% withdrawal rate. So, it's only natural to think in terms of needing to generate 6% to 7% dividend yields from my portfolio in order to meet that withdrawal. The problem is that to get a yield on a portfolio that high, you take a tremendous amount of risk. You are going to be very concentrated in specialty financials and low-quality MLPs; these are things where you are taking a lot of risk in order to try to meet what's already an unrealistic objective. So, it's actually much better to set your sights a little bit lower in terms of yield. I think 3% to 5% is where that number is.

On the other end of the spectrum--the younger investor--there is really no more reliable way to grow your income than to reinvest the dividend income you are already receiving. This idea that if you're young you have to go for growth ignores income and ignores total return--and growth is, in fact, less certain than that receipt of income. So, it's more about risk tolerance and what kind of investment philosophy you embrace. Now, if you are that younger investor, if you want to try to pick the next Chipotle (CMG) or the next Netflix (NFLX)--the next hot stock that's going to do really, really well over a series of years--and you are willing to take a lot of risk to do it, go for it. But realize also that that's a different type of investing than the more passive, conservative, I-eventually-want-to-have-a-nice-reliable-stream-of-retirement-income type of investing that the Morningstar DividendInvestor strategy is designed to deliver.

Glaser: So, if an individual did want to adopt this blended-portfolio type of strategy, what would be the best way to actually execute that in practice?

Peters: Well, one of the beauties of the newsletter model is that subscribers can adapt it to their own needs. Lots and lots of subscribers, maybe even most of them, just cherry-pick their best ideas as they are building their portfolios. But one of the reasons we have model portfolios and one of the reasons I went through the process of merging them was to also provide that additional example of not just the parts of the machine but the whole as we think it should work the best. With that in mind, it's an engine that's already in motion. We bought, say, Realty Income (O) many years ago when it was at lower prices. Right now, it's at a relatively high price. It wouldn't be a good standalone purchase. In that case, somebody might look at our portfolio and just buy the stocks that are under fair value, and then look for opportunities to add on the other names as, hopefully, normal market fluctuations take them into buy territory.

The other option is just to do the carbon copy. And I know that that means perhaps buying stocks that are over our fair estimates; but what you can assume if you see us holding stocks [that are maybe trading at a 10% premium to fair value in our Dividend Select portfolio is that we still think this] is a superior use of our capital relative to cash or other stocks. Otherwise, we would cash out or we would sell it and buy something else.

So, with that, it's a more passive approach. You just copy the types of trades that we are making and use the portfolio weightings of our individual holdings to apply to whatever dollar amount you are working with. And yes, it will perhaps underperform in the short term if those lower-priced stocks outperform and you only bought those, but we are looking to make changes over time, too. Our turnover is pretty low. It's been less than 20%, on average, over the first 10 years in operation. But that implies an average five-year holding period. It means 20% new ideas, in general, in the average year. So, with that, you will benefit both from our existing recommendations that we still think have some merit as well as the future buys and sells that we will make that you can execute on your own.

Glaser: Josh, thanks for your thoughts on portfolios today.

Peters: Thank you, too, Jeremy.

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

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