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When Dividend Yield Isn't Enough

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here with Josh Peters--he's the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy. He recently sold AT&T (T) and purchased Verizon (VZ) in his model portfolio. We're going to talk about why he made that swap.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, you recently made this change between AT&T and Verizon, which at a high level are very, very similar businesses. What prompted you to go ahead and make this move?

Peters: It started, really, with my dissatisfaction with AT&T, which has been swelling and compounding over the years. It's tough to own a stock for four years, as I did with AT&T, and feel like you've never been happy with a single decision that the company made. I remember, not long after I first bought the stock, they went after T-Mobile (TMUS) and that ended with a gigantic breakup fee that they paid plus some spectrum to T-Mobile. And where is T-Mobile now? It's their biggest, keenest competitor, trying to take market share away and, frankly, causing them some problems in the industry.

I don't know that AT&T can be blamed entirely for that, but it certainly didn't help to help finance one of your smaller competitors that way. And you also saw the company, which already had a very large dividend, was returning plenty of cash to shareholders; they decided to make $27 billion worth of share buybacks at an average price for the stock that I think is a little bit higher now, even for all those repurchases, than it trades at today. So, that's destroyed shareholder value.

And then more recently, they have bought assets in Mexico. Why are you getting into Mexico? Don't you have a pretty big wireless business here in the United States? Can you pay more attention and devote more to that? They paid too much, we thought, in a huge spectrum purchase that was $18 billion. And then DirecTV (DTV): I can understand that maybe they want a little bit more bargaining leverage over broadcasters and cable stations and stuff like that, but this is an unrelated business with a lot of long-term technological risk.

So, the message that finally sank in over a series of years was that AT&T wants to do, it seems, everything except focus on its core business and just be content with paying a large and rising dividend out of that. The dividend rose all four years that I've owned it, but the growth rate of only 2% just didn't make for a great total return even with a dividend yield over 5%.

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Glaser: How about Verizon, then? Do you think that they're doing a better job of focusing on the business? Or did you just want to have exposure to the telecommunication sector?

Peters: That's two questions. I'll answer the second one first: Telecom is a tough industry. It's the highest-yielding sector of the S&P 500 index, by virtue of Verizon, AT&T, CenturyLink (CTL), and some of these other names having really high dividend yields. So, on one level, you could think, for income investors, is telecom just too big to ignore? Do I need to have a stake there? The answer to that question is no. You do not need to own telecom if you are an income investor. Utilities would be very hard not to own at least some of, but telecom isn't an industry you need to have an exposure to.

And what I did is, in selling AT&T as well as another foreign telecom stock that I owned, I actually increased my exposure to the sector. I put more cash in than I raised by selling these other two names in order to fund a purchase of Verizon--because Verizon stacks up pretty well, not just as a telecom stock but as a high-yield stock in any industry.

And the contrast with AT&T is really strong in that AT&T has leveraged its balance sheet to go off and try to make all sorts of different acquisitions, really broadening and diluting its focus on what's most important--its U.S. wireless business. What has Verizon done? They have steadily sold off noncore assets on the edges of the core Verizon Wireless business. And when they did take advantage of low interest rates to leverage up, what did they do? They bought out Vodafone's (VOD) interest in Verizon Wireless, effectively doubling down on their best asset.

So, those better capital-allocation priorities as well as a better network for their business and a better customer base, I think, make them more resilient in the face of competition. It makes it a better business. Now, in the match-up, head to head, AT&T yields more. It has been yielding about a percentage point more than Verizon; but over the next couple of years, I think Verizon's dividend-growth rate--which has already improved a little bit and has already been better than AT&T's in the last couple of years--can move into that 4% to 5% zone. With a 4.5% yield on Verizon, that's a very attractive total-return prospect.

With AT&T, I think the further out you look, the more you have to question whether or not there could be some risk to the dividend, longer term. Verizon is covering its dividend 1.5 times with free cash flow. AT&T is just barely covering its dividend now with free cash. The margin of safety that was there for AT&T's dividend a couple of years ago has essentially been used up by, in my opinion, poor capital-allocation decisions, while Verizon still has this very strong coverage for the dividend and a lot of resources to continue to pay down debt. And as debt comes down, I think dividend growth can accelerate.

So, I was willing to take a swap here, even though initially, just head to head, I'm taking a lower yield, because I think the quality, the safety of the dividend, and the growth of the dividend and the total return it will drive are superior.

Glaser: Generally speaking, how do you know when it's time to, say, cut your losses or, if there aren't losses, to walk away from a stock that you are not happy with? Is it when you find something that would be a better fit? Is it worth going to cash sometimes if you are unhappy with a stock? How do you know when it's the right time?

Peters: It really depends on the situation. In this case, I wanted to get out of AT&T, but it's very hard to exit a stock that yields that much if you are trying to maintain a certain income level for the portfolio. Strategically, I think, every once in a while, you have to be willing to take one of those strategic retreats; but it really helps if you have something that you like that you can replace it with. And the way I like to think of it is that there are offensive sales and defensive sales. Not offensive, but "on offense"--more like the football terminology. Sometimes, you have the opportunity to "move the ball forward."

Let's say you own a stock that has a 3% yield and is growing its dividend 5% a year. If you can replace that with something that has the same growth rate of 5% but yields 4% or 5%, you're increasing your income but you're not giving anything up in growth. Those opportunities come along; you always want to be looking for them. I think the time to act is when you make a decision--when you've got enough information, you've done your homework, and you're ready to act. I've really learned over the last 10 years that you don't want to be too cute trying to time the market in general or individual stock prices in particular. You make a decision and then you act. You let that be your timing mechanism.

But on defense, too, look out a couple of years, think about all of these highly questionable--if not downright dubious in some cases--decisions that AT&T has made with its business and its balance sheet. This isn't a stock I want to own. I want a better-protected dividend, even if it's somewhat smaller at the outset. The fact that by swapping into Verizon I can pick up quality as well as faster income growth and likely total return over the long run, those factors make it a lot easier to consider making this type of a swap.

The worst kind of decision you might have to make is you have to protect capital, you have to protect the long-term earning power for this piece of your portfolio, and you sell and you go to cash for a while, and then immediately you try to look for something better to own. Sometimes, you're going to have a gap. I've held a lot of cash over the course of the last year because I sold some stocks I wasn't comfortable with. It took a long time to find the replacements. When those replacements came along, though, I was ready to act, and now we're back to being fully invested. Verizon has helped with that formula.

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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