Dividend-seekers: It's not your time yet

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

The start of 2016 has been a tumultuous one for stocks. I'm here with Josh Peters, the editor of our DividendInvestor newsletter and also our director of equity-income strategy, to see if it's opening up any opportunities in dividend-payers.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: The beginning of 2016 has been anything but calm. When you look at some of the dividend-paying sectors, have they also been hit by the volatility we've seen in the broad market?

Peters: Energy has been; that continues to be an area of some big dividend yields from the big oil companies, and especially the midstream energy names--MLPs and whatnot. They're off to a dreadful start, with tremendous volatility, the price of oil going up and down, flying around like it is.

For the most part, the rest of the high-yield universe has held up pretty well, which is really what you'd expect in a downturn. Your staples--utilities, REITs--defensive cash flow streams, less susceptibility to being pinched by a recession, if we turn out to have one. Currency is still an issue, certainly for the staples names, but these really dependable names have held up about as well as you'd expect.

The drawback is that they are not cheap at this point, and that's different than the downturn we had, the pullback we had, back in the late summer. You saw utilities actually get pretty cheap for a couple of weeks, and the same thing with REITs; it was good opportunity to add to those positions. The market may have come back even lower now in this latest pullback than it was in September, but these defensive groups, now when everybody wants to own them, they've actually gotten more expensive.

Glaser: Does that mean there aren't a lot of opportunities for the types of stocks you'd like to own.

Peters: I like to think of the best time to start an equity-income strategy--a high-yield strategy-is when you realize it's right for you, and not worry so much about trying to time an entry point. Valuations certainly matter, but what's really important is the decision you make as an investor, as opposed to what's out there in the market.

The one point I would make, though, is that when you decide on that strategy, you really have to be prepared to stick with it. You've got to have a long-term time horizon, think in multiple cycles. Long term is not 15 minutes as opposed 15 seconds. It's 15 years, or who knows how long, but a very long period of time.

As part of that strategy, you want to make sure that the companies you're buying are consistent with that, even in the tough times. For example, you've seen a lot of industrial names get a lot cheaper in the last month or so, to the point where you are finding names like Caterpillar or Cummins trading at 4%-5% types of yields. This is not normally what you expect. Industrials have been a pretty low-yield sector for a couple of decades, and now all of a sudden, look at all these yields! But you have to ask yourself, if we are headed into a recession, are these dividends sustainable? And I think that, in the example of Caterpillar, it's hard to make that case. If the global economy tips into recession, I think they've grown the dividend too aggressively in the last couple of years to be able to support it through the trough of the next cycle.

Now that may be OK. Maybe you don't need the dividend, and you think the stock is cheap--we don't actually think it's all that cheap, given the risk profile. But if you want to buy it as a value investor, that's one thing. But you really can't buy those names at this point in anticipation of a consistent, large and steadily growing income stream. It's just a mismatch between what your strategy is and what the securities are.

Glaser: So we're not seeing the kind of values that an equity-income investor would want to think about stretching a little bit, or thinking about some deep-value names.

Peters: The deep-value stuff, I'm going to stay away from, almost all the time. Very rarely have I bought a stock at a huge discount and actually turned out to be happy with it. The bigger that margin of cheapness is, you might think of it as margin of safety, but it also means that there is more potential for you to be wrong. So you have to keep that in mind.

Even if the valuations are not that attractive in the traditional defensive high-yield sectors, I don't think they are bad, I'm not selling these names. I'm not reducing my exposure. I am staying on an even keel. I'm still thinking five, 10, 15, 20 years, what do I want to own? What are the best value creators? Realty Income, to me, looks a little expensive right now to the point where maybe I even trim the position a little bit. But I'm going to keep the bulk of that position in place in my portfolio, I think, for decades.

Glaser: When looking at some of the factors that are driving this volatility, nothing is changing your opinion of your portfolio then?

Peters: No. I like to tell people, when everybody else is hunkering down, because they're worried about a recession, they are worried about volatility, a bear market, or whatever. I never hunkered up. I never hunkered up after 2008-2009. Because I don't think your tolerance for risk should be pro-cyclical. You might, in fact, want it to be anti-cyclical. You might want to, at the peak of a market--you don't know when peak is until after, in hindsight--as the bull market ages, as the economic expansion wears on, that would be a time to tighten up on your risk exposures. Maybe if you had some more cyclical names, you should really put them through the meat grinder. Think about whether you want to own them for the next downturn. But you don't chase those more cyclical names as the market expansion ages. That just sets you up to be whipsawed.

So make sure that you are thinking beyond just what's cheap. If there's anything I have discovered in 11 years managing this strategy it's that valuation is important. I'm not going to ever de-emphasize valuation. I can't emphasize that enough; I don't want to overpay. But it's not really a value strategy. Priority number one is to generate the income. Make sure you are collecting the dividend income that you are expecting.

Step two is make sure those income streams are growing--you are getting regular dividend increases. Valuation is the last gate. If you do that right, you should get some capital appreciation, but if your dividends get cut, you're going to have nothing but capital losses to show for it.

Glaser: So, the beginning of this year hasn't really created any big opportunities or changed your thinking.

Peters: I don't think so.

Glaser: Josh, thanks for joining me today.

Peters: Thank you, too, Jeremy.

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