Morningstar's dividend playbook

DividendInvestor editor Josh Peters walks investors through his drill for uncovering sustainable and growing dividends in this special presentation.

Josh Peters, CFA 21 July, 2015 | 5:00PM Jeremy Glaser
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The following is a replay from the 2015 Morningstar Individual Investor Conference.

Jeremy Glaser: Welcome back to our final session of the day, "Morningstar's Dividend Playbook." Josh Peters, the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy, will share some of his thoughts on how to build a portfolio of dividend payers. Just as a reminder, a PDF of the slides are available to download in a link below the player.

With that, I'd like to hand it over to Josh.

Josh Peters: Thank you, Jeremy. And thank you all for joining us here this afternoon. I'd love to have the opportunity to talk about one of my favorite topics, which is dividends. I always think back to the very first dividend check that I received. I was 13 years old. I had bought about $200 worth of the hometown utility stock, Minnesota Power and Light. My first dividend check was for $3.76, which certainly doesn't sound like anything you can retire on now. But it had a big impact on a brand-new investor--this idea that companies can pay you directly. And even though I went on for a series of years speculating--trying IPOs, biotechs, penny stocks, options--that one little dividend check always came back to mind. And eventually, seeing how many other ways there were to fail in investing, it became the root of a very successful investment strategy that we've been able to build here at Morningstar.

So, I'd just like to give you a little bit of an overview of DividendInvestor. I am the manager of its model portfolio, as well as the founding editor of the newsletter itself. In January of this year, we celebrated our 10-year anniversary. I'm very happy to have notched that record, and later on I'll talk a little bit about our performance over this time.

We have also written a book, the title of which has lent itself to the title of today's session, The Ultimate Dividend Playbook, which was released in early 2008. One of my favorite statistics is how many dividends we've actually received. Our model portfolio is built with real money that Morningstar had deposited into a brokerage account many, many years ago. And every time we make a trade, if I say buy, then it is stock that I am actually buying or have bought. If I say sell, it means something that I am actually selling or have sold. Hold means just that. I may not be a buyer or seller, but I am holding it. And over that time, we've collected now more than 1,200 dividend payments from those companies that we've held here over the last 10 years.

And of those dividend payments, the best of them, 398 of them, have represented dividend increases--companies that are providing our portfolio with more income through no incremental effort on our part. We're being rewarded for the use of our capital and for hopefully having made a good investment decision. And the companies are doing the work, driving total return both through the dividends themselves as well as the share-price appreciation over the long run that is encouraged by dividend increases. Sixteen times we have had dividend cuts. These are the worst events in my universe, what we try assiduously to avoid. Fortunately, 398 to 16 is not a bad score, I'd like to think.

Now, to begin talking about our investment philosophy--and mind you, I am going to get into some real practical details about how we evaluate stocks in just a few minutes. But everybody who wants to be involved with the dividend-paying universe of stocks and embrace a dividend strategy really ought to understand why dividends work. It can't be just a matter of getting that check in the mail. Certainly, for retirees, the opportunity to fund portfolio withdrawals through dividend income, and perhaps interest and other flows of income from other assets you might hold in your portfolio, is very valuable.

Why? Because if you don't have income funding your portfolio withdrawals, then you're essentially living off the pile. You're dollar-cost averaging in reverse; you're selling off shares in order to create cash for a withdrawal. But if prices are low, you have to sell a lot more shares and you can eat through your portfolio's value more quickly. Dividends, by being much less correlated with stock prices and more correlated with the actual performance of the companies that are paying them, essentially bypass a lot of that market volatility and provide you with the direct source of return.

Now, a lot of people think that dividends are only for retirees. But for people who are younger and are still in saving and wealth-accumulation mode, dividend investment is an extremely powerful tool to grow your income and compound your wealth well in advance of that retirement age. It even helps answer those really prickly questions, "When do I have enough money to retire, and how much do I need retire?" The answer isn't a portfolio balance at the bottom of your statement. It's actually when do you have enough dividends that it comfortably covers your living expenses? That's certainly how I plan to retire some years from now--when my portfolio is throwing off enough dividend income to live off of. Every stock I own personally, even the couple that aren't part of the dividend-investor strategies--some smaller-cap stocks that I own--all of them pay dividends. I expect that from any company that is going to receive my capital.

In addition to these natural advantages of the flow of cash to shareholders, you also have a better class of companies that you're dealing with. They are typically more mature in terms of their businesses, as well as their management. They tend to be concentrated in more defensive sectors. They are not going to be as volatile as other areas of the market. You need a certain amount of financial strength in order to pay a dividend, and that dividend provides a good reminder that the company is not just a function of press releases touting earnings per share growth--it's also generating cash that it can return to shareholders. The whole principle of dividend investing, I think, is made easier and more practical by the fact that it makes companies easier to analyze, and that's something that we're getting into in just a couple of slides.

Dividends also have great advantages for the issuers--for the companies that pay them as well. It demonstrates that ability as well as a willingness to reward shareholders directly; not all companies do. In today's market, there is a tremendous emphasis on share repurchases; total dollars spent by large American companies on share repurchases is much larger, actually, than what is paid in dividends. But what are they doing? They are returning cash to shareholders, all right. Former shareholders. As a continuing loyal shareholder of a company, I want to know how am I being rewarded? Share buybacks do factor into the potential growth of dividends over the long term, as there are fewer shares outstanding and then there is more cash available to pay dividend on a per share basis. But it's important not to think of share buybacks as being tantamount to, or an adequate substitute for, dividend income itself. The income is still very important.

Also, in making a dividend a large part--a dominant part, hopefully--of a company's capital-return program, they are taking on some discipline. They are making a commitment that investors are going to expect them to maintain over a very long period of time. And that helps block potentially bad capital-allocation decisions that could destroy wealth for shareholders. It doesn't block all potential mistakes that a company might make; but when a company has to recognize and it has to reckon with a certain outflow of cash that they are expected to make to shareholders, that discipline forces them to allocate the remaining cash flow that they have more effectively and should lead to overall better returns for most companies. Then, there is the theoretical point, which is that if you want to talk first principles, dividends are what give a stock value.

If you think about a bond, why do you buy a bond? Because it has a guaranteed interest payment and then a return of your original principal at the end of the duration of the bond. Common stocks don't have guaranteed interest, and they don't have maturity dates. Now, why would you buy a bond that didn't guarantee interest or mature? Well, you would still want some flow of cash. So, even for companies like Google (GOOGL), which don't pay a dividend at all, the stock still represents a claim on future dividends that could be paid. And to find companies that do already pay good dividends and leverage this direct connection between the company and its shareholders to analyze, select, own, and then succeed with these stocks, I think, is an excellent framework for practical investment results.

Of course, all of this would not matter if dividend-paying stocks had a history of greatly underperforming the market. Fortunately, the opposite is true. If we look at the performance of higher-yielding stocks, not necessarily the ones with the very highest yields--the mortgage REITs or BDCs with double-digit yields that have a lot of risk, stocks that I always tend to avoid and shy away from. Those are not part of our strategy because we insist on quality. But the upper 30% of stocks arranged by yield, these have historically, in the post-World War II period, outperformed the rest of the market by about 2 percentage points annually. And you start talking about, "What's 2%?" Well, over a long period of time, if you give it 10 years to compound at a 2% faster total return, that's an extra $575 on every $1,000 you originally invested. So, this is a very powerful trend that you see in 53 of the 60 10-year rolling time period since the end of World War II. Higher-yielding dividend stocks have outperformed the market.

What's maybe most interesting right now is that today people are worried about low interest rates and high valuations in some areas of the dividend-paying universe; they think these are stocks you don't want to own. Well, in fact, we're coming off of a period here over the last 10 years, where higher-yielding stocks have actually been underperforming, which is not usual. It's relatively rare, as shown in the chart below. And this, I think, gives me some confidence to feel like that historic pattern of outperformance, which is based on the advantages I discussed on the last slide of these being better, more well-established, financially stronger companies that are rewarding shareholders directly, not destroying value for shareholders. And in other ways, because the dividend is blocking and prioritizing returns to shareholders instead, we can look forward to a period over the next 10 years where perhaps dividends will show their historic outperformance again.

Certainly, you want to be cognizant of the low-interest-rate environment and the impact that that might have on future valuations; but by no means is this a terrible time to be investing in dividend-paying stocks. The right time to set course on a dividend strategy is when you realize that it's best for you and your financial goals.

Now, moving into the practical deployment of our investment strategy, it starts by defining your universe. There are thousands of stocks to pick from just in the United States and many more thousands, maybe tens of thousands, abroad. We have to find some way to narrow this universe down.

The basic screening parameters that I use in order to establish an investable universe that I can actually work with is to look at the companies we cover; that's the first item listed here in the sample screen below, that it has Morningstar analysis available.

The second is a dividend yield above 2.5%--what I look at as a really low minimum. I usually look for yields of at least 3%, but I'll cast a little bit wider net in order to get a universe of companies to start exploring. And with that, you have to remember that 2.5% is actually an above-average yield. It may not sound like a lot compared with some of the super high yields that are out there, but the market overall, using the S&P 500 as a proxy, is only at 2%. And historically, it's been closer to 4%. This is a low-yield era that we're living in. It's not just interest rates. To get a higher dividend yield, as well as the growth in the long-term total-return characteristics off of that above-average dividend yield, to me, it feels like I'm in a more normal environment for making investment decisions about individual stocks as well as my portfolio.

The third item listed here is absolutely critical. I will only consider narrow- and wide-moat-rated stocks for our modeled portfolio. And as I'll explain in the next couple of slides, that plays both into the safety of dividends as well as dividend growth. And then I also use our fair value uncertainty ratings as a proxy for risk. And I can deal with companies of average cyclical and risk characteristics, or preferably low, which you'll find in utilities, food stocks, and things like that; but your high-uncertainty--very-high or extreme-uncertainty--companies, even if these companies are paying dividends, they are usually not the kind of reliable income generators that you want to have as part of a long-term income strategy.

So, while I would never completely rule out the possibility of looking for stocks in a little bit wider net than this, the thing I will absolutely always insist on is that there is a narrow or wide economic moat around that business.

Now, once we have defined our universe with a screen and we've gotten that down to a manageable group of stocks to work with, we have what I call the "Dividend Drill," which is a three-stage questioning process for framing our analysis of an individual company. The first question is, "Is it safe?" And I'm referring specifically to the dividend with that question. Is the dividend reliable?

Dividend safety always has to be the number-one priority. It's not that there aren't other risk factors that you have to be concerned about--valuations are important, the macro environment is important--but the best way to drive your portfolio directly into a giant pothole, as illustrated in the little graphic here on this chart, is to buy stocks that go on to cut their dividends, because then you won't get the income you expected. And typically, even before a dividend cut is announced, you are going to look at a long and deep slide in the share price that's going to result in a capital loss.

So, that is something you really want to avoid. And in our history, in all of the stocks that we've owned in our portfolio over our first 10 years, you'll see a very tight correlation between the fate of the dividend and the fate of the stock. Eighty-nine percent of the stocks that have increased their dividends while we've owned them have resulted in positive total returns. We've also had some stocks--including mostly recent purchases in our portfolio--where we just haven't gotten our first dividend increase yet, and we still have made out OK with a profit 71% of the time. But in those situations where we've owned the stock and the dividend has been reduced while we owned it, we've only made money 19% of the time. Eighty-one percent of those stocks have been losers, and those three stocks out of that group that have proven profitable [have become so] because their dividends have come back and we've continued to own them. Wells Fargo (WFC), in the bar chart there, is that red line that is out on the far right side of the chart. It shows that we have earned a good total return from Wells Fargo. That's because the dividend, once reduced to $0.05 a share each quarter, is now back up to 37.5 cents. It's back at a record high.

So, it actually has been more of a dividend-growth story for us for the whole time we've owned it than a dividend-cut story, but I still would rather not have owned the stock when it cut its dividend. The share price, like that of almost every bank, suffered greatly in that late 2008-09 time period. I want to make sure that when the next recession comes, I'm not caught with companies that are cutting their dividends. How do we do that? Here's where economic moats play into the story.

These sustainable structural competitive advantages that we identify for individual businesses that we expect to last 10, 20, or more years, those are defending the profitability of the company. And it's those profits and cash flows that are, in turn, needed to pay dividends. So, if you don't have an economic moat--you are a Dow Chemical (DOW), for example--and you are just riding the cyclical waves up and down, and you can't really control the demand for your product, how much you can sell it for, or how much it costs to produce, that's not compatible with a safe and growing dividend. In fact, Dow is a pretty good example of a high-yielding no-moat stock. The dividend growth has been very poor over the years. In 2009, they had to cut their dividend.

What I prefer, instead, would be something like a Coca-Cola (KO), where they can influence demand for their product and have had terrific success over the years growing the demand for their product. They have very good profit margins, and they have the opportunity to expand them further. They generate a tremendous amount of free cash flow, even in the tough times for their industry, even when the company, like right now, is in a little bit of a funk. It's not really performing up to its full potential. That wide economic moat--that tremendous competitive-advantage set that Coke has--defends the dividend and sees to it that we continue to be paid regularly on a quarterly basis as shareholders.

Also, playing into avoiding dividend cuts and finding safe dividends are healthy balance sheets. Remember that all creditors stand ahead of you in line for companies' cash flows, so you don't want too much debt on the balance sheet. It's very important for the company to have some excess borrowing capacity so that it can smooth out potential short-term shortfalls in cash flow, while continuing to invest in the business and maintain its dividend.

The payout ratio is really the key number in evaluating dividend safety, but it's not a magic bullet. It's the context for the way you think about other aspects of dividend safety; but what's a good payout ratio for a utility--say 70%--would be much too high for a steel mill or an oil refiner, which are much more volatile businesses where earnings could be wiped out at the bottom of a cycle and the dividends get cut. So, you have to think about how a payout ratio--that proportion of earnings that is paid out as dividends--balances against the company's need to invest for internal growth, as well as providing that cyclical safety margin for future downturns.

Perhaps the best indicator of dividend safety is continued growth. If the company just raised its dividend, it's quite unlikely--unless it has a deliberately and obviously variable policy for paying dividends on a quarterly basis--it's very unlikely it's going to turn around and cut it immediately. But you also don't want to be faked out. This is not a perfect indicator. None of these factors are perfect indicators; you have to consider them all. Sometimes, companies go on raising their dividends for 30 or 40 years, and then they get cut because wrong set of circumstances come along.

The point here is not that you're going to be able to avoid every dividend cut; it's going to happen sooner or later. When you find stocks that yield 3%, 4%, 5%, or 6%, it's more burdensome to pay those kinds of dividends than it is to pay none, certainly, or a 1% yield or a 2% yield. But in order to get those higher yields, you have the opportunity to try to maximize and optimize the safety of those dividends. What you want is not "no dividend cuts at all"--that's the ideal and certainly what I'm shooting for--you really want to minimize it. You can't avoid all risks in pursuit of income and total return, but these are some guidelines to help you try to avoid as many dividend cuts as possible.

The second--and this is now where we start talking about a key driver of total return--is the growth of the dividend over time. I like to think of total return as being a very simple formula; it's dividend yield plus dividend growth. This is kind of confusing because it doesn't necessarily line up with the exact experience of a stock over any one period of time.

Yes, I can see that I'm getting, say, a 3% dividend yield from a stock like General Mills (GIS), but if the dividend grows 7% or 8% a year, which is about what I think is a good estimate here, that's just increasing this dividend that's relatively small. What you have to do is think about what is the impact on the share price of a rising per-share dividend rate over time?

What you see in the chart here of General Mills' stock price relative to its dividend rate over time is actually a very tight correlation. This makes for a neat example: As that dividend has grown over the last 20 years, you see that the stock price is following right along with it. Typically, the stock has been able to maintain a yield between the high-2% range and the mid-3% range and to provide this very consistent total return between the dividend income itself as well as the capital appreciation encouraged by that dividend growth.

Now, what drives dividend growth? It's really two factors. One is growth of earnings for the company. I like to think in terms of breaking this down into a couple of subfactors. For General Mills, are they growing volumes? Are they selling more yogurt, more cereal, more Häagen-Dazs ice cream? They've certainly sold me a lot more cereal in the last couple of years as I've got a house filled with small kids. And so much of that cereal seems to wind up on the floor that I feel like I'm single-handedly responsible for General Mills' last dividend increase. But it's not a fast-growing industry; people are only going to eat so much. So, maybe volume growth, even for an innovative manufacturer of packaged foods like General Mills, is only 1% or 2% a year. But then you think about what builds on that. Can they price in line with inflation? Maybe 2% a year pricing power over the long run. So now, 1% or 2% volume growth turns into 3% or 4% revenue growth. Can they expand their operating margins by becoming more profitable, particularly as this industry continues to consolidate?

By the time we get down to the operating-income line, this is probably more of a mid-single-digit growth in net income as opposed to low-single-digit growth in revenues. And then what does General Mills do with the cash that it doesn't spend on dividends? Most of the rest will go to share repurchases. Again, it's no substitute for dividends; but if every year there are 2% fewer shares outstanding because they've deployed the rest of their excess cash this way, then the dividend can grow 2 percentage points a year faster. So, even though we started with the business that maybe physically grows the volume of its business only 1% or 2% a year, we have the opportunity, I think, for 7% or maybe 8% long-term dividend growth. And that's on top of the 3% dividend yield.

So, what I just described were the drivers of earnings growth, but you also have to consider dividend policy. Does the company raise its dividend in line with earnings? Is it raising the dividend more slowly because they don't perhaps want to prioritize the dividend so much? Or is the dividend becoming more generous over time, and at what point does that max out? In the lower right-hand corner of the screen, you see a 10-year history of General Mills' earnings per share--this is being presented on a core or adjusted basis to exclude some unusual items--as well as the dividends paid in each of their fiscal years. And you see some up-drift; the dividend has grown almost 11% a year on average over the last 10 years compared with a 7% earnings-growth rate. That's not, frankly, sustainable forever, and you see that the growth rate in the dividend has actually come down a little bit more recently. Seven percent was the most recent dividend increase announced here for General Mills in this year of 2015.

If they can continue to grow earnings at 7% a year, chances are you can continue to get that kind of dividend growth. It's not 11%, but 7% is still a solid figure. And 59%, what we see as the estimated payout ratio for General Mills this year, that provides a nice balance. At least 40% of the earnings to be redeployed internally for high-return growth projects within the narrow economic moat that we think surrounds General Mills' business and enables them to grow at a profitable pace. Or, if the company doesn't have a lot of reinvestment opportunities and is just generating lots of free cash flow, it can fund share buybacks or make acquisitions and grow earnings per share in that way.

So, from here, I can think in terms of extending the trend. The relative trend here for the dividend of General Mills would be the earnings-growth rate. Can I think of this as a business that raises its earnings and then raises the dividend at a good 7% or 8% type of pace over the next five or 10 years? Things are in a little bit of a slump right now, but people are still eating. General Mills is still innovating, still becoming more productive. The basic story hasn't changed. So, I think it's a pretty reasonable estimate to peg General Mills as a 7% or 8% long-term dividend grower. And with that 3% yield, a 10% or 11% total-return type of story over a five- or 10-year type of period.

Now, when we think about total return, we are adding, as I mentioned earlier, the dividend-yield component, as well as the dividend-growth component; but there are a few more things to think about. You might go through a company and say, "Yes, there's a real stable dividend here, yield is 3%, and they've got a good chance of maintaining 4% annual growth in the dividend, as they have been." I'm kind of thinking about, say, a gas utility like Piedmont Natural Gas (PNY) here. It's a very high-quality company, but frankly a 3% yield is not enough, considering that the dividend only grows 4% a year. The indicated total return of 7%, I think, is too low.

Even for the lowest-risk businesses, I typically want that dividend yield plus dividend growth to be at least 7.5%; preferably I'm looking for 8%, 9%, 10%, and up, even from the lower-risk names, if I can find it.

And I think, in terms of a hurdle rate, this is what kind of total return I need to be able to count on from my individual-stock selections once I'm done analyzing them in order to meet my portfolio objectives. But there is one more piece that you have to consider, and that is the stock's valuation. And here on the right, I show two examples that actually come right out of our own portfolio performance over time.

When you buy a stock, you might see a good dividend-growth rate and a safe and decent yield, but if the stock can't keep up with the growth rate of the dividend over time, then you are going to earn less than you expected. So, in the case of Johnson & Johnson (JNJ), on the lower-right-hand corner of the screen, the dividend has, frankly, grown faster over the 10 years I've owned the stock than I initially expected. But because that dividend growth has slowed along with earnings growth slowing, the dividend yield has had to come up to compensate. That means the share price has gone up more slowly than the dividend rate. And today, Johnson & Johnson is more of a high-2%-yielding stock as opposed to less than 2% when I bought it.

So, instead of, say, that 2% yield plus a 10% growth rate in the dividend, leading to a 12% annualized return, I've made something more in the high single digits. Not bad. It's a low-risk company. And, certainly, the dividend is much more generous now than it used to be, but I didn't get what I expected because I frankly paid too much when I bought the stock back in January 2005.

What you hope for, instead, is the opposite, which is that the share price can go up even faster than the dividend. And this is the experience we've had from Realty Income (O), which, like Johnson & Johnson, is a core holding but one that has worked out much better for us and our strategy over the years. When we initially bought that stock in the summer of 2006, it yielded a little more than 6%. That sounded good, but it was actually great. It was too high considering the subsequent growth potential of Realty Income's dividend--to say nothing of the fact that they are one of the few REITs that didn't cut their dividend but continue to grow it every quarter even through the trials of 2008-09.

Today, the stock yields less than 5%. That means that I've gotten the benefit of the dividend growth of about 4% or 5% annually over the time I've held the stock and capital appreciation in addition to that. So, even though I think Realty Income is now a little bit of an expensive stock, most of that additional total return has been justified and is worthwhile and lasting. That's the hoped-for outcome.

So, the best way to get a sense--for me anyway--of the stock's valuation and whether or not it can sustain that valuation so that I get dividend yield plus dividend growth or better as my total return is to look for stocks that are trading at or below our Morningstar fair value estimates, which considers all of our research, all of our forecasting of the company's future financial performance, and condensing it down into that valuation.

I'm willing to pay a fair price for a very good business. For B-quality businesses, I want a bigger discount. For C-quality businesses, I wouldn't want them to own them at all. But the point here is that you don't want to overpay; you don't want to pay meaningfully more than the company is worth on a sustainable basis, because then, even if you are right about the dividend being safe and you cash those dividend checks, even if you're right about the dividend growth, you are still probably not going to get the total return you hoped for.

Let's put this into action using one of the recent additions to my Dividend Select portfolio in DividendInvestor--Verizon Communications (VZ). It's certainly a household name with tens of millions of customers across the country. You already know what business it's in, so let's look at it in terms of these three questions.

Is the dividend safe? Well, Verizon, for one thing, has never cut its dividend in the past. That's a favorable sign. Dividend cuts in the past don't mean that dividend cuts are going to be there in the future, and the absence of a cut doesn't guarantee that the dividend won't be cut in the future. But if you have a pattern of dividend cuts, it certainly raises important questions about the business. Maybe it's too volatile to sustain what you expect.

Dividend coverage, on both an earnings and a free cash flow basis, you need to have about 1.5 times coverage--about two thirds of earnings and free cash flow are being used to pay the dividend. That leaves you a big safety cushion, a big margin of safety for a potential short-term drop in cash flow. The dividend is still covered without the company having to choose between borrowing to maintain the dividend or cutting it. And it helps, too, that this is a defensive business. People need their cellphones in thick or thin. It's a business that we think is competitively advantaged relative to rivals, especially the smaller wireless providers like Sprint (S) and T-Mobile (TMUS). It has a better customer base, a superior network, economies of scale to enhance their profitability, as well as a strong investment-grade credit rating. Then, we see the potential for their leverage to actually come down over time because most of the free cash flow they are not paying out as dividends right now is targeted to help reduce debt over the next couple of years.

With that, you have here, on an annual basis, in terms of some of the dividends paid in each calendar year, you've had a dividend increase from Verizon every year since 2005. They didn't actually announce an increase during 2006, so if you are thinking about an increase being announced in the year, you could date it from 2007. Either way, you have a pattern here that the dividend has grown every year for a number of years. That suggests that the trend should continue because companies typically that make a point of raising the dividend every year don't want to abandon a favorable track record on a whim.

More importantly, what we see is that the dividend-growth rate has picked up a little bit. It hasn't been real fast. It's been 3.3% a year over the last 10 years; but just in the last couple of years, it's gone from an annualized increase of $0.05 a share to $0.06, now up to $0.08 in the most recent year. This is a favorable trend. I like to see dividend growth accelerating a little bit. Looking forward, I think we can look for 4% to 5% annual dividend increases, and that doesn't even account on much growth left in the wireless business in the United States. It's mostly a function of how productive can Verizon be in reinvesting its excess free cash flow--first through debt reduction and maybe, down the road, through share repurchases, acquisitions, and other things.

But one my favorite things about Verizon is that this is a business, especially in contrast to AT&T (T), that has become more and more focused on its best core business, wireless service in the United States, over the years. They've been selling off noncore businesses, wireline assets that they don't really need or want anymore, and when they leveraged up their balance sheet in a low-interest-rate environment, they essentially doubled down on the ownership of Verizon Wireless. Vodafone (VOD), the British company, used to own 45% of it. Now, they have full control of their best asset. These are all good aspects of the business that lend themselves toward a confidence that the dividend is safe and will continue to grow.

Now, in terms of valuation, you can see that there have been times in the past where you would not have wanted to buy Verizon for its dividend or really for any other reason. Back in the dot-com bubble, the dividend wasn't even growing, and yet the share price got up to close to $70.

Eventually, that snapped back into a more realistic relationship between the dividend and the share price. And there was a time back in 2010-11 when the stock was relatively cheap; I frankly wish I'd bought it then. But at this point, it looks about fairly valued. You see a consistent relationship where the stock tends to want to be yielding in the 4.5% range, give or take. It is trading also a little bit below our fair value estimate of $50 a share, which, in turn, helps justify this as a normal and sustainable yield. So, if I'm looking at a 4.5% yield plus 4% to 5% long-term dividend growth, I think I can buy Verizon and expect a 9% long-term total return.

I'd frankly be satisfied with 8% from an economically defensive and financially healthy business like this one; but to have 9% as a forecast, that gives me a little extra margin of safety. Even if dividend growth doesn't pick up as I hope and expect it will, I can still earn what's at least an adequate return and, frankly, an attractive one for today's environment.

At the portfolio-management level, you go through and you select a universe of stocks you want to evaluate. You go through them; you look at dividend safety. You look at dividend-growth potential. You consider valuation, and you come up with that potential total return. But you also need to have a context for those ultimate recommendations, and that's where portfolio management kicks in. I like to work against absolute targets. Most people seem to be oriented around beating the market. One of the most wonderful things about dividends is that it's not about beating the market so much; it's about delivering on real-world financial objectives.

The portfolio I manage for Morningstar is worth around $440,000 right now. That number is interesting, but far more interesting is the $17,000 a year of annualized income. That represents about a 4% yield on the portfolio's current market value. My goal is to have next year be $18,000 or $19,000 of annualized income, partly because I'm reinvesting but more importantly because I expect my holdings to raise their dividends and give me more money as a shareholder over time.

The year after that, I want to be up around $21,000 or $22,000. If I'm getting this growth of income, it's going to drive the total return in portfolio balance for my strategy, and the beating of the market should take care of itself. So, my targets are 3% to 5% dividend yields; right now, we're right around 4%. With this, even though these are above-average yields, I still think I can expect what's a historically normal rate of dividend growth for the market overall of 5% to 7% over the long run, and that suggests that my portfolio could compound at 9% to 11% annually.

Now, if you're withdrawing dividends, your portfolio balance isn't going to go up as much; you don't have the reinvestment component. But you should still benefit from the dividend growth and, of course, you're benefiting directly from the income that you're able to withdraw. But with this type of portfolio strategy, even though it bypasses a lot of the bread and circuses on Wall Street and the whole beat-the-market game to deliver a direct and practical stream of cash flow to the investor, you have to accept that it's going to act and behave differently. You're going for a different result. The market, overall, if you buy an S&P 500 Index fund, you're going to get about a 2% yield. With our strategy, our model portfolio, we're looking for 4%. We're going to have a very different-looking portfolio, and it's going to behave differently.

Here, below, I just show our sector exposures. The blue bars show the weighting of individual sectors in the S&P 500. You see that technology is the biggest sector at about 20% of the overall market's value; our weighting there is zero because I haven't found, at least at this point, any companies that I want to own that I think can deliver safe and growing dividends at good valuations over a very long period of time. It's tough for technology companies. Technology changes, markets evolve. I, for one, look at Apple (AAPL) and I love them as a customer, but will they still be as profitable and will they continue to grow over the next five or 10 years in a way that supports a safe and growing dividend? I can't have that kind of confidence the way I can with a stock like a General Mills or even a Verizon.

We do have a little more in health care. We're underweight in financials, in part, because the banks' dividends have been generally pretty slow to come back. But [if we look at] consumer defensive, the staples companies, there, we have significantly more weighting than the average of the market. Utilities--much more than the overall market weight. Utilities make up only about 3% of the S&P 500; in our strategy, they're 17%. So, we take a lot of risk related to the utilities industry, and if utilities are out of favor, it's going to drag on our portfolio's performance. But I'm less concerned about performance relative to the market than I am in just managing the concentrations of risks in my portfolio.

And for utilities, your main risk is regulatory, and it's carried out principally on the state level. So, as long as I've got diversification of my utility holdings across different states, then I should not have a tremendous vulnerability to dividend cuts that could really hurt me in that sector. Prior to the crash, though, I had a really large weighting in banks, and their risks turned out to be highly correlated. They were all vulnerable to the housing bubble, all vulnerable to the huge market dislocations, all vulnerable to unfriendly regulatory changes that have now restrained their ability to pay dividends.

So, go where the dividends are, but be aware of risk. Not in terms of falling short of the market return, but threats to your dividend income, the safety of it, as well as the dividend growth over time. It's good, I think, to be concentrated in those areas of the market where the safe and growing dividends are, just make sure that you still have enough diversification so that your income stream is not at risk.

Now, what does this all boil down to? I mention all the time that I am not trying to beat the market. And in only four of the first 10 years we were in business with our model portfolio did our return exceed the S&P 500; but cumulatively, without even trying, without targeting this head-to-head horse race that so many professional and even individual investors think about, we've been able to top the return of the market while earning a lot more income and taking a lot less risk. This chart set on top shows the cumulative total return. Starting at zero on our first day in business, we've compounded at 9.2% in just over 10 years, while the S&P 500 has done 7.9%. Now, that's nice, but how did we get there?

I really don't think it is strictly a function of my brilliance as a stock-picker. I think we have a sound investment strategy, but what has really advantaged to us was just the dividend income itself. If you separate our returns into a price-only component and an income-only component, our stocks don't go up as fast as the market. You can see that on the lower left. We have a disadvantage in terms of capital gains. But we more than make up for that disadvantage and put ourselves in the black by choosing to have a much higher yield. We've had an average yield higher than the market by 2.4 percentage points over the full 10-year run of DividendInvestor.

This is the kind of choice that anybody can make for their portfolio. To simply prioritize and require a lot more income, yes, it might mean a little bit less growth, a little less capital appreciation, but it also means less risk; it doesn't hurt your total return. Or, at least as long as you get the safe and growing dividends, it's going to have a good chance of outperforming--just as I mentioned earlier, many slides ago, how the highest 30% of yielding stocks tend to outperform by 200 basis points a year. We're taking advantage of some natural attributes associated with dividends that can work even if you're not a brilliant stock-picker and you don't have a PhD in finance or advanced mathematics. It's meant to be a very practical strategy that delivers real-world results.

Well, that concludes the prepared remarks part of my presentation today. I certainly want to thank you all for watching. We're going to take some questions here in just a moment. Just one thing I wanted to mention is that I own, personally, all of the stocks that are part of the Dividend Select portfolio in Morningstar DividendInvestor. That includes the stocks that I talked about today as examples, like General Mills and Verizon.

Glaser: Thanks, Josh. We do already have some questions. One of the big ones is finding value in a market that is a pretty overvalued or at least fairly value right now. You mentioned that it's important not overpay for a stock, like Johnson & Johnson. When you look at the market today, do you see any dividend payers that look like they are at all attractive?

Peters: I do, but they're mostly on a case-by-case basis. And we've seen some variability. Last year, we had terrific returns from REITs and utilities. And guess what--they became overvalued, both those groups as a whole. Early in 2015, they traded down, even though interest rates hadn't moved that much because the momentum broke. And all of a sudden, you had some names come back into buy territory. So, you're going to see a lot of correlation in sectors. All REITs are going to tend to want to go up and down together. But what you hope for is to pick out the Realty Income and find the opportunity to buy it at a fair price that can then deliver outstanding results to you year after year after year.

If you pay too much for a great company, your return is going to suffer. If you pay too much for a lousy company, you're going to get clobbered. And I like to think of high-yield investing not so much as a value-investing strategy--there is a tendency, I think, to conflate the two--but I prefer Charlie Munger's view, imparted to Warren Buffett: It's better to pay the fair price for the great business than the great price for the crummy business. And that definitely has shown itself to be a principle worth using in the first 10 years of our portfolio.

The companies I thought I was getting a great bargain on, even though they were kind of second rate, those didn't work out very often. And paying a fair price for Realty Income has worked out much better.

Glaser: Sticking with REITs, we had a question about mortgage REITs. You mentioned they're risky in your presentation. You don't think those look very attractive?

Peters: Just because something pays a dividend, even a big one, doesn't mean that it has the appropriate risk characteristics for a conservative income strategy. Now, you might buy a mortgage REIT because you like the yield, and certainly the yield is hopefully going to be the dominant driver of your total return like any other dividend-paying stock. The problem you have is what does the business have to do, what risk does it have to take in order to generate 8%, 10%, 12%, or 15% for a current dividend yield? And when those factors change, does the dividend get cut? That is almost always going to be the case.

These are companies that are geared to taking either a huge amount of interest-rate risk or funding risk with their borrowed money--or just frankly leverage, credit risk. They are really best suited as speculations on these different economic factors--the shape of the yield curve or the fate of credit quality in some sector. If you want to own them, you've got to go in with your eyes wide open, and that [means you need to realize] it is highly speculative. It's not the same as buying a utility or as a staples firm or a midstream energy partnership that just transports oil and gas and doesn't produce it. Those reliable payers are, I think, where you get the best results. So, you've got a lot more quality, a lot lower risk. Yes, the yields are lower, but you're going to get growth in total return to provide you with more and more income over time.

Glaser: We had a question here about inflation protection. Do you see dividends as providing some protection against inflation or is that not a characteristic of your strategy?

Peters: That is a characteristic of dividends. A good attribute of our strategy is that, with dividend growth, you hope to collect your current income and have the growth of the dividends themselves issued by the companies in which you've invested take care of maintaining purchasing power for your portfolio and its income over time. In order to have that work the best, you need those narrow- and wide-moat companies; you need companies that are competitively advantaged so that if their costs go up, they are in a better position to pass those incremental costs along to consumers and grow their profits a little bit faster in nominal terms so that their dividend rate can go up in a more inflationary environment.

Those no-moat companies may not have that ability; they may not be able to accelerate their dividend growth as inflation rises, and so your total return and the purchasing power of your income suffer. So, in general, over a very long period of time, you see that dividend growth in the market overall will respond to changes in inflation, but that isn't enough. You also want to think about the individual businesses that you are investing in--their economic characteristics and whether or not you can expect that dividend growth to improve in nominal terms, if inflation picks up.

Glaser: How about master limited partnerships? Is that a part of the market that you think is generally a good idea for dividend investors? And how about specifically today--are any MLPs that you think look attractive?

Peters: We've used a lot of MLPs over the years in our strategy, and frankly, at this point, we've got as few as we've had, I think, since our first year. And that, I think, relates back to some of their changing risk characteristics in the industry. At its best, a pipeline is kind of like a utility in that it sits in the ground, there's a big capital investment upfront, and it spits out cash flow that you grow over time. What changed in the last, let's call it, eight years was the dramatic growth of energy production. All of a sudden, you have the midstream energy industry, mostly through these master limited partnerships with their tax advantages, expand very rapidly in order to build out the gathering systems to transport all of this new natural gas and crude-oil that we're producing.

So, it turned from being kind of a steady utility-like business into a big growth business. Well, at some point, North American energy production is going to peak out, and there is not going to be as much opportunity to grow anymore. So, I think you have to become more selective in the partnerships that you want to choose.

My favorites are Magellan Midstream Partners (MMP), which has a crude-oil business that they've been growing very rapidly, which is very good and protective with long-term contracts, but most of that business is still a very utility-like delivery system for refined-petroleum products. So, it connects refineries to the truck terminals that then drop gasoline off at your local gas station. This business doesn't really depend on rapid growth of crude-oil production in North America continuing. All you need here is just for people to continue to drive or fly jet planes or use diesel in their tractors. It's a very nice business that has a wonderful regulatory regime. It gets an automatic pass-through of inflation in their rate structure. So, that's one. And it has some of the midstream-industry growth aspect, but really it's got just a wonderful utility business.

The other one is Spectra Energy Partners (SEP), which is in the natural gas field. But it, too, is mostly geared toward taking natural gas in very large quantities to areas where it's consumed in the Northeast as opposed to a gathering system in which you build a gathering system for a bunch of wells that somebody is drilling. When the wells are empty and the gas stops flowing, then those assets have no more value. The pipelines of Spectra, long-haul systems like that, have much longer lives and can generate much more reliable cash flow for decades probably. And it still has a lot of growth potential because low natural gas prices and the abundance of supply is encouraging more consumption and that means more customers to connect; but in general, in this area, I want to be closer to the customers and farther away from the wells. The wells may last for a couple years, maybe 10 or 20 years in a big basin if it's really successful, but eventually that's gone. The annuity-like cash flow streams that people look for in this part of the market are actually kind of rare.

So, you need to go company by company, partnership by partnership. And then, as always, you want to consider the tax attributes. These are not good to own in tax-deferred accounts like IRAs and 401(k) plans. Always consult a tax professional before you decide to make a move in this area of the market.

Glaser: We're about out of time. So, thanks for joining us today, Josh.

Peters: Thank you, too, Jeremy.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Alphabet Inc Class A175.09 USD-1.21Rating
Apple Inc214.29 USD-1.10Rating
AT&T Inc18.05 USD2.15Rating
Coca-Cola Co62.63 USD0.02Rating
DuPont de Nemours Inc80.72 USD0.37Rating
General Mills Inc66.66 USD0.56Rating
Johnson & Johnson145.65 USD-0.21Rating
Magellan Midstream Partners LP  
Realty Income Corp53.10 USD0.06Rating
T-Mobile US Inc177.61 USD0.13Rating
Verizon Communications Inc40.08 USD1.57Rating
Vodafone Group PLC ADR8.91 USD0.56Rating
Wells Fargo & Co59.05 USD1.39Rating

About Author

Josh Peters, CFA

Josh Peters, CFA  Josh Peters, CFA, is a portfolio manager for Morningstar’s Investment Management group and edits the monthly newsletter Morningstar® DividendInvestorSM.

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