Top picks from our dividend expert

Josh Peters, Morningstar's director of equity income strategy, describes the two model portfolios he manages in his DividendInvestor newsletter and shares his best dividend-paying ideas.

Christian Charest 9 April, 2014 | 6:00PM Josh Peters, CFA
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Christian Charest: For Morningstar, I'm Christian Charest. All this week, we're highlighting some of Morningstar's Best Ideas, and today we're looking at some of the research that our equity analysts have been doing. With me on the phone is Josh Peters, he is the director of equity income strategy and the editor of Morningstar's DividendInvestor newsletter.

Josh, thanks for being with us.

Josh Peters: Good to join you here today.

Charest: Now, we don't often talk on about dividend strategy, so before we get into the specifics, [can you] give a general idea regarding the kind of work that you do? So the DividendInvestor Newsletter is a monthly publication that follows two model portfolios. Why don't you start by telling us about those portfolios?

Peters: Well, both of the model portfolios which we've had here for quite a few years, the older one of them dates back to January 2005, are meant to provide not just a buy list of our best ideas at any moment, but also to illustrate our philosophy and strategy for managing a portfolio of stocks for income. And for both of them, even though they have different yield characteristics, the underlying mandate is pretty simple. With buying the stocks we want to generate a stream of income and then protect and grow that stream of income over time, mostly through dividend increases provided by the companies that we own.

Whenever I sit down to look at a stock, I'm always occupied by three specific questions, all of which have to do with the dividend: Is that dividend safe? Will that divided grow over time? Which means, is the company growing, and is the management going to share that growth with shareholders through higher dividends? And then between the yield and the growth that is offered by the stock, what's the total return that's formed by the dividend?

So with this strategy, even though it's just three seemingly simple questions, it actually touches on all aspects of the business. And how we use those recommendations in the model portfolios is that some people are looking for relatively lower yields, at least relative to our universe. In DividendInvestor, say 3% to 4% type yields, but a lot more dividend growth. That's what we call our Builder Portfolio and then other folks are looking to really maximize their income, that's what our Harvest Portfolio is designed to do, and we own stocks typically with yields between 4% and 6%. We don't get quite as much growth, but at the same time we emphasize dividend growth and dividend safety as checks against capital losses.

So, you won't find mortgage REITs and business development companies and other sort of odd critters that are designed to generated fat double digit yields. We're still very concentrated on getting a well-balanced and low-risk total return.

Charest: Now, can you give us some examples of some of the stocks that you've held in each portfolio for a long time, and why you like them? Let's start with the Builder Portfolio.

Peters: The Builder is where you are going to find a lot of the classic names that are really familiar to people who are interested in blue-chip stocks in general, even if they don’t have a real focus on dividends.

Some of my favourites right now include General Electric, yielding around 3.5%. I think that’s quite attractive and yes, they did cut their dividend back in 2009, but they're bringing it back. Company's commitment to paying that large dividend and growing it hasn’t changed. They are shrinking the size of the financials operation that got them into trouble in the first place. I'm very happy with the progress they're making there.

Clorox is another name I like a lot, has a yield in the low 3% range. It's not a real fast growing business. You’re only looking at maybe 1% or 2% volume gains, maybe a couple of percentage points from pricing. It's kind of a mid-single-digit growth story in terms of revenues at best. But these are almost bulletproof franchises. I like to ask people, in the United States, anyway, what is the number two brand of bleach after Clorox? What's the number two brand of charcoal after Kingsford? You’re hard pressed to even come up with those answers.

So, here you have a business that’s in some very attractive niche areas and they are not going head to head with the global giants like Unilever and Proctor & Gamble. That’s a name like GE that has a wide economic moat.

Then midstream energy is an area where I have a lot of exposure especially in our Harvest Portfolio, but also in the Builder. Spectra Energy is a name I think a lot of Canadians might be familiar with. They own Union Gas that serves a large area of Ontario. The big portion of this business now actually is their natural gas pipeline and storage business down the United States. They recently took that business and turned it over to their captive master limited partnership outfit called Spectra Energy Partners, that I think is quite attractive as well.

Spectra Energy Corporation has a yield again in the mid-to-high 3% range, but we're looking for high-single-digit dividend growth year over the next couple of years. We think that forms the basis for a good total return.

Charest: Now your portfolios focus mostly on U.S. stocks, but you also hold a few non-U.S. companies. Right now, the only Canadian company that you hold is Rogers Communication, but you've hinted in the last issue of your newsletter that that might change in the near future. What's your opinion of Rogers right now?

Peters: As you said, I only own one stock based in Canada, that's Rogers. In buying it last spring, I still felt like this was a company that could generate high-single-digit dividend growth going forward and at the time, it was yielding in that mid-3% range that I think of as my sweet spot. It looked like a pretty good investment candidate. But here's the risk, when you buy a stock and you're anticipating a fair amount of growth in order to justify your expected total return, if the growth slows down dramatically or it stops, then that kind of leaves you in the lurch.

So right now, I'm evaluating whether or not I want to keep Rogers. Obviously there's a lot of government pressure on the wireless carriers, the big three wireless carriers. Some seem to be handling it better than others. Frankly, kind of adding insult to injury that Bell raised their dividend by a larger percentage amount here this year than Rogers did.

I want to give the new CEO of Rogers an opportunity to talk about a longer term strategy for the business. How we're going to get that high-single-digit type of dividend growth back at some point in the future. But I can't say that this is a stock I'm necessarily going to own six months or a year from now. I'm going to wait and see what we can learn and then make a decision.

Charest: Fair enough. Now for Canadian investors, when we think of dividend investing, we automatically think of the big banks or at least the financial sector in general. It's not unusual when we look at dividend funds here in Canada to see their stake in the financial sector in the 40% to 50% [range]. But you hold none of the Canadian banks, in fact, you only hold one U.S. bank and that's Wells Fargo. Why don't you see more potential in the financial sector?

Peters: Well, this has been a big change here over the last; let's call it, five or six years. I actually did have a lot of exposure to U.S. banks going into the crash period in 2008 and 2009. Every bank that I owned, cut its dividend and it was always dramatic, it was always a tremendous loss of income. Now, the better quality banks like Wells Fargo and U.S. Bank, which is another which I recently sold, I was willing to hold on to those. I figured their dividends could come back, the franchises were intact, these were more macro problems as opposed to flaws associated with their own business models.

So, I had the opportunity to participate in the recovery. But what's changed since the pre-crash era is that dividend payout ratios for the large American banks are a lot lower than they used to be. Consequently, the yields are a lot lower than they used to be. There are very few banks now in the United States of any size that yield even as much as 3% and typically that's what I'm looking for is a minimum current yield of 3% when I'm considering adding new stocks to the portfolio.

With that low payout ratio, you can say, yeah, well the lower payout ratio in some future recession or financial market event, the dividend should be safer and, yes, that's true. But now I'm in a catch-22. I'd like to get a bigger yield from these names, but if I did than the dividends are more likely to be cut.

So, Wells Fargo is the one that I continue to own. I'm looking forward to hopefully a good dividend increase shortly. I think it's strongest of the big U.S. banks and it still has a lot of appeal on a total return basis. But banks really taught investors that leverage and dividends don't mix well. When you have a lot of creditors, depositors or bondholders, the government, whoever that are in front of you in line to receive a payout from the business, that leaves you more vulnerable.

So today, in the Builder Portfolio, where at one point I had a 40% weighting in banks. Now the biggest area of exposure I have there is in the staples group, where the companies typically do carry some debt, but it's not nearly the burden in terms of the potential threat to the dividend, and you've got that underlying stability.

General Mills, you know that people are going to be eating Cheerios despite what happens. The kind of name [that will get you in] the mid-3% range, and I’m much more comfortable owning. As well, I've had good run of dividend growth from that name as well.

Charest: Okay. Now right now, there's a lot of cash in your portfolios because you've recently sold a few of yours stocks. Can you tell us a little bit about that? What was the thought process behind those sales?

Peters: Well, I have been spending a lot of time thinking about how I would have done things differently in 2006 and 2007 with my model of portfolios. Emphasis on dividend safety has always been part of the DividendInvestor approach from day one. But as I said just a moment ago, I had 40% of my Builder Portfolio in banks headed into that very stressful period in 2008. I didn't like having that much sector concentration as it turns out in hindsight. That created some vulnerabilities. Also I want to have big margins of safety, even for relatively conservative businesses.

One of the companies that I sold that I had actually held for all nine years plus of managing our portfolios was Kinder Morgan Energy Partners. A very good business and certainly very steady in terms of the cash flow that it's generated historically. But they pay out literally every cent on the dollar that they earn for investors. That doesn't really give them any cushion in the event that the business experiences some unforeseen stresses. And even though pipelines can be a very steady business, it doesn't mean they're guaranteed.

So, I wanted to make sure that in every instance where I'm holding a stock in our portfolios that I have the utmost confidence that the dividend can continue to grow in good times and at least be held steady in the down times.

Another name I sold was Intel, which doesn't look like its dividend is vulnerable now, only paying out about 50% of earnings, but last year they didn't raise their dividend after having raised it for many years in a row. I felt like that's an important signal, when the economy is relatively healthy at least by current standards and Intel isn't able to grow its earnings, isn't able to provide a dividend increase, then what does that business look like under stress? I'm not sure that that's necessarily something that hits that very high quality area that I think is a sweet spot for typical income investors.

So with this cash I am looking to redeploy it. I’m definitely not into any kind of a market timing approach. I'll be the first to admit that I'm much too dumb to actually pull that off, and I'd like to think I'm smart enough not to try to pick the near-term highs and lows in the stock market. But I'm evaluating some opportunities right now and Coca-Cola is a name that I'm looking at very carefully right now. There are couple of other names in midstream energy like Enterprise Products Partners that I'm evaluating and I think it will be in the near future, I'd say a matter of weeks, that I'd expect to have the bulk of that cash reinvested.

Not to say that holding cash is a bad thing, it's part of a personal portfolio strategy. But DividendInvestor has always been geared toward that piece of your portfolio that you can put into high quality, high yielding stocks and leave there as more or less a permanent commitment. If you're going to change the cash allocation in your portfolio that's fine. That's not the kind of overall asset allocation type of advice that we are geared to provide.

It's much more about getting into the nitty gritty of these companies. How they pay and raise those dividends and what kind of prices we're comfortable paying for them.

Charest: Interesting. Thank you very much, Josh, for joining us and for sharing your insights with us today.

Peters: Thank you too very much.

Charest: Okay. And for more on Morningstar's Best Ideas Week, we invite you to click on the links right below the video player.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Clorox Co131.53 USD0.18Rating
General Electric Co167.33 USD1.25Rating
General Mills Inc68.30 USD-1.14Rating
Kinder Morgan Inc Class P19.07 USD-0.05Rating
Rogers Communications Inc59.20 CAD0.00
Wells Fargo & Co60.21 USD0.89Rating

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Christian Charest

Christian Charest  

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