Holly Cook: Welcome to the Morningstar series, "Ask the Expert." I'm Holly Cook and joining me today to talk about dividend investing is Morningstar's Josh Peters.
Josh, thanks for joining me.
Josh Peters: Very good to be here.
Cook: So you are our Director of Equity Income Strategy and in your role you are picking dividend stocks for your own portfolio. Can you give us a little bit of an idea as to why the focus of dividend stocks because so many people are always looking for undervalued stocks? What is it about dividends that you find so interesting?
Peters: I think every investor even if they are interested in dividends they have to concentrate on total return, which is, of course, the dividend component as well as long-term capital appreciation. But there are so many practical advantages associated with having that above-average dividend, and I operate in the United States where still a lot of large companies don't pay dividends at all. A number of them still prioritise share repurchases and the dividend yields are very small. Our market yields only 2% on average. So, I come over here and I just salivate at all the high dividend yields that are available!
But to get an above-average yield in almost any market tends to furnish, first, a practical stream of income that you can use for reinvestment or to fund portfolio withdrawals, if you are in retirement or have some other obligation to meet. As well as, those larger companies that pay the big dividends tend to be more financially secure, not all of them, you want to avoid the highest dividends that might be cut. But I like the defensive characteristics, less risk in a recession, for me, the utility or the staples firms, things like that.
Then also you have got a lot of historical evidence suggesting that the [stocks with] above-average yields in a given market are going to tend to outperform over long periods of time, not all the time—and, honestly, this has been a period in the last year here where higher-yield stocks have tended to suffer, other areas of the market are doing better and the overall market is sort of stagnated with a lot of macro pressures of various kinds—but over long periods of time, you start thinking about retirement, a 10-year, or 20-year, 30-year horizon it’s absolutely relevant to think about a long-term investment strategy. Dividends tend to outperform even though they are lower risk. So, there are lots of both practical advantages as well as a performance tailwind associated with these higher-yielding stocks.
Cook: So, that's a really interesting point. I mean, when it comes to finding these high-yielding stocks, obviously if you were to just screen purely on yield, you could end up with some stocks that really aren't so favourable. So, what else are you looking for as well as that yield number?
Peters: The way I sort it down is to think in terms of dividend safety and long-term dividend growth. And you're absolutely right. The very highest yielding stocks, those are more of potential value plays or maybe the high dividend yield is signalling that the stock is severely
undervalued. But if that's the case, the company might also be in a real pinch financially and the dividend is going to be cut. And if the dividend cut is not discounted in the share price already then you are probably going to suffer and in any event, if the cut is made then you are going to suffer a loss of income. So, those are certainly firms that I want to avoid.
Secondly, in order to get that long-term total return prospect, it's not enough to just say have a 4%, 5%, 6% dividend yield because that's a very attractive yield, especially in a low interest rate environment but it's not sufficient for a total return, long term from owning stocks. So, I'm going to expect dividend growth not just from a certain segment of my portfolio that has lower yields and better growth prospects, I think every company needs to be able to provide some dividend growth in order to furnish an adequate total return.
To provide for both of these features the most valuable aspect that I’ve found in the more than 10 years now that I have been running the strategy is to find companies with economic moats—our framework for evaluating companies' competitive advantages and how long they may last and how valuable and profitable those advantages will turn out to be—because the moat is going to defend the profits of the firm against competition, which is going to secure the earnings that are necessary to maintain that dividend, so it plays into dividend safety. It also implies that when a company is expanding internally, even if there is not a lot of growth potential, say in staples for example, that whatever the earnings the company is retaining, those will be reinvested at a high rate of return and lead to that long-term dividend growth.
Cook: So, just briefly going into sectors, you mentioned earlier that you have a UK-based utility stock and I think you also hold a UK-based pharmaceutical stock. Are there any other sectors where you are seeing sort of interesting dividend trends recently?
Peters: It's been, I think in the last couple of months, in the United States at least, fashionable to start dumping utilities and REITs, as people are worried about higher interest rates. But this is where our long-term framework for valuing firms comes in very handy because we're not discounting future cash flows under the assumption that interest rates are going to stay at 1% or 2% forever.
In fact, we've normalised all of our long-term interest rate assumptions that underpin what we expect for equity returns as well. So, now we're seeing some firms in the United States looking fairly attractive that have high yields. Even though interest rates have just started to move up, the stock market has got so far out ahead of this just in terms of chasing performance and being very quick to dump anything that people think is going to be a loser, that now some names are pretty attractive.
Cook: Josh, thanks very much for sharing your insights with us today.
Peters: Thank you too, Holly.
Cook: For Morningstar, I'm Holly Cook. Thanks for watching.