Morningstar Advisor - Spring 2008 - (Page 40) Spotlight An Attractive Yield Is Only Skin Deep To find high-quality dividend payers worthy of a retirement portfolio, investors should focus on income growth rates. Equity analyst Josh Peters, CFA, is editor of Morningstar DividendInvestor, a monthly newsletter devoted to current income and income growth from stocks. He is also author of The Ultimate Dividend Playbook, a new book on dividend investing. We asked him to discuss his strategy in finding high-quality dividendpaying stocks. Morningstar Advisor: It’s been a volatile ride for stocks over the past few months. How are the dividend-paying stocks that you follow holding up? Josh Peters: High-quality dividend payers have sufficient to cover the dividend? Is this stream of earnings stable enough to fund the dividend even in a downturn? And recognize that debt always has its foot on the accelerator, whether you’re heading toward a vacation spot or straight into the ditch. Equally important is my focus on dividend growth, which not only bolsters total return but provides abundant insights into dividend safety. A rising dividend rate is usually (though not always) associated with prosperous, financially stable enterprises. But a flat dividend rate that absorbs all or nearly all of current earnings may have nowhere to go but down. I look at many of the high-yielding telecom stocks such as Citizens Communications CZN this way. Even if the yield is an attractive 8% or 9%, a lack of consistent growth ought to be treated as a warning sign. I wouldn’t buy any stock whose dividend isn’t likely to grow in the next one to three years, no matter how high the yield nor how cheap the valuation. MA: Do you consider any other factors in your strategy? combination of yield and growth adequate? Every different business will have important aspects to consider in detail, but this point of view brings the details back into a useful big-picture perspective. As part of both the safety and growth questions, I consider whether or not the business has sustainable competitive advantages—a concept we refer to as an economic moat. Without a moat, there’s nothing to prevent competitors from driving down prices to the point where profits might no longer be enough to cover the dividend. But with a moat, the company should be able to invest in expanding its existing businesses over time, creating earnings and dividend growth for shareholders. MA: How have dividend payers reacted in times of stressful economic conditions? JP: Dividends in the stock market tend to be held up very well, especially since January. The key has been avoiding dividend cuts. In the past three years, my holdings have racked up 106 separate dividend increases with just one cut. If the income stream of your portfolio is reliable, you can count on good cash returns whether prices go up or down. Take too much risk, and all bets are off. MA: What’s the secret to avoiding cuts? JP: I never react to a stock’s yield alone. In fact, a high yield (anything over 8%) is usually a sign of trouble, and the one cut I did experience fell into that category. Instead, investors should look through the dividend to the income statement, the balance sheet, and the basic economics of the business. Are earnings JP: One of the most beautiful aspects of dividend investing is that the dividend itself reduces the vast amount of information available about every business to just three questions: Is the dividend safe? How fast will it grow? Is the potential total return from this much less volatile than prices. Almost all companies prefer to maintain their dividends in recessions and downturns if doing so remains feasible. That in turn is why dividend cuts are taken as such a negative signal by investors—it often means that earning power has been permanently impaired; even the viability of the enterprise might fall into question. So firms usually cut back in other ways first so as not to hand shareholders a pay cut. 40 Morningstar Advisor Spring 2008
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