Morningstar Advisor - Spring 2008 - 41

Still, the “stickiness” associated with dividends doesn’t necessarily mean that specific dividend-paying stocks or sectors are insulated from price volatility, even when their dividends are reliable. We’ve seen that recently with bank stocks, even though the vast majority are well-capitalized and profitable. A few years back, we saw extreme stress in the utility industry. That had very little to do with the economy but rather the fallout of deregulation and the Enron crisis. The appeal of owning dividend-paying stocks is being able to extract predictable and growing cash returns from one’s investment that are independent of market prices, not the idea that dividends limit price volatility. And if dividends provide the investor with enough cash so that he or she doesn’t have to sell, market prices—high or low—don’t need to matter. MA: For your newsletter, you manage two dividend-focused portfolios: Builder and Harvest. What are the goals of each? JP: Running two accounts with the same growth at least equal to inflation—an objective most retirees can identify with. Right now, the Harvest yields about 7% overall, and I figure this income stream should advance at least 2% to 4% annually (and maybe as fast as 6%). The Builder portfolio targets a lower 2% to 4% average yield. It’s about 3.3% right now, still well above the 2% yield of the S&P 500. Instead of maximizing yield, I look to maximize total return through stocks that can raise their dividends at least 8% to 10% annually. Between dividend growth, the capital gains this growth encourages, and steady dividend reinvestment, I expect Builder to earn average annual total returns in the 11% to 13% range. MA: What are some of your favorite holdings? JP: My top pick this year comes from the 3% yield into something north of 4.5% in a year’s time. I also like XTEX in its own right for its 8%-plus yield in the Harvest. I like Kinder Morgan KMP and NuStar Energy NS. These two master limited partnerships don’t make much money off of high energy prices, but they generate excellent and highly stable cash flows from moving oil and natural gas around the country. For tax reasons, investors shouldn’t own MLPs like these in tax-deferred accounts, but for those with ordinary taxable money to invest, you can get 7% to 8% yields and income growth in the mid-single digits. Kinder Morgan has a separate entity, called Kinder Morgan Management KMR, that bypasses the tax issues by paying dividends in the form of additional shares instead of cash. This makes KMR a great pick for tax-deferred accounts— the investor can just sell off the new shares to capture the income. I’m also a big fan of several regional banks: BB&T BBT and US Bancorp USB are my favorites. Neither have material exposure to subprime mortgages or structured products like CDOs; they just play the basic banker’s game (borrow at 3, lend at 6, play golf at 3). Both yield a bit over 5%, and both have 30-plus consecutive years of dividend growth. I can’t make any pitches without mentioning my favorite one of all, Realty Income O. This very conservative REIT is in the business of sale-leasebacks of freestanding, single-tenant retail properties. It earns good returns on equity even though debt is rarely more than 30% of total capital. It yields over 6% while putting up growth in the mid-single digits for a very attractive total return. I’ve never seen a management team more devoted to dividends than this one—they come into the office every day thinking about, as they say, “the 75-year-old lady in Dubuque for whom dividends aren’t a luxury, but a necessity.” K Josh Peters personally owns shares of 0, XTXI, and KMR. basic strategy illustrates how useful dividends are both before and during retirement. For the Harvest portfolio, my goal is to generate as much current income as possible without sacrificing safety or long-term income Builder: Crosstex Energy Inc. XTXI. The current yield isn’t too high at about 3%, but the dividend rate is growing very quickly as its subsidiary, Crosstex Energy LP XTEX, builds out a natural-gas-gathering system in the Barnett Shale fields of Texas. XTXI serves as general partner of the Crosstex LP, and as such, it’s entitled to a disproportionate share of the cash-flow growth of the LP. I came into 2008 looking for a 35% to 40% hike in XTXI’s dividend; management’s most recent projections put that growth at 58%. That will turn a Top Picks from Builder and Harvest Dividend Portfolios Company/Ticker Morningstar Rating QQQQ Size Moat Fair Value Estimate ($) Current Price ($) Dividend Rate (%) Current Yield (%) Est’d Div Growth (%) BB&T BBT Crosstex Energy Inc. XTXI* Crosstex Energy LP XTEX* Kinder Morgan Energy KMP Kinder Morgan Mgmt KMR NuStar Energy LP NS* Realty Income O US Bancorp USB Narrow UR UR Wide Wide UR Narrow Wide 43.00 UR UR 70.00 70.00 UR 25.00 41.00 32.06 33.95 30.74 54.69 50.97 48.44 25.62 32.36 1.84 1.04 2.44 3.68 3.68 3.94 1.65 1.70 5.7 3.1 7.9 6.7 7.2 8.1 6.4 5.3 8.0 15.0 8.0 8.0 8.0 6.0 4.5 8.0 UR UR QQQQQ QQQQQ UR QQQ QQQQQ *In March, Morningstar’s equity analysts placed the majority of their midstream master limited partnership coverage under review to assess the financial markets’ impact on their valuations. Josh Peters, however, expects no change in the fair value estimates of the stocks listed here. Data as of March 31, 2008. Note: XTEX, KMP, and NS are master limited partnerships. For tax reasons, we suggest you consult a tax professional before buying. MorningstarAdvisor.com 41

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Morningstar Advisor - Spring 2008

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