Best Bets Among Dividend Payers

• By Christine Benz
• On 7:00 am EST, Thursday November 12, 2009

Times are tough for income-oriented investors. Bond yields are skimpy, and a rash of dividend cuts has reduced the S&P 500's dividend yield to less than 2%. To help make sense of the landscape for dividend-paying stocks, I recently sat down with Josh Peters, Morningstar’s resident dividend guru and the editor of Morningstar DividendInvestor. Josh discussed the lessons of 2008's market debacle, as well as where he's spying attractive opportunities for the Builder and Harvest portfolios featured in his newsletter.

Christine Benz: We last did an interview in March of 2008, but a lot has changed since then. What have you learned over the past year?

Josh Peters: This year has been a pretty tough one for dividend-paying stocks, at least in terms of relative performance. If you had clairvoyance and you could time the market, well of course you would have dumped conservative, solid stocks at the bottom of the market and bought into a bunch of companies that were just hanging on to solvency by their fingernails. But when a stock loses 90%, even if it quadruples on the rebound, you're still down 50%. So I'm not frustrated by this year's performance; I have no regrets about staying conservative. Instead I look back and say the opportunity to build in a lot of performance was in 2008, and the Builder and the Harvest portfolios both fell a lot less than the S&P.

You have to be very careful in the companies you select, and you have to be willing to think creatively in terms of what can go wrong, what can come out of nowhere to hurt what otherwise looks like a good business. And a good dividend does not make a bad business into a good one. My process starts with looking at an individual company and asking, Is this a business I want to own? Is it financially secure? Is it competitively advantaged? Is it going to be able to generate a good return on capital? Then my next question is not about price, but how am I going to participate as a shareholder? Is this a company that thinks that the way you return value to shareholders is to make lots and lots of acquisitions and amass a big empire? Does management think it's all about share buybacks and other forms of financial foolishness, or does it have an appropriate dividend policy that balances internal growth prospects and their capital requirements against providing shareholders with a good income on their investments? Once a business has cleared those hurdles, then I move ahead and I think about price, valuation, what kind of total return I can expect. But I'm thinking less in terms of looking for bargains. If you do that, especially in the dividend world, you find the cheapest highest-yielding stocks are usually the ones that have the poorest fundamental prospects.

Benz: What are your thoughts on the current market environment?

Peters: When I look at the stock market, I'm just not seeing that many high-quality opportunities to deploy capital right now. I'd say dividend-paying stocks are a great relative value, relative to non-dividend-paying stocks and just weaker companies in general, relative to the S&P 500. I think a lot of boring stocks are priced to outperform the market's racier fare in the years ahead. I wouldn't expect to earn fat double-digit returns, like we saw in the late 1990s, but higher-quality companies (unlike a decade ago) are finally priced to generate solid returns even in an uncertain economic environment.

The point that I would emphasize perhaps more than anything is that I just cannot come up with a reason why an investor needs to own stocks that pay no dividend, or even stocks that pay very low ones. There's enough to pick from in the universe of companies that do pay good dividends that you can get a well-diversified portfolio and it's going to throw off income you never have to give back. Both investors and corporate boards have drifted away from dividends as providing that essential link between the business and its true owners. That leaves the market as essentially a speculative vehicle: I'm buying it because I think someone else is going to pay me more for it in two months, or three years, or whatever my time horizon happens to be. I would rather position myself as an owner-partner in a business, where I can pay a reasonable price, and expect a reasonable return, and expect management to treat me fairly.

Benz: What are your highest-conviction ideas in the dividend-paying space?

Peters: Johnson & Johnson (NYSE:JNJ - News) and Abbott Labs (NYSE:ABT - News), which are both large positions in the Builder portfolio. Health-care firms are generally defensive in nature, which means that investors haven't been at all interested in them since March. You've also got this backdrop of health-care reform and how that might affect industry profitability or industry growth rates over the long term. And that to me has really been a nonevent. The legislation that's taking shape is not posing a significant threat to the profitability of pharmaceutical manufacturers or device manufacturers. Both Abbott and Johnson & Johnson have large consumer products businesses, too.

The bigger threat to the industry is patent expirations, which are only negative and you know exactly when they're going to happen. Johnson & Johnson and Abbott Labs have had a few patent expirations, but they've been relatively minor. They've had their other businesses to rely on for steady profitability and continued growth. If you're worried about what's going to happen in the United States eventually from a health-care reform standpoint, these are very well-diversified businesses geographically, too. They are both very good at allocating capital, and they've done a good job of growing their businesses, getting a lot of bang for the earnings they don't pay out as dividends. Yes, they yield less than a Merck (NYSE:MRK - News) does, or a Bristol-Myers Squibb (NYSE:BMY - News), but those dividends are not going to grow, whereas Abbott and Johnson & Johnson should be able to keep up dividend growth in the high single digits or better.

Benz: If dividend tax treatment changes, does that change your outlook for dividend payers?

Peters: Let's assume the worst-case scenario, which is that the current tax law simply expires at the end of 2010 and the tax rate on dividends goes back to that on ordinary income. That definitely is not a plus, but if you own dividend-paying stocks in a tax-deferred account, it doesn't matter what the tax rate is on those dividends anyway. If you're a taxable investor only, then it becomes harder to try and deal with the hit. But I think dividend investing is going to retain its appeal, because even if the tax law changes, the need that investors have for income from equities is not going to change. The practical value of a portfolio is its ability to convert itself into a paycheck when you're retired, and capital gains just can't be relied upon to do that.

That said, I think we are going to see the government do something; I don't think the tax rates are simply going to expire. What is critical for me, and I think a lot of other investors and companies, is that we continue to see dividends and capital gains taxed at the same rate. Because if dividends are taxed upward of 40% and capital gains are taxed at 20%, what is this doing? It's telling investors go for the capital gains, don't go for dividends. It's telling companies don't pay a dividend, try to get your stock to go up. Fortunately, both parties seem to have some recognition of the fact that the tax code shouldn't favor one form of investment return over the other.

A version of this article appeared in the November 2009 issue of Morningstar PracticalFinance.

Christine Benz does not own shares in any of the securities mentioned above.

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