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Living in a Low-Yield World

Do your homework and invest for the long term, DividendInvestor's Josh Peters says.

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Paul Larson recently spoke with Josh Peters, an equities strategist and editor of the Morningstar DividendInvestor newsletter about the state of dividend investing today.

Paul Larson: How does the market look to you today?

Josh Peters: It's just a low-yield world.

It's not just income investors who are facing this problem. I think all types of investors are trying to figure out how they can earn a good return from their investments when stock prices are arguably so high in a long-term, normalized context. Bond prices are high and yields are low. Essentially, the whole world is overcapitalized. Too many investment dollars are chasing too few earnings dollars. That makes it a very difficult environment. But it's one where picking individual stocks very carefully, getting to know the businesses that you own, and knowing whether you're in fixed income or equity holdings is absolutely essential in order to not just earn a good return, but preserve your capital for the long run.

Larson: Given today's rates, how have your portfolios performed given the tailwind that dividend-paying securities have had?

Peters: Pretty well. Our strategy tends to split into the Builder model portfolio, which consists of dividend-growth-oriented stocks that have above-average yields, but growth is a more important long-term driver of total returns. The Harvest model portfolio, which has higher-yielding stocks, is the one that's been the best performer all the way through the recovery from the crash and the bear market that ended in March 2009. People are craving stability, they're craving quality, they're craving income, and they're especially craving that combination of big income today and growth going forward. Those are the stocks that have worked best for us. At other points along the curve, we've had some good results from some other stocks, such as  Phillip Morris International (PM), which does have a very solid growth component but also has an attractive yield component, about 5% on the current yield when we bought it.

Larson: What do you think is going to happen to the stocks that you own when interest rates go up?

Peters: Low interest rates, especially at the cash/short-term certificate-of-deposit end of the spectrum, have nudged some money into higher-yielding stocks that otherwise might not be in equities. Think of the investors who would prefer to be getting 2%�4% on a one-year CD. It's under 1% right now, so they're thinking in terms of, "Well, I guess I got to go buy some stock that pays a dividend." That money's going to come back out once short-term interest rates start to go up. And I think that does suggest that you could have a short- to intermediate-term spell when these companies continue to pay out very good dividends and continue to raise their dividends, but you might not get a whole lot in terms of capital appreciation. You might underperform some of the growth areas compared with the pipelines, utilities, and REIT stocks that we own that have high yield.

That said, once you get past that adjustment phase, once interest rates have gotten back to whatever will be a new normalized type of environment, then it's the same old story of total return, which is when you have the opportunity to get a 5% or 6% yield--dividend growth that's 5%�6% a year or better. That's a very powerful total return combination for a long-term investor, and it's very difficult to meet that with the same income component from any other area of the securities market. So, I think that the long-term outlook for companies that do pay decent dividends remains very good, not least because demographics are going to drive more and more people during the next 10, 20, and 30 years toward the companies that can provide a lot of income and provide some income growth to offset inflation. But in the short term, I would not recommend that anybody run out and buy dividend-paying stocks just on the basis of their dividends right now. You have to be looking at that long-term total-return picture.

Larson: In the context of a stock market that is looking, at least in our aggregate view at Morningstar, as being roughly fairly valued, where are you finding some pockets of opportunity for new money today?

Peters: It's very, very difficult. You can call it a problem if you wanted to; I call it a challenge. When you meet the challenge, it works very well for you. First, try to find some margin of safety or try to find a discounted price relative to the intrinsic value of the business, so you've got some room perhaps for things to go wrong, such as some short-term disappointments, a market correction, or what have you, without actually suffering a long-term and permanent impairment of your capital investment. Those margins of safety, right now, are just extremely difficult to find. I think if you're working with new money, you want to think in terms of maybe taking a six-month stretch or a year-long stretch, averaging in very slowly into some companies that have stocks that rotate through different ups and downs day to day, month to month, to pick things up less expensively.

But to me, for the best protection, if you can't get it in terms of price, then it's got to be in terms of quality. So, if I can get a moderate bargain, not something that I'm going to be real excited about from a valuation standpoint, but something I can be satisfied about, and if I can get the other investment-quality metrics that I like to look for, then it's names like  Abbott Laboratories (ABT),  Procter & Gamble (PG), and  American Electric Power (AEP).

These can be boring businesses with not a lot going on, not a lot that's going to catch people's eyes, and not a lot of leverage to an economic recovery. But they're the kind of steady-Eddie businesses that are going to be around for the long haul, that are going to be able to grow their dividends consistently, and that can do that on top of what are historically very attractive yields for these stocks. It's not really easy to move new money in, especially if you're as sensitive to valuation as we are. But give yourself some time and focus on quality, and I think you can still work at being able to build a good portfolio during the course of a six- to 12-month period.

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Paul Larson has a position in the following securities mentioned above: ABT, PG. Find out about Morningstar’s editorial policies.