DividendInvestor - rebel Financial

Transcription

December 2013 Vol. 9 No. 11
DividendInvestor
SM
Quality recommendations for current income and income growth from stocks
Seems Reasonable,
So Let’s Carry On
It still doesn’t feel like mass prosperity—perhaps
because it isn’t—but 2013 is shaping up to be the best
year for the U.S. stock market in the nine-year run
of DividendInvestor to date. As of this writing Nov. 13,
the S&P 500 Index stood at yet another all-time
high—the 33rd new high since topping the 2007 peak
in April. Investors have enjoyed a 27.3% year-to-date
total return. If we finish the year at this level, 2013
will be the highest-returning year since 2003, and the
best year since 1998 that didn’t follow an annual
decline. (In the case of 2003, its 28.7% return followed
three straight years of negative returns.)
A year like this one can’t help but inspire some strong
emotions. Certainly the updraft in stock prices reflects
that cash is moving into the market, perhaps by
selling bonds that have lost their luster. I also detect
plenty of nervousness, particularly in emails from
DividendInvestor subscribers and media stories
describing a “melt-up” in prices. In the past 14 years,
two romping bull markets were followed by plunges
exceeding 50%. Economist John Kenneth Galbraith,
a historian of euphoria and panic in markets, once
wrote of the “extreme brevity of the financial memory
… There can be few fields of human endeavor in
which history counts for so little as in the world of
finance.” Perhaps our collective memories aren’t
quite as short as they used to be. These days, it seems
there’s a bubble around every corner.
Fear of loss is a valuable trait for investors to have.
No amount of upside is worth considering before
you’ve contemplated the possible risks and losses.
Still, I think it’s important to separate the trend in
stock prices from their value, as the latter holds much
more sway over our long-run fate. Just because
the S&P is up more than 40% since the end of 2011
doesn’t mean that stocks have become absurdly
overpriced. I think it’s more accurate to say that stocks
were absurdly cheap in 2011 (a conclusion that I,
like a lot of investors, missed at the time) and are now
in the ballpark of fair value.
I say this with the following context in mind: Stocks are
no longer cheap, they will not go on rising forever
on the 20%-plus annual track they’ve been on, and
a downturn could strike at any time. But for longterm investors, I don’t believe this is a time to bail on
stocks. Instead, it’s yet another opportunity to focus
on strategy and controlling the variables we can.
Know Your P/E History
Price/earnings ratios, often referred to as simply
multiples, are hardly the ultimate yardstick for value.
Some companies, industries, or periods of economic
history merit high multiples; others deserve low ones.
Still, this statistic has some value in appraising
value, particularly for the stock market as a whole.
Continued on Page 2
S&P 500: Operating P/E Since 1989
30
p Trailing P/E p Median
26
22
18
14
89
91
93
95
97
99
01
03
05
07
09
Data from Q1/1989 through Q3/2013. Source: Standard & Poor’s.
11
13
Josh Peters, CFA
Director of Equity-Income
Strategy and Editor
Builder Portfolio
4
Still more dividend hikes and fair
value increases in a strong 2013
Builder Focus
7
Procter & Gamble:
We believe a slow and steady
revival is underway
Harvest Portfolio
8
Record number of dividend and
distribution hikes last month;
details on recent trades
Harvest Focus
11
Altria Group:
Overpriced if profits eventually
decline, but that’s a ways off yet
Income Bellwethers
12
What will Chairwoman Yellen
mean for interest rates?
The Dividend Drill
17
Boardwalk Pipeline Partners
Vornado Realty Trust
2
Seems Reasonable, So Let’s Carry On
Continued From Cover
The preceding chart uses trailing operating earnings
per share for the S&P 500 to determine the market’s
P/E, and it goes a long way toward explaining recent
gains. Since the end of 2011, earnings for the S&P
are up only 6%, but the price level of the index has
surged nearly 42%. The P/E turns out to be the
swing factor, moving from 13.0 then to 17.4 today.
The lack of earnings growth raises the notion that this
has been a low-quality rally. However, looking at
the history of the market’s P/E, it’s hard to say that the
stock prices are way ahead of earnings: The median
P/E since 1989 (17.8) is actually a bit higher that the
current level. It’s far easier to conclude that stocks
were cheap in 2011: The S&P’s P/E of 13.0 at year-end
was the second lowest since 1990, following only
the third-quarter 2011 P/E of 12.0. The most obvious
explanation for the recent rally isn’t monetary
stimulus or the rapid formation of bubbles; it’s that
the market’s P/E simply went back to normal.
Reaching further back into market history, one can
draw a slightly different conclusion. S&P only has
quarterly operating EPS data from 1988 onward; before
that, I blend in results under generally accepted
accounting principles on the premise that unusual items
were indeed more unusual back then. On this basis,
the median P/E since 1946 is 15.8, and here we stand
at 17.4. If this comparison suggests that stocks
are 10% overpriced, it’s important to recall that long
stretches of low P/Es are usually associated with
periods of high inflation (1946 –1948, 1951, 1968 –
1982). Given how low Consumer Price Index inflation
is right now—about 1.3% —a P/E ratio slightly above
the long-run median makes sense.
Evaluating the ‘E’
The price in P/E ratios is easy. The earnings, however,
are wide open for interpretation. Lots of technical
details muddy the waters. Should we use trailing
earnings or forward-looking forecasts? (For macro
purposes, I prefer trailing—in addition to a timing
mismatch, Wall Street consensus earnings estimates
tend to be too high.) How about operating earnings
versus GAAP ? (Operating results that exclude unusual
gains and losses is the market’s convention, so that’s
what I used above, but it is fairly noted that nonrecur-
ring losses have a habit of recurring and do reflect a
loss of shareholder value. Since 1989, profits under
GAAP have typically been 10% lower than the operating figures provided by companies.)
Cyclical conditions have a significant effect on P/E
ratios too (especially under GAAP, since unusual
write-offs have surged during recent recessions). Yale
professor Robert Shiller, author of Irrational Exuberance and, as of this year, a Nobel laureate, believes
earnings should be smoothed over longer periods
to properly account for cyclical factors. He calculated
a cyclically adjusted P/E (or CAPE) by averaging
S&P earnings over trailing 10 -year periods with an
adjustment for inflation. This version of the CAPE
now stands at 24.6, compared with a median of 15.9
going back to 1871. That suggests wild overvaluation—not dot-com wild, but dangerous nevertheless.
Here’s where the discussion gets interesting: What’s
the right CAPE? Except during the recession of
1990 and the darkest days of the 2008 –09 crash, the
CAPE hasn’t been below its since-1871 median
since 1989; 24.6 sounds like a big number, but it’s only
5% above the 23.4 median since 1989.
My sense is that the mean to which the market’s P/E
reverts has shifted because corporations have
become a lot more profitable. The S&P 500 is earning
about a 15% return on equity right now; 15% is also
the average for the index since 2000. I don’t have ROE
data for the S&P before 2000, but records for the
Dow Jones Industrial Average show a median ROE of
12% between 1945 and 1990. With higher returns
on equity, a company generates more free cash flow
that it can use to reward shareholders, even if the
rate of earnings growth doesn’t change. And while a
move from 12% to 15% ROEs (admittedly using
different sets of data) is a material step up on its own,
I suspect the improvement is greatly understated.
Goodwill and other intangibles—mostly arising from
mergers and acquisitions—now make up half of
shareholders’ equity for the S&P 500. The ROE associated with internal growth for the S&P 500 as a whole
is probably much higher than 15%, reflecting both
historically high profit margins in the ROE numerator
and lower capital investment in the denominator.
Morningstar DividendInvestor
Now for the biggest question of all: Can today’s level
of profitability be sustained? The reduction in
capital intensity strikes me as permanent; American
industry is now dominated by knowledge- and
service-based fields that don’t require hard assets
(factories, machinery, inventories, and so on) that
weighed on returns for the corporate giants of the past.
As for profit margins, one macroeconomic statistic—
corporate profits as a share of U.S. gross domestic
product—is clearly above its long-run median.
Corporate Profits’ Share of U.S. GDP
12
p Corporate Profits/GDP (%) p Median
10
8
6
4
2
1947
1957
1967
1977
1987
1997
2007
3
December 2013
ability will revert to the long-term mean, which for
many economic relationships is a sound assumption.
Yet mean reversion, especially of this particular
type, doesn’t take place in a vacuum. Some combination
of forces would need to push profit margins lower,
and I can’t see any obvious problems on this front.
For example, corporate income taxes could go up,
reducing aftertax profits. There is a broad, centrist
mandate for reform—cutting out loopholes—but this
is usually joined with a call for lower tax rates. Or
interest costs could rise; corporations have certainly
benefited from the low-rate environment. However,
higher rates would benefit some financial institutions,
and few publicly traded nonfinancial firms are heavily
indebted right now. The biggest likely swing factor
is labor costs, but outside of CEO pay, there isn’t much
upward pressure. Benefit and retirement costs
are going up, but the burden is steadily shifting from
companies to workers. Persistent underemployment
limits the potential for wage growth, and organized
labor has little clout—especially in the private sector.
Data from Q1/1947 through Q2/2013. Source: St. Louis Federal Reserve Bank
Some smart fellows argue forcefully that today’s
levels can’t be maintained indefinitely—including the
strategists at Jeremy Grantham’s firm of Grantham,
Mayo, Van Otterloo. They expect that corporate profit-
The final question is: What happens to the earnings?
Will they benefit shareholders? For years, I’ve harped
about the low dividend payout ratios for the S&P as
a whole. Between 1946 and 1994, the median payout
Continued on Page 19
DividendInvestor Portfolios: Combined Performance
Date
Builder
Portfolio
Period
Return (%)
Harvest
Portfolio
Period
Return (%)
01/07/2005 1
100,000.00
12/30/2005
102,324.82
+2.3
12/29/2006 2
124,722.19
+21.9
100,000.00
12/31/2007
121,180.73
-2.8
101,776.82
+1.8
12/31/2008
99,046.55
-18.3
70,128.71
-31.1
12/31/2009
105,161.54
+6.2
94,045.47
12/31/2010
120,339.85
+14.4
120,346.67
12/31/2011
134,138.79
+11.5
12/31/2012
154,064.74
+14.9
Year-to-Date 2013
191,873.19
+24.5
Totals (since inception)
191,873.19
+91.9
Annualized (since inception)
MDI Portfolios
Combined
Period
Return (%)
100,000.00
+7.6
Compound
Value of $100k
S&P 500
Return (%)
MDI B/(W)
than S&P
M* Div Ldr
Return (%)
MDI B/(W)
than MDL
100,000.00
102,324.82
+2.3
102,324.82
+7.1
-4.8
+5.2
-2.9
224,722.19
+21.9
124,722.19
+15.8
+6.1
+25.5
-3.6
222,957.55
-0.8
123,742.80
+5.5
-6.3
-10.2
+9.5
169,175.26
-24.1
93,893.30
-37.0
+12.9
-31.4
+7.2
+34.1
199,207.01
+17.8
110,561.11
+26.5
-8.7
+14.8
+2.9
+28.0
240,686.52
+20.8
133,582.49
+15.1
+5.8
+16.7
+4.2
141,647.14
+17.7
275,785.93
+14.6
153,062.88
+2.1
+12.5
+15.0
-0.4
159,410.81
+12.5
313,475.55
+13.7
173,980.85
+16.0
-2.3
+9.8
+3.9
193,162.48
+21.2
385,035.67
+22.8
213,697.15
+27.3
-4.5
+21.4
+1.4
193,162.48
+93.2
385,035.67
+113.7
213,697.15
+80.9
+32.8
+67.1
+46.6
+6.9
+2.0
+6.0
+3.0
+10.1 3
+9.0
Data through Nov. 13, 2013. “M* Div Ldr”  Morningstar Dividend Leaders index of high-yielding stocks. 1 Inception of Builder. 2 Inception of Harvest. 3 Annualized return for the Harvest covers a shorter time period.
Cumulative returns for the combination of our two portfolios are calculated on a time-weighted basis according to guidelines published by the CFA Institute and reflect different inception dates for the two accounts.
The cumulative value of a single $100,000 investment earning returns across our strategy since Jan. 7, 2005 is shown in the column labeled “Compound Value of $100k”.
4
The Dividend Builder Portfolio
Morningstar Stock Portfolios | Josh Peters, CFA
It’s tough for a generally conservative portfolio to keep
up with the market when the S&P 500 Index returns
a whopping 27.3% year to date. Still, our Builder Portfolio is doing an admirable job, with a total return
of 24.5% thus far in 2013. Between Oct. 11 and Nov.
13, the Builder actually beat the S&P by a small
margin, as low-double-digit returns from two of our
more cyclical holdings (General Electric GE and
United Parcel Service UPS) offset the drag of our
currently out-of-favor energy holdings (Chevron CVX,
Kinder Morgan, Inc. KMI, and Spectra Energy SE).
What is the goal of the
Builder Portfolio?
To earn annual returns of
10%–12% over any
three- to five-year rolling
time horizon.
For our portfolio as a whole,
this goal is composed of:
3%–4% current yield
6%–9% annual income
growth
Income Update
Dividends Received
Interest Income
Total Income
254.15
0.00
254.15
Performance Update
Yield on Original Cost
Yield on Current Value
4.2
3.2
Income Yield, Year Ago
Income Growth (TTM)
3.6
9.3
Price/Fair Value–Portfolio
Price/Fair Value–Market
0.97
1.04
Reporting Period: Oct. 11, 2013 to
Nov. 13, 2013. Yield and Price/Fair
Value data exclude cash balances.
Income growth (TTM) measures the
impact of dividend increases net of
dividend cuts, excluding the effect of
portfolio transactions.
Invest in the Dividend
Portfolios’ Approach—The
Hassle-Free Way
Did you know that Morningstar
Investment Services now offers a
customizable portfolio patterned
after the Dividend Builder and
Dividend Harvest portfolios? To
learn more, call 1-866-765-0663.
Morningstar Investment Services,
Inc. is a registered investment advisor
and wholly owned subsidiary of
Morningstar, Inc.
We also received a pair of dividend increases last
month, bringing the Builder’s full-year count to 17 for
a cumulative income increase of 8.4%. Kinder Morgan
has now raised its dividend each quarter since we
bought the stock two years ago; the most recent dole
of $0.41 a share represents a 2.5% increase from the
previous quarter and 13.9% growth from a year ago.
Emerson Electric EMR provided the Builder’s other
dividend hike this month, a 4.9% increase to $0.43 a
share on a quarterly basis. This marked a second year
of below-trend dividend growth; my long-term forecast calls for annual hikes of 7% –8%, consistent with
the past 30 years. But it’s not hard to see what’s
holding Emerson back: Global spending on capital
equipment remains weak. In the fiscal year ended
September, operating earnings per share rose only 4%
on a scant 1% gain in revenue. Management’s initial
outlook for fiscal 2014 is modest as well, calling for
EPS growth of 4% –7%.
We think Emerson remains on a solid track for the
long term, and we raised our fair value estimate $3 a
share to $61 after reviewing the year’s results. We’ve
done very well with the stock thus far, earning a
total return near 40% in just 13 months as the market
(apparently) anticipates faster economic growth
in the years ahead. However, the stock trades at a 10%
premium to our updated valuation, and while the
current dividend yield of 2.6% is only slightly below
the stock’s long-term average, it’s not what I would
call attractive. Given the lack of ready alternatives, I
have no immediate plans to sell, but I would describe
our position as “lightly held” at this point.
With these two dividend increases in the books, the
Builder’s annualized income has grown 8.4% thus far
in 2013 before the effect of trades and reinvested
income. I see only one more likely dividend increase
on the horizon—GE, from which I expect a 10.5%
boost to $0.84 annualized. Assuming I’m correct, our
income growth should reach 9.0% for the full year
and hit the top end of our long-run target even though
I haven’t included the 9.8% boost Spectra Energy
has already planned for 2014. (I have no doubt that
Spectra will make good on its promise, but I’m
not sure it will continue to announce annual dividend
increases in the final months of the preceding year.)
In addition to the fair value estimate boost for
Emerson, I can report several other positive updates
from our research staff.
We now value Chevron at $130 a share, up $5 from
our previous appraisal. Part of this change reflects
an 8% cost of equity assumption versus our prior 10%.
All else being equal, this change increases the present
value of cash flows we’ve forecast for the future,
though it does not alter the actual total returns we
expect shareholders to earn—it simply indicates
that, due to a favorable risk profile, we think a higher
price is justifiable. We also believe Chevron will
soon generate a torrent of free cash flow. Its $ 37
billion of capital spending has slightly exceeded that
of ExxonMobil XOM in the past 12 months, even
though ExxonMobil’s revenue is nearly twice as large.
We believe Chevron’s investments will pay off with
a surge in operating cash flow as big new projects start
producing between 2014 and 2016. As capital
spending tails off after 2015, the company will be in a
position to return even more cash to investors.
Despite the stock’s sluggish relative performance this
year (up 13.7% including dividends), Chevron remains
a core Builder holding and my top pick in the oil patch.
Continued on Page 6
December 2013
5
Builder Portfolio Transaction Summary and Performance Breakdown
Morningstar Ratings & Fundamentals
Star
Rating
Economic
Moat
Credit
Rating
Philip Morris Int’l PM
QQQ
Wide
Chevron CVX
QQQQ
Narrow
Kinder Morgan Inc. KMI
QQQQ
Spectra Energy SE
QQQQ
Clorox CLX
U.S. Bancorp USB
Portfolio Data
Fair
Value
Fair Val
Uncert
A-
95.00
Med
90.62
AA
130.00
Low
120.09
Wide
—
41.00
Med
Wide
A-
39.00
Low
QQQ
Wide
A-
95.00
QQQQ
Narrow
A+
43.00
McDonald’s MCD
QQQQ
Wide
AA-
105.00
Intel INTC
QQQ
Wide
AA
25.00
Wells Fargo WFC
QQQ
Narrow
A+
46.00
Procter & Gamble PG
QQQQ
Wide
AA
87.00
F Unilever PLC ADR UL
QQQQ
Wide
A+
F Rogers Communications RCI
QQQQ
Narrow
A-
Johnson & Johnson JNJ
QQQ
Wide
General Mills GIS
QQ
Narrow
Paychex PAYX
QQ
General Electric GE
QQQ
United Parcel Service UPS
Emerson Electric EMR
Portfolio Holding
Current Price/Fair
Price
Value
Div
Rate
Yield
(%)
First
Purchase
# of
Shares
Cost Per
Share
Current
Value
% of
Acct
Total
Rtn (%)
Annual
Income
0.95
3.76
4.1
05-21-10
140
44.30
12,686.80
6.6
128.4
526.40
0.92
4.00
3.3
10-05-11
100
97.62
12,009.00
6.3
29.5
400.00
34.53
0.84
1.64
4.7
11-17-11
315
28.60
10,876.95
5.7
30.3
516.60
34.10
0.87
1.22
3.6
09-14-10
310
22.99
10,571.00
5.5
62.4
378.20
Low
92.42
0.97
2.84
3.1
10-22-09
110
58.43
10,166.20
5.3
75.4
312.40
Med
38.02
0.88
0.92
2.4
11-18-05
250
31.38
9,505.00
5.0
34.5
230.00
Low
98.11
0.93
3.24
3.3
10-22-12
95
87.56
9,320.45
4.9
15.6
307.80
Med
24.60
0.98
0.90
3.7
10-11-12
375
21.54
9,225.00
4.8
19.3
337.50
Med
42.76
0.93
1.20
2.8
11-01-05
200
30.00
8,552.00
4.5
65.9
240.00
Low
83.50
0.96
2.41
2.9
04-12-11
100
63.02
8,350.00
4.4
42.3
240.60
45.00
Med
39.82
0.88
1.45
3.6
07-30-13
165
40.65
6,570.30
3.4
-0.3
238.56
60.00
Med
44.78
0.75
1.66
3.7
05-31-13
140
45.32
6,269.20
3.3
0.0
232.15
AAA
90.00
Low
93.34
1.04
2.64
2.8
01-10-05
165
65.13
15,401.10
8.0
65.3
435.60
A
48.00
Low
50.88
1.06
1.52
3.0
06-22-12
285
38.15
14,500.80
7.6
38.8
433.20
Wide
—
38.00
Med
42.77
1.13
1.40
3.3
03-11-08
300
30.19
12,831.00
6.7
55.9
420.00
Wide
AA-
27.00
Med
27.15
1.01
0.76
2.8
04-17-08
465
23.95
12,624.75
6.6
24.9
353.40
QQQ
Wide
A+
92.00
Med
101.04
1.10
2.48
2.5
01-03-07
120
74.48
12,124.80
6.3
51.1
297.60
QQQ
Narrow
A
61.00
Med
66.85
1.10
1.72
2.6
10-11-12
135
49.07
9,024.75
4.7
40.4
232.20
Stocks to Consider Buying
Stocks to Hold
Cash Holdings
0.0
534.02
0.3
Dividends Receivable (CLX, EMR, INTC, KMI, PAYX, PG, SE, UL, WFC)
—
730.07
0.4
Builder Portfolio Total
3.2
191,873.19
100.0
0.00
6,132.21
Cumulative Total Return Comparison (%)
p Builder Portfolio p S&P 500 Index
105
p Morningstar Dividend Leaders Index
70
35
0
-35
2005
2006
Legend:
Shares added
Shares sold
New holding
C
UR Under Review
Å
Í
2007
2008
2009
2010
Taxing the Builder:
All of the stocks currently held in
the Builder Portfolio are eligible for
“qualified” dividend tax rates, but
RCI may have foreign dividend taxes
withheld. Please contact your broker
for more information.
2011
2012
2013
Trailing Return (%)
Index Level
This Month 12 Month
Builder Portfolio
Annualized
Since Inception
4.9
28.1
7.6
S&P 500 Index
1,782
4.8
32.5
6.9
M* Dividend Leaders
4,627
3.5
23.4
6.0
Top Sectors (%)
Style Breakdown (%)
s Consumer Defensive
27.2
p Industrials
24.3
o Energy
17.4
y Financial
9.4
d Healthcare
8.0
Footnotes:
Morningstar ratings and fundamentals
data as of Nov. 13, 2013. Builder
Portfolio inception: Jan. 7, 2005.
Cost basis for individual holdings, as
well as all portfolio returns, include
commissions we have paid.
Total returns for individual holdings
include dividends and realized capital
gains and losses, if any.
“Stocks to Consider Buying” are those
holdings trading below our their
current fair value estimates.
Value Core Grwth
38
41
16
Lrg
0
5
0
Med
0
0
0
Sm
p51 – 100
p26 – 50
p11 – 25
p0 – 10
Other definitions may be found in the
DividendInvestor Subscriber’s Manual.
Builder Portfolio
Continued From Page 4
6
Second, we raised our fair value estimate for United
Parcel Service by $5 a share to $92. This reflects
numerous small changes as well as the time value of
money effect in discounted cash flow analyses. (If
a business performs in line with our expectations, our
fair value estimate naturally tends to rise as the
cash flows we forecast are realized.) With its wide
economic moat, abundant cash generation, and solid
long-term growth prospects offsetting its cyclicality,
I have considered UPS a core holding for years, and our
patience has paid off with a year-to-date total return
of 39.6%, the second strongest of any Builder holding
this year. I’m no longer enthusiastic about the price,
as the yield has slumped to 2.5%, and the stock still
looks 10% overvalued relative to our new fair value
estimate. But I still have no plans to sell—nothing of
comparable quality from a fundamental perspective
strikes me as more attractively priced.
Finally, though our fair value estimate remained
unchanged at $95 a share, we raised our moat rating
for Clorox CLX to wide from narrow. This reflects
our confidence in the company’s ability to sustain high
returns on invested capital (23% on average over the
past five years) for at least the next 20 years.
Though Clorox doesn’t have the massive scale or global
scope of Procter & Gamble PG or Unilever UL,
it generally doesn’t compete head-to-head with these
giants in its categories. Instead, it dominates
smaller niches like bleach, water filters (Brita), charcoal
(Kingsford), and ranch dressing (Hidden Valley).
Nearly 90% of its brands hold either the number-one
or number-two share in its category, allowing
it to maintain premium prices and push through price
increases (64 of 66 of which have stuck since 2005)
that offset rising commodity costs. We also regard
Clorox as a highly efficient manufacturer, and
management does an excellent job allocating capital.
Yielding 3.1% at present, I think the stock is a buy. œ
© 2013 Morningstar, Inc. All rights reserved. Any opinions, recommendations, or
information contained herein: (i) are for educational purposes only; (ii) are not
guaranteed to be accurate, complete, or timely; (iii) have not been tailored to suit
any particular person’s portfolio or holdings; and (iv) should not be construed
as investment advice of any kind. Neither Morningstar nor any of its agents shall
have any liability with respect to such opinions, recommendations, or information. Morningstar has not given its consent to be deemed an “expert” under the
federal Securities Act of 1933. Past performance is no guarantee of future
results. Before making any investment, consult with your financial advisor. Morningstar employees may have holdings in the stocks recommended.
Builder Portfolio Payment Schedule
Expected Payment
Dividend Growth
Company Name
Payment
Cycle
Johnson & Johnson JNJ
3, 6, 9, 12 11-22-13
12-10-13
0.66
Top pick in healthcare sector as new drugs, R&D pipeline revive L-T EPS/div growth
McDonald’s MCD
3, 6, 9, 12 11-28-13
12-16-13
0.81
Smallest div hike since 2002 amid N-T headwinds, still expect faster growth L-T
Rogers Communications RCI
1, 4, 7, 10 12-11-13
01-02-14
0.42 2 Verizon declines to enter Canada, reduces risk & underscores resiliency of oligopoly
1, 4, 7, 10 late Dec
mid Jan
0.94
US Bancorp USB
1, 4, 7, 10 late Dec
mid Jan
0.23
General Electric GE
1, 4, 7, 10 late Dec
late Jan
0.21 1 Looking for 10.5% div hike in December as profit recovery continues, GECS shrinks
General Mills GIS
2, 5, 8, 11 early Jan
early Feb
0.38
Core Builder holding drives div growth with innovation, efficiency, financial strength
Clorox CLX
2, 5, 8, 11 mid Jan
mid Feb
0.71
Procter & Gamble PG
2, 5, 8, 11 mid Jan
mid Feb
0.6015
Kinder Morgan Inc. KMI
2, 5, 8, 11 late Jan
mid Feb
0.42
Paychex PAYX
2, 5, 8, 11 late Jan
mid Feb
0.35
Intel INTC
3, 6, 9, 12 early Feb
early March
Wells Fargo WFC
3, 6, 9, 12 early Feb
Unilever PLC ADR UL
3, 6, 9, 12 early Feb
United Parcel Service UPS
Ex Date
Pay Date
Anticipated
Amount ($)
Our most recent thoughts
Past 5 Yrs 5-Yr Forecast
8.2
7.0
13.9
8.0
31.2
8.0
Ethical concerns aside, top L-T total return profile (high yield and growth) in our field
—
9.0
High quality and highly profitable, but low payout ratio/yield limits appeal for income
Cut
8.0
Cut
8.0
11.0
7.5
New wide-moat rating reflects brand dominance of niche products, efficient mfg
9.9
7.0
Revival slow in N-T, clawing back mkt share with promotions, decent L-T prospects
9.6
7.5
Otherwise strong appeal dimmed a bit by KMP’s oil biz, L-T challenge surmountable
—
9.5
Despite premium price, still view as core holding for wide moat, attractive div policy
2.1
7.0
0.225
Disappointed by flat div in 2013, plan to give firm a chance to revive div hikes in ‘14
14.1
6.5
early March
0.30
Mortgage profits fall before higher rates benefit interest income, still a solid L-T buy
Cut
8.5
mid March
0.37 2 Weakness in emerging mkts a N-T challenge, still a big benefit for UL over long haul
6.0
8.0
3, 6, 9, 12 early Feb
mid March
0.67 1 Surges past $100 on economic optimism, yield falls and now overvalued, still a hold
6.3
8.0
Chevron CVX
3, 6, 9, 12 mid Feb
mid March
1.00
Top Big Oil pick: Output growth accelerates in next few yrs, free cash flow to surge
9.2
8.5
Emerson Electric EMR
3, 6, 9, 12 mid Feb
mid March
0.43
4.9% div hike extends long streak but doesn’t do much for yield, which remains low
8.8
7.5
Spectra Energy SE
3, 6, 9, 12 mid Feb
mid March
5.4
8.5
1
0.335 1 Div hike delayed until Q1/2014, planned 9.8% increase gives forward yield of 3.9%
Data through Nov. 13, 2013. Denotes an increase we expect, but which has not yet been announced. Dividend to be paid in foreign currency; subject to exchange fluctuations.
1
2
Procter & Gamble PG
Star Rating
Economic Moat
Morningstar’s Take
Procter & Gamble PG is the leading consumer
product manufacturer in the world, with more than $80
billion in annual sales. Its wide moat derives from
the economies of scale that result from its portfolio of
leading brands, 25 of which generate more than $1
billion in revenue per year. Given its dominant market
positions (35% of baby care, 70% of blades and razors,
30% of feminine protection, and 25% of fabric care),
retailers rely on P&G’s products to drive traffic in their
stores. Further, the size and scale P&G has amassed
over many years enable it to realize a lower unit cost
than its smaller peers. P&G supports its advantages
by investing in research and development (2.5% of
sales) and marketing (11.5% of sales) for core brands.
QQQQ
Wide
Uncertainty Rating
Low
Fair Value ($)
87.00
Current Price ($)
83.50
Price/Fair Value
0.96
Dividend ($)
2.41
Yield (%)
2.9
Payout (%)
56
5-Yr Growth (%)
9.6
Credit Rating
AA
However, P&G has stumbled over the past several
years, indicating its wide moat may be eroding.
We think the firm entered too many new markets too
quickly, especially in emerging economies where
it was late to the game relative to key global competitors. In addition, its products missed the mark with
value-conscious consumers, and volume and market
share retreated. These miscues led to the early
retirement of Bob McDonald, who had held the CEO
job only four years, and the return of his wellregarded predecessor, A.G. Lafley. Lafley left in place
Procter & Gamble: Stock Price and Dividend Rate ($)
p Stock Price
p Dividend Rate
80
2.20
60
1.65
40
1.10
20
0.55
95 96 97 98
Data through Nov. 13, 2013.
99
00
01
02
03
04
05
06
7
a $10 billion cost-saving initiative designed to lower
costs (via reduced overhead, lower material costs
from product design and formulation efficiencies, and
increased manufacturing and marketing productivity).
However, most savings are likely to be reinvested
in operations, and we expect Lafley to focus on stabilizing market share and driving product innovation.
Builder Focus | Josh Peters, CFA, and Erin Lash, CFA
Procter & Gamble PG
December 2013
07
08
09
10
11
12
13
Though progress will probably be slow in the near term,
we’re encouraged that results in the most recent
fiscal quarter were in line with management’s full-year
expectations (3% –4% revenue growth, 5%–7%
operating earnings per share growth). However, the
degree to which recent revenue growth is benefiting from price cuts is still a concern following recent
comments from two of P&G’s chief global competitors (Colgate CL and Unilever UL), which both cited
stepped-up promotional activity in the U.S. In our
opinion, promotional spending isn’t a sustainable
long-run growth strategy.
The Dividend: What’s New?
In April, P&G raised its dividend for the 57th year in a
row with an increase of 7.0%, identical to the
previous year. Growth in operating earnings per share
has been sluggish for some time—just 3.4% a year
on average since fiscal 2008, compared with 10.9% in
the five years from 2003 to 2008. With dividends
rising faster than EPS, P&G’s payout ratio rose from
42% to 56% in fiscal 2013 (ended June). Given the
size and stability of free cash flows, P&G can easily
afford this higher payout level, if not more. However,
we think P&G needs more earnings growth to provide
high-single-digit dividend growth in the years ahead.
We expect sales growth to average 4% annually over
the longer term—slightly faster than the 3% growth
rate of the firm’s product markets. We also expect
operating margins (19.3% in our 2014 forecast) to
reach 22% in 2018. Using free cash flow in excess of
the dividend, we expect P&G to retire about 2% of its
shares each year. These factors result in the potential
for average annual EPS growth of 8%–9% through
2018. As we suspect faster EPS growth may lead P&G
to trim its payout ratio a bit, we see dividend growth
of 7%–8% a year. In the context of a 2.9% yield, we
believe P&G offers attractive long-run total returns. œ
8
The Dividend Harvest Portfolio
Morningstar Stock Portfolios | Josh Peters, CFA
While the Harvest’s year-to-date total return now
stands at 21.2%, our high-yield portfolio slipped a
little further behind the rollicking S&P 500 in the past
month. Nevertheless, I’m pleased to report that the
Harvest received eight dividend increases between
Oct. 11 and Nov. 13, our highest one-month total ever.
Four of the hikes came from master limited partnerships, and three of these met my forecasts: Kinder
Morgan Energy Partners KMP (up 2.3% from
last quarter and 7.1% from a year ago), Magellan
Midstream Partners MMP (4.7% and 14.9%),
and Spectra Energy Partners SEP (1.5% and 5.4%).
What is the goal of the
Harvest Portfolio?
To earn annual returns of
9%–10% over any
three- to five-year rolling
time horizon.
For our portfolio as a whole,
this goal is composed of:
4%–6% current yield
4%–5% annual income
growth
Income Update
Dividends Received
Interest Income
Total Income
245.42
0.01
245.42
Performance Update
Yield on Original Cost
Yield on Current Value
6.9
4.9
Income Yield, Year Ago
Income Growth (TTM)
5.5
7.4
Price/Fair Value–Portfolio
Price/Fair Value–Market
0.98
1.04
Reporting Period: Oct. 11, 2013 to
Nov. 13, 2013. Yield and Price/Fair
Value data exclude cash balances.
Income growth (TTM) measures the
impact of dividend increases net of
dividend cuts, excluding the effect of
portfolio transactions.
Invest in the Dividend
Portfolios’ Approach—The
Hassle-Free Way
Did you know that Morningstar
Investment Services now offers a
customizable portfolio patterned
after the Dividend Builder and
Dividend Harvest portfolios? To
learn more, call 1-866-765-0663.
Morningstar Investment Services,
Inc. is a registered investment advisor
and wholly owned subsidiary of
Morningstar, Inc.
Energy Transfer Equity ETE was the outlier: Its
quarterly dole rose 1.75 cents a unit (2.7% and 7.6%)
rather than the penny I was looking for. This acceleration in growth reflects continued expansion for its
subsidiary MLPs as well as recent transactions meant
to simplify an overly complex organizational structure.
But the units now trade above our fair value estimate;
I wouldn’t buy more here.
The four other hikes were gratifying as well. The 2.0%
boost from American Electric Power AEP on
Oct. 22 came as a surprise, as AEP had already raised
its dividend 4.3% on April 23. Between the two
increases, shareholders’ pay is up 6.4% this year, and
we expect the dividend to continue rising at the upper
end of management’s 4% –6% target for annual earnings per share growth. We also raised our fair value
estimate by $2 to $50. AEP remains my top utility pick.
On Oct. 23, we got our first dividend increase from
GlaxoSmithKline GSK, which I added to the Harvest
at the end of May. The interim quarterly dividend
rose 5.6% to GBX 19 for the firm’s ordinary shares in
London; this translates to $0.6161 per American
depositary share. Also, in our recent review of development pipelines for large global drugmakers, Glaxo-
SmithKline notched the best ranking, which
suggests the potential for faster earnings growth in
the years ahead. I still like the stock here, and it’s
one of my two best ideas for new money right now.
My other top idea right now is Health Care REIT HCN,
which on Nov. 5 announced that its board has approved
a quarterly dividend rate of $0.795 a share for 2014,
up 3.9% from this year’s payments. Thanks to higher
interest rates, the stock is 25% off the all-time high
it reached in May and 16% below our $71 fair value
estimate. In this context, I think the Harvest’s current
weighting of 4.3% is too low, given the likelihood
of 3% – 4% annual dividend growth going forward.
Finally, Vodafone VOD raised its interim dividend 8%
to what I estimate will be $0.55 an ADR at current
exchange rates. Until lately I’ve been inclined to sell
the Harvest’s stake before Vodafone makes special
distributions of cash and Verizon VZ stock in the first
quarter of 2014. In addition to some unfriendly tax
aspects of these distributions for taxable accounts,
the ADRs have been trading above our $35 fair value
estimate (recently raised from $33 on the rebound
of the British pound relative to the dollar). But I haven’t
been able to identify a suitably attractive replacement
for Vodafone thus far. I’m not yet convinced that
Bell Canada BCE is a better option, in part because
Canada (unlike the United Kingdom) levies a 15%
withholding tax on U.S. shareholders that seems to be
very difficult to recover in tax-deferred accounts.
I plan to continue holding Vodafone for now.
All told, these eight increases added $159 (1.8%) to
the Harvest’s annualized income, bringing our
full-year income growth from dividend hikes to 7.0%—
trouncing our long-term target of 4%–5%. I’ll have
a full review of our progress, as well as dividend forecasts for 2014, in next month’s issue.
Transaction Update
I made two trades in the Harvest on Oct. 14, just after
our data cutoff date but just before the November
issue went to press, which allowed me to mention
them only briefly. Now I can relate the full story.
Continued on Page 10
December 2013
9
Harvest Portfolio Transaction Summary and Performance Breakdown
Morningstar Ratings & Fundamentals
Portfolio Data
Star
Rating
Economic
Moat
Credit
Rating
Fair
Value
Fair Val
Uncert
R Realty Income O
P Spectra Energy Partners SEP
P Kinder Morgan Energy KMP
P AmeriGas Partners APU
QQQ
Narrow
—
44.00
Med
40.10
QQQQ
Wide
—
46.00
Low
43.45
QQQQ
Wide
BBB+
98.00
Med
QQQ
Narrow
BB+
46.00
Med
Kraft Foods Group KRFT
QQQ
Narrow
BBB+
53.00
American Electric Power AEP
QQQQ
Narrow
BBB+
Narrow
AA-
Portfolio Holding
Current Price/Fair
Price
Value
Div
Rate
Yield
(%)
First
Purchase
# of
Shares
Cost Per
Share
Current
Value
% of
Acct
Total
Rtn (%)
Annual
Income
0.91
2.18
5.4
12-29-06
335
27.49
13,433.50
7.0
72.8
731.05
0.94
2.07
4.8
11-19-12
275
27.99
11,948.75
6.2
62.5
567.88
80.67
0.82
5.40
6.7
12-29-06
140
47.81
11,293.80
5.8
102.8
756.00
43.04
0.94
3.36
7.8
12-29-06
260
34.80
11,190.40
5.8
49.0
873.60
Med
52.52
0.99
2.10
4.0
10-10-12
210
46.59
11,029.20
5.7
17.1
441.00
50.00
Low
47.32
0.95
2.00
4.2
04-12-11
230
35.69
10,883.60
5.6
45.5
460.00
71.00
Low
68.26
0.96
3.60
5.3
10-05-11
155
65.23
10,580.30
5.5
14.6
558.00
Stocks to Consider Buying
F Royal Dutch Shell B ADR RDS.B QQQ
QQQ
Wide
A-
95.00
Med
90.62
0.95
3.76
4.1
10-14-13
110
84.89
9,968.20
5.2
6.7
413.60
Public Service Enterprise PEG
QQQ
Narrow
BBB+
35.00
Med
33.57
0.96
1.44
4.3
07-10-12
275
32.00
9,231.75
4.8
10.1
396.00
R Health Care REIT HCN
F GlaxoSmithKline ADR GSK
QQQQ
Narrow
—
71.00
Med
59.99
0.84
3.18
5.3
02-13-09
140
37.83
8,398.60
4.3
89.7
445.20
QQQ
Wide
A+
56.00
Med
51.94
0.93
2.55
4.9
05-31-13
145
52.15
7,531.30
3.9
1.8
369.53
Southern Company SO
QQQQ
Narrow
A-
45.00
Low
41.74
0.93
2.03
4.9
05-31-13
175
44.40
7,304.50
3.8
-3.7
355.25
QQ
Wide
BBB+
54.00
Low
60.69
1.12
2.23
3.7
12-05-08
380
17.27
23,062.20
11.9
232.0
847.40
QQQ
Narrow
BBB+
35.00
Med
37.05
1.06
1.63
4.4
06-22-12
305
27.31
11,300.25
5.9
41.4
498.52
QQ
Wide
BBB
32.00
Med
37.58
1.17
1.92
5.1
09-11-09
300
19.01
11,274.00
5.8
122.9
576.00
QQQ
Narrow
BBB+
60.00
Low
62.43
1.04
3.22
5.2
07-09-09
165
43.29
10,300.95
5.3
72.2
531.84
QQQ
Wide
—
65.00
Med
69.21
1.06
2.69
3.9
03-16-11
100
39.73
6,921.00
3.6
91.6
269.00
QQ
Narrow
A-
32.00
Med
35.07
1.10
1.80
5.1
03-16-11
165
27.51
5,786.55
3.0
45.1
297.00
Stocks to Hold
P Magellan Midstream MMP
F Vodafone Group ADR VOD
Altria Group MO
F National Grid PLC ADR NGG
P Energy Transfer Equity ETE
AT&T T
Cash Holdings
0.0
294.50
0.2
Dividends Receivable (AEP, APU, ETE, GSK, HCN, KMP, MMP, O, RDS.B, SEP, SO)
—
1,429.13
0.7
Harvest Portfolio Total
4.9
193,162.48
100.0
Cumulative Total Return Comparison (%)
pHarvest Portfolio p S&P 500 Index
120
p Morningstar Dividend Leaders Index
80
40
0
-40
2007
2008
2009
Legend:
Shares added
Shares sold
New holding
C
UR Under Review
UR+ Under Review, positive outlook
Å
Í
2010
2011
2012
2013
Taxing the Harvest
P Master limited partnerships. Income is taxed at ordinary rates, though a
portion of cash distributions may not be taxable until units are sold. Not
suitable for tax-deferred accounts including IRAs, Roth IRAs, and 401(k) plans.
R Real estate investment trusts; mostly taxed at ordinary rates.
F Foreign stock, income treated as qualified dividends.
Trailing Return (%)
Index Level This Month
Harvest Portfolio
0.00
9,386.88
12 Month
Annualized
Since Inception
3.0
25.3
10.1
S&P 500 Index
1,782
4.8
32.5
5.6
M* Dividend Leaders
4,627
3.5
23.4
3.5
Top Sectors (%)
Style Breakdown (%)
o Energy
33.0
f Utilities
25.3
s Consumer Defensive
16.7
u Real Estate
11.3
i Communication Svcs
8.8
Value Core Grwth
49
16
4
Lrg
6
25
0
Med
0
0
0
Sm
p51 – 100
p26 – 50
p11 – 25
p0 – 10
Footnotes:
Data as of Nov. 13, 2013. Harvest Portfolio inception: Dec. 29, 2006. Please refer to
Page 5 or the DividendInvestor Subscriber’s Manual for other definitions.
10
Harvest Portfolio
Questions? Comments?
p Sold 595 shares of People’s United Financial
PBCT at $14.74 each. When I bought this regional
bank in July 2012, I recognized that dividend growth—
just 1.6% a year on average over the past five years—
would remain modest until 1. People’s deployed the
rest of the excess capital stemming from its full demutualization in 2007 and 2. short-term interest rates
rebounded, relieving the downward pressure on net
interest margins. At the outset, I felt fairly compensated by a 10% discount to our original $13 fair value
estimate and a hefty 5.4% yield. Then, as the stock
price rose much faster than our fair value estimate
(now $14) or the dividend, People’s yield dropped
to 4.4% and became somewhat overvalued. I was also
concerned about a downgrade in our Stewardship
Rating to Poor, reflecting a failure to efficiently integrate past acquisitions. The stock provided us with
a market-beating total return of 32.3%, but with faster
dividend growth still several years away and an
attractive replacement at hand, it was time to sell.
You can contact me via email
at josh.peters@morningstar.com.
I can’t promise a reply to every
message, but I do read them all,
and when a topic shows up
repeatedly I will address it for all
subscribers in DividendInvestor
or our weekly email update.
Josh Peters, CFA, owns these
stocks in his personal portfolio:
AEP, APU, CLX, CVX, EMR, ETE,
GE, GIS, GSK, HCN, INTC, JNJ,
KMI, KMR, KRFT, MCD, MMP,
NGG, O, PAYX, PEG, PG, PM, RCI,
RDS.B, SE, SEP, SO, UL, UPS, USB,
VOD, WFC.
p Bought 110 shares of Philip Morris International
PM at $84.89. Philip Morris is no stranger to the
pages or portfolios of DividendInvestor; it’s been part
of the Builder Portfolio since May 2010. The stock
has performed exceedingly well since then, yet it still
struck me as attractively priced in mid-October. By
swapping People’s for Philip Morris, we got the same
current yield, but replaced a narrow-moat stock
with a wide-moat one, a stock that was 5% overvalued relative to our fair value estimate with one
that was 11% undervalued, and gained a management
team whose stewardship we rate as Exemplary rather
than Poor. Best of all, the swap brings dramatically
improved prospects for dividend growth. Rather than
roughly 1.5% annual increases from People’s that
could eventually improve to 5.0%, I expect Philip
Morris to deliver 8% –10% annual dividend growth for
many years to come. As Peter Lynch has said, “The
best stock to buy may be the one you already own.”
In Other News
Only one other development last month bears
mention. We raised our fair value estimate for Altria
Group MO by $1 a share to $32. Though the stock
still looks overvalued, I plan to continue holding. œ
Harvest Portfolio Payment Schedule
Payment
Cycle
Expected Payment
Company Name
Ex Date
Pay Date
Vodafone Group VOD
2, 8
11-20-13
02-05-14
Realty Income O
Monthly
11-27-13
12-16-13
0.181854
Public Svc. Enterprise PEG
3, 6, 9, 12 early Dec
late Dec
0.36
National Grid NGG
1, 8
mid Jan
Altria Group MO
1, 4, 7, 10 late Dec
Kraft Foods Group KRFT
1, 4, 7, 10 late Dec
Dividend Growth
Anticipated
Amount ($)
Our most recent thoughts
Past 5 Yrs 5-Yr Forecast
6.7
4.0
Top-rate capital allocation, valuation already consistent with 4%–5% interest rates
4.8
4.0
N-T div growth low amid low wholesale power prices, but both should rebound L-T
4.0
6.0
1.15 2 Targets div growth equal to or above UK inflation driven by infrastructure spending
6.4
4.0
early Jan
0.48
Likelihood of slowing growth crimps our valuation, but total return prospects still OK
—
6.0
mid Jan
0.525
Raised div 5% on Oct. 1, look for 5%–7% hikes L-T as mgmt revitalizes operations
—
6.0
1, 4, 7, 10 late Dec
mid Jan
0.94
Builder holding joins Harvest as well, provides excellent div growth for yield of 4%+
—
9.0
AT&T T
2, 5, 8, 11 early Jan
early Feb
0.46
Rumored to pursue VOD after VZW sale complete, hurts prospect of faster div hikes
3.9
4.5
Kinder Morgan KMP
2, 5, 8, 11 late Jan
mid Feb
1.36 1 Oil biz, IDRs hurt L-T growth, but expansion elsewhere should overcome headwind
7.4
5.5
AmeriGas Partners APU
2, 5, 8, 11 early Feb
mid Feb
0.84
5.6
5.0
Energy Transfer Equity ETE
2, 5, 8, 11 early Feb
mid Feb
0.69 1 Steps up distr. hikes from 1c to 1.75c as key subsidiary ETP returns to growth itself
8.3
15.0
Magellan Midstream MMP
2, 5, 8, 11 early Feb
mid Feb
0.5825 1 Willing to hold top position despite premium valuation for double-digit distr. growth
7.4
12.0
Spectra Energy Partners SEP
2, 5, 8, 11 early Feb
mid Feb
Becomes a core holding thanks to SE’s dropdowns, broad opportunity for expansion
9.1
6.5
Health Care REIT HCN
2, 5, 8, 11 early Feb
late Feb
0.795 1 Announces 3.9% div hike for 2014, high payout ratio but strong finances, cash flow
2.5
3.5
Surprises with 2nd div hike in ‘13, which signals growth outlook for regulated units
3.5
6.0
Cost overruns make AEP a bit more attractive, but SO still a good pick in utilities
early Dec
0.55 2 No replacement buys on the horizon so inclined to hold, even through VZW payouts
0.52625
1
Weather creates S-T volatility in results, but L-T outlook holds steady distr. hikes
1
American Electric Power AEP 3, 6, 9, 12 early Feb
early March
0.50
Southern Company SO
3, 6, 9, 12 early Feb
early March
0.5075
4.0
4.0
GlaxoSmithKline ADR GSK
1, 4, 7, 10 late Feb
mid April
0.74 1 Got top slot in our annual ranking of Big Pharma R&D pipelines, may boost growth
7.5
4.0
Royal Dutch Shell B RDS.B
3, 6, 9, 12 mid Feb
late March
0.90
4.0
5.0
Another bad qtr, but cash flow outlook strong, restructuring likely under new CEO
Data through Nov. 13, 2013. Denotes an increase we expect, but which has not yet been announced. Dividend to be paid in foreign currency; subject to exchange fluctuations.
1
2
Altria Group MO
Star Rating
Economic Moat
Uncertainty Rating
QQ
Wide
Medium
Fair Value ($)
32.00
Current Price ($)
37.58
Price/Fair Value
1.17
Dividend ($)
1.92
Yield (%)
Payout (%)
5.1
The addictive nature of tobacco products, smokers’
brand loyalty, and significant scale benefits make
the tobacco industry conducive to wide moats. As the
dominant player in the U.S. market with more than
50% share, Altria MO generates the greatest economies of scale in the industry. Its iconic Marlboro
brand has an exceptionally loyal following, with 90%
of Marlboro smokers purchasing the brand 100%
of the time. The scale that cigarette manufacturers
possess gives them immense power over tobacco
farmers, suppliers, and distributors.
77
5-Yr Growth (%)
Cut
Credit Rating
BBB
Altria also holds leading shares in moist smokeless
tobacco and machine-made cigars. Its Copenhagen
and Skoal brands combined enjoy roughly 50% share
in the steadily growing smokeless tobacco market.
Unlike its cigarette brands, the company’s smokeless
tobacco products enjoy increasing demand in addition
to strong pricing power and high profit margins.
We recognize that the U.S. government could take
actions that would significantly shrink the industry, but
we think this is unlikely due to governments’ dependence on tobacco excise tax revenue (more than $36
billion for federal and state governments in 2012).
Separately, while litigation threats have been ebbing
for more than a decade and Altria retains a very
Altria Group: Stock Price and Dividend Rate ($)
p Stock Price
p Dividend Rate
36
2.16
27
1.62
18
1.08
9
0.54
2008
2009
2010
2011
2012
11
capable legal team, the risk of further litigation
remains an unpredictable threat to our valuation.
Harvest Focus | Josh Peters, CFA, and Thomas Mullarkey, CFA
Altria Group MO
December 2013
2013
Altria is rolling out its MarkTen electronic cigarette
brand across select parts of the U.S. Though their
impact on industry profitability has been limited to date,
e-cigs could be quite disruptive to Big Tobacco,
and there is a chance that the 2025 profit pool from
cigarettes/e-cigs could be smaller than it is today—
particularly as e-cigs have slimmer margins than cigarettes. We think that Altria will be slow and deliberate as it expands MarkTen.
The Dividend: What’s New?
Since spinning off Philip Morris International PM
in early 2008, Altria has raised its dividend seven
times for an average annual growth rate of 8.8%, which
includes the 9.1% boost announced Aug. 23. Though
dividend growth has benefited from an 80% payout
ratio target, up from 75% at the time of the Philip
Morris spin-off, adjusted earnings per share have been
rising at an 8% annual clip as well. However, top-line
growth has been modest since the 2009 acquisition of
UST, and the primary driver of profit growth has
been cost-cutting—particularly in the selling, general,
and administrative expense category.
We expect Americans to decrease their cigarette
consumption by 3% –4% per year for the next several
years, though we believe the immense pricing power
of Altria and its rivals should eclipse volume declines
in the decade to come. However, following a six-year
period of rapidly improving profit margins for Altria,
further cost-reduction opportunities are more limited.
We expect margins to slowly trend lower, leading to
medium-term per-share earnings and dividend growth
of 5%–6% annually (below management’s target
of 6%–9%). Also, for years beyond our 10 -year explicit
forecast horizon, we incorporate in our valuation
an assumption that profits will decline 3% annually.
For these reasons, we currently value Altria at $32 a
share, pegging the stock as somewhat overvalued.
However, as long as Altria provides a reliable yield
around 5% or better and annual dividend growth
remains in the mid- to upper single digits, the stock
can continue generating worthwhile total returns. œ
12
Income Bellwethers
Dividend Watchlist | Josh Peters, CFA
About Income Bellwethers
This is our coverage list of
100 large, widely held higheryielding stocks on U.S.
exchanges. Our “strategic
appeal” ranking reflect
our views of the company:
High  Potential Builder or
Harvest buy if the valuation
becomes relatively attractive.
Avg  A run-of-the-mill issue
from a dividend perspective.
Low  Needs dividend policy
to improve or risks reduced to
attain an “average” rankings.
None  Significant concerns
regarding dividend safety or
fundamental quality.
Payouts in Peril
BGC Partners BGCP
Entergy ETR
FirstEnergy FE
Frontier Commmunications FTR
Garmin GRMN
GFI Group GFIG
NuStar Energy NS
NuStar GP Holdings NSH
R.R. Donnelly RRD
Windstream WIN
Asset Management MLPs
Energy Production MLPs
Mineral Mining
Mortgage REITs
Ocean Transport
Oil Refiners (MLPs or stocks)
Rural Telecom
Specialty Financials/BDCs
Stocks and industry groups whose
dividends may be at risk of being
reduced. We would avoid these stocks
for income purposes.
folios are attractively priced even for a normalized
interest rate environment. I also know they’ll probably
lag the market when rates are moving higher, but that’s
a trade-off I’m happy to accept given the reliability and
growth of their dividends and their limited downside
risk should the economy stall or contract once more.
President Obama’s nomination of Janet Yellen to
become chairwoman of the Federal Reserve was
nearly lost on the market in the thick of the recent
federal government shutdown, but it’s back in the
news. Her credentials for this extraordinarily powerful
role are as impeccable as anyone could hope, but
there’s also a wide perception that she is a policy
“dove,” more disposed to let inflation rise than tamp
down on economic growth.
Lost in Transmission
I recently added ITC Holdings ITC to the Bellwethers,
one of only two utilities to garner our wide economic
moat rating. Though it wouldn’t be a good fit for
the stated income objectives of our Builder Portfolio,
a current yield around 2% strikes me as justifiable,
given ITC’s outlook for mid-double-digit earnings and
dividend growth. But this attractive story now faces
some trouble, with implications for other utilities too.
Though I don’t care to take public stances on political
appointments, and I can’t say for sure whether Yellen
is a true dove, I do think her public statements reflect
a carefully considered position. Inflation is tough
to corral once it takes hold, as the country discovered
disastrously in the 1970s and early 1980s, but inflation isn’t our chief economic problem—that would be
persistently weak economic growth and employment.
We’ve now had five years of aggressive monetary
stimulus, yet the Consumer Price Index is rising at only
a low 1% rate. It seems you can’t have inflation
without printing a lot more money, but you can print
a lot of money without necessarily getting inflation.
In addition to steady revenue and cash flows, the chief
attraction of interstate transmission is the generous
(12% –14%) returns on equity allowed by the Federal
Energy Regulatory Commission. These returns for
transmission are meant to encourage much-needed
investment in the nation’s power grid, and new
systems often pay for themselves by making generation markets more competitive. But power customers
in several parts of the country are now demanding
cuts in the rates that ITC and other operators are
allowed to charge, since the FERC hasn’t lowered the
allowed returns for transmission despite years of
low interest rates. While we think any cuts are likely
to be modest, it is a point of vulnerability worth
watching—not just for ITC, but also other transmission-heavy stories like Northeast Utilities NU.
The Harvest’s AEP and Public Service Enterprise
Group PEG are also looking to transmission to
drive growth, so I’ll be keeping an eye on this story.
If anything, I believe a too-hasty return to tighter
monetary policy in the short term could tip us into
deflation at a time when consumers and governments
are still heavily indebted, and deflation is just as
bad or worse of an economic ill as inflation. The Fed’s
current toolkit for encouraging faster economic growth
may not be ideal for the task, but at least Yellen’s
nomination lends continuity to current policy.
I still expect that interest rates will eventually rise,
though I don’t have a time frame in mind—this isn’t a
forecast. Instead, I use a 10 -year Treasury yield of
4% – 5% as a planning assumption when evaluating
rate-sensitive stocks like American Electric Power
AEP and Realty Income O. At this point I believe
these and several other high-quality names in our port-
Bellwether Changes
People’s United Financial PBCT joins the Bellwethers after I sold it from the Harvest last month, but
it isn’t a likely repurchase candidate. Texas Instruments TXN also joins with recent dividend increases
giving the stock a $1.3 billion annual payout and
a 2.8% yield; I’ll be looking to profile the stock in
a future issue. Making room for these additions were
two of the lowest-yielding issues: Walgreen WAG
(2.1%) and Marsh & McLennan MMC (2.2%). œ
December 2013
13
Income Bellwethers
Company Name
Star
Rating
Fair
Value
Last
Price
Price/Fair
Value
Dividend
Yield
(%)
5-Yr Div
Grth (%)
3M MMM
QQ
AbbVie ABBV
120.00
128.59
1.07
2.54
2.0
4.2
Avg
Keeping 2% yielder as Bellwether on wide moat, 55 years of hikes, potential for faster div growth, but may not offer 3% again until next bear mkt.
QQQ
45.00
47.85
1.06
1.60
3.3
—
Avg
Raised FVE on optimism for drug pipeline, particularly hepatitis C, but
Humira still the main story and its eventual decline leaves huge hole to fill.
AGL Resources GAS
QQ
40.00
47.49
1.19
1.88
4.0
1.1
Low
Atlanta Gas Light still an attractive utility, but Nicor acquisition (in uteunfriendly Illinois) and unregulated operations keep overall story mediocre.
Air Products & Chemicals APD
QQQ
110.00
108.04
0.98
2.84
2.6
11.1
Avg
Activist investor shakes up board, CEO McGlade to retire, but change takes
time—seeing only modest growth in 2014. Stay on sidelines for now.
Alliant Energy LNT
QQ
47.00
52.64
1.12
1.88
3.6
7.2
High
Midwestern utility with solid regulatory relations, healthy finances & good
rate base growth. 5%–7% L-T div hikes. Appealing should yield top 4%.
Ameren AEE
QQQ
34.00
36.18
1.06
1.60
4.4
Cut
Low
With wholesale generation plants being sold, decent rate-base growth
story emerges, albeit at low returns. Regulation in IL, MO remains tough.
American Water Works AWK
QQ
33.00
42.41
1.29
1.12
2.6
—
Avg
A very steady business, but easily (and apparently) overappreciated: Extreme
capital intensity and low allowed returns on equity limit L-T returns.
Apple AAPL
QQQ
600.00
520.63
0.87
12.20
2.3
—
Low
Revenues likely continue growing, but margins almost certainly contract,
hindering profit growth. High uncertainty sharply limits appeal of dividend.
Automatic Data Proc. ADP
QQ
65.00
76.45
1.18
1.92
2.5
9.1
High
Uninterrupted div hikes since 1974 continue with another 10.3% hike. Not
owning the stock becoming one of my top regrets, but too pricey here.
Baxter International BAX
QQQQ
80.00
66.37
0.83
1.96
3.0
16.9
High
Biotech with wide-moat franchises, promising drug pipeline, emerging-mkt
growth and solid div policy. Considering carefully now that yield is 3%.
BB&T BBT
QQQ
33.00
33.26
1.01
0.92
2.8
Cut
Avg
Settled with regulators over capital ratio accounting issues, no further
dividend hikes in 2013. Div growth likely next year, albeit at modest pace.
QQQ
43.00
44.04
1.02
2.22
5.0
9.2
High
Canada’s version of AT&T T, albeit with a stronger commitment to dividend
growth. Wireless, media assets offset declines of legacy voice service.
Bemis Company BMS
QQ
35.00
39.23
1.12
1.04
2.7
3.6
Low
Restructuring and focuing on higher-end packaging, but recent price more
than discounts improvement potential. Slow pace of div growth likely.
Blackrock BLK
QQQ
300.00
298.68
1.00
6.72
2.2
17.5
Avg
Manages $4 trillion across geographies, asset classes, styles. Results will
reflect market fluctuations, but efficiency, dividend policy are appealing.
QQQQ
30.00
27.80
0.93
2.13
7.7
4.2
Low
Supported by fee-based revs and strong GP, but industry gas glut hurts
regional px differentials to result in weak (2%) L-T distr. growth potential.
QQ
41.00
51.86
1.26
1.40
2.7
3.6
Low
Despite a solid drug pipeline, major patent expirations still loom in 2014–
15. Div growing only about 3% annually, making stock look expensive.
QQQ
68.00
65.45
0.96
4.30
6.6
5.2
Avg
Resumed growth in distributions gives px a big lift this year, biggest headwinds subsiding, gas storage biz a drag but lack of IDRs a long-term aid.
Campbell Soup CPB
QQQ
43.00
42.18
0.98
1.25
3.0
5.4
Avg
First dividend hike since 2010 a sign of progress. Innovation, asset shuffling should help, but KRFT offers comparable L-T growth with higher yield.
CenturyLink CTL
QQQQ
41.00
31.48
0.77
2.16
6.9
Cut
None
Buying back shares with both hands after payout cut earlier this year.
Reduced dividend more sustainable than WIN or FTR, but no hikes in sight.
Cisco Systems CSCO
QQQ
26.00
24.00
0.92
0.68
2.8
—
Avg
Best viewed as a cyclical—not unlike “old economy” industrials—though
capital allocation polices are improving, one of the better tech-sector divs.
Coca-Cola KO
QQQQ
45.00
40.12
0.89
1.12
2.8
8.5
High
One of the all-time greats, 2013 brought another nice dividend increase
(9.8%), 51 straight years of growth. Possible Builder buy if yield tops 3%.
Colgate-Palmolive CL
QQ
59.00
65.09
1.10
1.36
2.1
11.8
Avg
Wide-moat global franchises furnish high-single-digit EPS & div growth,
not much to criticize, but I prefer higher yields (CLX, UL, KRFT) in staples.
Compass Minerals Int’l CMP
QQQQ
84.00
73.45
0.87
2.18
3.0
9.1
High
Caught in the potash industry’s bizarre drama, but 75% of profits still come
from mining salt—a wonderful business despite weather fluctuations.
ConAgra Foods CAG
QQQ
30.00
32.81
1.09
1.00
3.0
5.7
Low
Second-rate play in staples as weak brand portfolio, above-avg exposure
to commodity prices, near constant restructuring minimizes L-T appeal.
ConocoPhillips COP
QQQ
69.00
73.34
1.06
2.76
3.8
10.0
Avg
Planned production growth, asset portfolio changes are helpful but already
discounted in current price. Prefer CVX, even at somewhat lower yield.
F BCE BCE
P Boardwalk Pipeline Ptrs BWP
Bristol-Myers Squibb BMY
P Buckeye Partners BPL
Data through Nov. 13, 2013. UR 5 Under Review
5 Master Limited Partnership
5 REIT
Strategic
Appeal Comments
5 Foreign Stock Cut 5 Div. reduced in past 5 years.
14
Income Bellwethers (continued)
Company Name
Star
Rating
Fair
Value
Last
Price
Price/Fair
Value
Dividend
Yield
(%)
5-Yr Div
Grth (%)
Consolidated Edison ED
QQQ
54.00
57.13
1.06
2.46
4.3
0.9
Low
Reliable payer, but disappointing growth. Another tough rate case in NYC
hinders L-T prospects despite big need for infrastructure replacement.
Darden Restaurants DRI
QQ
45.00
52.21
1.16
2.20
4.2
22.7
Low
Same-store sales and profits still under pressure, lofty payout ratio a risk
factor. Activist investor agitating for breakup, better to stay on sidelines.
125.00
128.74
1.03
3.03
2.4
6.6
High
Dividend hikes continuing to accelerate (up 9% most recently), admirable
wide-moat brands and distribution, but income appeal hurt by low yield.
F Diageo ADR DEO
QQQ
Strategic
Appeal Comments
Dominion Resources D
QQ
58.00
66.33
1.14
2.25
3.4
7.6
High
Plans MLP for midstream assets, regulated operations in Virginia remain
attractive. Thx to above-avg growth, a Builder candidate if yield tops 4%.
Dr. Pepper Snapple DPS
QQQ
46.00
48.14
1.05
1.52
3.2
—
Avg
Above-avg yield compared to rivals KO, PEP offset by poor internal growth
potential, hindered by focus on sugar soda and lack of global presence.
DTE Energy Holding DTE
QQ
58.00
68.16
1.18
2.62
3.8
2.6
Avg
Decent growth potential driven by regulated investment and unregulated
operations, but we remain wary of economic conditions in Michigan.
Duke Energy DUK
QQQ
72.00
70.92
0.99
3.12
4.4
3.3
Avg
New CEO has work cut out following Progress merger and mgmt turmoil.
Recent div hike—just 2%—indicative of medium-term growth potential.
E.I. du Pont de Nemours DD
QQQ
57.00
60.94
1.07
1.80
3.0
2.3
Low
Continues shift toward ag/bioscience with planned spinoff of performance
chemicals, story gets more interesting but dividend appeal still modest.
QQQQ
84.00
72.45
0.86
1.68
2.3
12.1
Avg
Once heavily reliant on deeply cyclical heavy truck market, now a diversified industrial focused on electrical products w/respectable L-T div outlook.
Edison International EIX
QQQ
48.00
48.07
1.00
1.35
2.8
2.2
Low
Appealing SCE all that’s left of once-diversified utility. Would like higher
payout, but funds may be diverted to non-regulated acquisitions instead.
Eli Lilly LLY
QQQ
52.00
50.55
0.97
1.96
3.9
2.9
Low
Promising new product pipeline, but massive patent expirations create flat
sales profile for perhaps a decade. Higher-yielding GSK offers growth.
P Enbridge Energy Partners EEP
QQQQ
35.00
29.05
0.83
2.17
7.5
2.9
Low
Selling 40% of natural gas unit (Midcoast) helps, but coverage still very
poor, huge expansion plans may yield little by way of per-unit distr. hikes.
P Energy Transfer Partners ETP
QQQQ
63.00
52.52
0.83
3.62
6.9
0.4
Low
Kelcy Warren pulled it off: M&A spree and simplification drive allows distr.
growth to resume after 5-yr lull. IDR burden still weighs on L-T growth.
QQQ
70.00
62.79
0.90
3.32
5.3
5.2
None
Merchant units in better shape than Exelon’s, but div may be “right-sized”
after transmission spinoff. Regulated assets far less profitable than SO.
QQQ
64.00
60.88
0.95
2.76
4.5
5.8
High
One of the highest-quality midstream MLPs with simple organizational
structure and healthy distr. growth despite some commodity-sensitive ops.
Exelon EXC
QQQQQ
42.00
28.06
0.67
1.24
4.4
Cut
None
Despite yield, very little appeal for income buyers following dividend cut.
Still a play on the uncertain path of natural gas/merchant power prices.
ExxonMobil XOM
QQQ
97.00
92.59
0.95
2.52
2.7
9.7
Avg
Still the industry’s preeminent operator, nice to see dividend growing faster
(21% for ‘12, 11% for ‘13), but CVX offers higher yield, L-T div growth.
R Federal Realty Investment FRT QQQ
100.00
105.64
1.06
3.12
3.0
3.7
High
Appealing REIT with uninterrupted div hikes since 1967, strong balance
sheet, nice growth potential and good mgmt … but yield is still too low.
FirstEnergy FE
QQQ
42.00
36.07
0.86
2.20
6.1
1.9
None
Payout ratio hovering near 75% as wholesale profits shrink, coal plants
are shuttered. Lofty current yield indicates elevated risk of a dividend cut.
Frontier Communications FTR
QQQ
5.50
4.78
0.87
0.40
8.4
Cut
None
Further dividend cuts are possible as revenues continue to decline, competitive pressures remain intense, and cost-cutting opportunities are finite.
General Dynamics GD
QQQ
92.00
87.08
0.95
2.24
2.6
17.9
Avg
Like peers, defense spending cuts hurt revenue growth, offset by efficiency
and capital redeployment. Low payout ratio leaves room for larger div.
Genuine Parts GPC
QQ
65.00
81.76
1.26
2.15
2.6
6.3
High
Sincerely hope to own this auto-parts distributor again someday, but with
dividend yield at historically low levels, unlikely to buy anytime soon.
Hasbro HAS
QQQ
53.00
52.95
1.00
1.60
3.0
23.7
Avg
Reliance on licensed movie characters for toy lineup creates volatility, but
likely aids results in next 2 yrs. Like rival MAT, offers attractive div policy.
R HCP HCP
QQQQ
50.00
39.45
0.79
2.10
5.3
2.4
Avg
Surprise dismissal of longtime CEO—who steered HCP through more than
a decade of steady div growth—is a concern, best to wait and watch.
F HSBC Holdings ADR HBC
QQQ
58.00
55.23
0.95
2.40
4.3
Cut
Low
Dividend up in last 3 years after slash during the crash. Still question ability
of such large bank to control risk, but back-to-basics push is promising.
F Eaton ETN
Entergy ETR
P Enterprise Products Ptrs EPD
5 REIT
December 2013
15
Company Name
Star
Rating
Fair
Value
Last
Price
Price/Fair
Value
Dividend
Yield
(%)
5-Yr Div
Grth (%)
Illinois Tool Works ITW
QQQ
76.00
79.25
1.04
1.68
2.1
8.6
High
Like 3M, keeping ITW in the Bellwethers for appeal of business (enhanced
by restructuring plans) and record of dividend growth, but no buy here.
Iron Mountain IRM
QQQ
26.00
26.45
1.02
1.08
4.1
—
Low
Ample cash generation and 4% yield—even before planned REIT conversion—are alluring, but best to stay on sidelines as IRS approval plays out.
ITC Holdings ITC
QQQ
98.00
94.31
0.96
1.70
1.8
5.3
Low
Not a Builder candidate, yet mid-double-digit growth potential justifies low
yield. Key risk is FERC ROE rollbacks, but we think any cuts will be modest.
J.P. Morgan Chase JPM
QQQ
52.00
54.14
1.04
1.52
2.8
—
Low
Regulators slamming the bank on multiple fronts as post-crash glow goes
dark. First big bank to fully restore dividend, but income appeal still low.
Kellogg K
QQQ
60.00
62.47
1.04
1.84
2.9
7.7
Avg
4.5% dividend hike for 2013 comes in relatively disappointing for second
year, product innovation/marketing should help growth accelerate L-T.
Kimberly-Clark KMB
QQ
93.00
108.84
1.17
3.24
3.0
6.9
High
We expect growth to accelerate—7%–9% gains in EPS and dividend—
based on competitive strength and cost controls, but price discounts this.
Lockheed Martin LMT
QQ
111.00
137.26
1.24
5.32
3.9
23.1
Avg
Backlog, cost cutting, cash returns surprisingly effective in offsetting DoD
spending cuts. Rising rates aid pension funding, but stock still overpriced.
Lorillard LO
QQQ
45.00
52.08
1.16
2.20
4.2
27.8
Low
Lowest yield in domestic tobacco, though best growth outlook thanks to
Newport, e-cig biz. Mostly risk of menthol regulation that wards me off.
M & T Bank MTB
QQ
101.00
111.67
1.11
2.80
2.5
1.5
Avg
Strong, well-managed regional lender with a knack for acquisitions. Div
flat since 2008 but never cut during crash, growth may resume in 2014.
Mattel MAT
QQQ
46.00
45.55
0.99
1.44
3.2
10.6
Avg
Long-term headwinds for traditional toys a minus, but story aided by foreign
exposure and prudent capital allocation—incl. rapidly-rising dividend.
Merck & Co. MRK
QQQ
52.00
47.34
0.91
1.72
3.6
2.1
Low
Flat top-line prospects thru 2018 as patent expirations offset likely new
products, puts emphasis on cost cuts/buybacks to drive EPS/div growth.
Microchip Technology MCHP
QQQ
42.00
43.44
1.03
1.42
3.3
3.1
Low
Early adopter of a generous payout in tech, but other chipmakers are
catching up on the dividend policy front, and div hikes have been very small
Microsoft MSFT
QQQ
38.00
38.16
1.00
1.12
2.9
15.7
Avg
Payout ratio now tops 40%, though I’d prefer 60%. Possible for a new CEO
to improve capital allocation, though L-T business headwinds persist.
F Nestle ADR NSRGY
QQQ
76.00
72.72
0.96
2.23
3.1
13.6
Avg
Wide economic moat rating reflects expansive global footprint, strong
brands. Decent L-T div growth, but UL slightly more attractive for income.
NextEra Energy NEE
QQQ
80.00
86.10
1.08
2.64
3.1
7.9
High
Leader in renewable energy w/o much market risk, decent regulated assets
too, but peer-leading dividend growth not enough to justify 3% yield
Norfolk Southern NSC
QQQ
86.00
87.62
1.02
2.08
2.4
15.1
Avg
Declining coal traffic has been matched with cost cutting, performance that
reflect wide moat. Wish payout ratio target was higher than 33%.
Northeast Utilities NU
QQ
36.00
42.17
1.17
1.47
3.5
11.3
High
Heavy investments in electric transmission are key earnings/dividend
growth driver, but possible rollbacks in FERC allowed returns creates risk.
QQQ
80.00
78.85
0.99
2.50
3.2
9.6
Avg
Solid all around with multiple business lines and geographic diversity, but
growth is modest—trailing rival J&J—and yield struggles to compensate.
Nucor NUE
QQQ
56.00
52.39
0.94
1.47
2.8
5.3
Low
Better than rivals, good dividend policy, but needs faster economic recovery
(especially in construction) to get earnings/dividends out of low gear.
Occidental Petroleum OXY
QQQ
102.00
97.00
0.95
2.56
2.6
18.1
Avg
History of solid dividend growth is encouraging, as are recent moves to cut
costs, enhance focus on Texas. Prefer CVX, but wouldn’t rule OXY out.
Old Republic International ORI
QQQ
16.00
17.17
1.07
0.72
4.2
7.0
Low
Rebounding profitability, falling mortgage insurance claims help support
generous dividend, though outlook for dividend increases remains muted.
QQQ
58.00
52.63
0.91
2.90
5.5
5.4
High
NGL glut pushed coverage below 1x and crimped N-T distribution growth,
but OKS retains appeal for those willing to ride commodity px swings.
People’s United Financial PBCT QQQ
14.00
14.65
1.05
0.65
4.4
4.2
Low
Sold from Harvest on Oct. 14. Still see dividend as reliable, but low rates
hurt, efficiency targets are questionable, bigger div hikes still years away.
PepsiCo PEP
QQQ
88.00
85.95
0.98
2.27
2.6
8.4
High
Trails KO in beverages, but the clear leader in salty snacks (Frito-Lay),
performance improving after rough 2012. L-T div hikes in high single digits.
Pfizer PFE
QQQ
30.00
31.87
1.06
0.96
3.0
Cut
Avg
Past the worst of patent cliff, sales flat over next 4–5 years. Cost cuts,
buybacks allow div hikes, but yield still low given lack of internal growth.
F Novartis ADR NVS
P ONEOK Partners OKS
5 REIT
Strategic
Appeal Comments
16
Company Name
Star
Rating
Fair
Value
Last
Price
Price/Fair
Value
Dividend
Yield
(%)
5-Yr Div
Grth (%)
PG & E PCG
QQQQ
46.00
40.97
0.89
1.82
4.4
4.8
Low
Current appeal limited as penalties over San Bruno explosion still unclear,
but once those issues are resolved, a much better story may reemerge.
Piedmont Natural Gas PNY
QQ
27.00
33.24
1.23
1.24
3.7
3.8
High
Small but conservative and well-run utility stays on Bellwethers despite
persistent overvaluation, hoping for chance to buy for Harvest someday.
Pinnacle West Capital PNW
QQQ
55.00
54.33
0.99
2.27
4.2
0.2
Avg
Second straight year of dividend growth reflects mgmt optimism that ROEs
will improve, Arizona regulatory environment better than it once was.
QQQ
48.00
50.92
1.06
2.40
4.7
5.2
High
Ideally positioned to capitalize on rising tide of domestic crude prod’n, not
perfect (gas storage biz a drag) but see high single dight distr. growth.
QQQQ
35.00
30.33
0.87
1.47
4.8
3.4
Avg
Acquisition-led shift in business mix shores up safety of dividend, but
ongoing exposure to wholesale power prices limits medium-term growth.
123.00
160.26
1.30
5.60
3.5
17.1
High
Another hefty div hike (12%) reflects PSA’s moat, would surely consider
buying at fair value. Yet growth is bound to slow L-T, shares overpriced.
P Plains All American PAA
PPL Corporation PPL
R Public Storage PSA
QQ
Strategic
Appeal Comments
Raytheon RTN
QQQ
83.00
85.46
1.03
2.20
2.6
14.4
Avg
Raised FVE 24% on better-than-expected 2013 performance, shrinking
pension deficits, though longer-term rev growth outlook remains stagnant.
Reynolds American RAI
QQ
42.00
52.12
1.24
2.52
4.8
7.8
Low
Shares U.S. cigarette oligopoly with Altria MO & Lorillard LO, but weaker
brands hurt L-T growth potential, and RAI is most expensive on price/FV.
F Royal Bank of Canada RY
QQ
55.00
68.02
1.24
2.56
3.8
4.7
Low
Div rising fast (2 hikes in ‘13 totaling 12%) as Canadian banking and its
largest bank are admirable, but inflated house prices too much of a threat.
Sempra Energy SRE
QQ
74.00
89.49
1.21
2.52
2.8
14.1
Avg
State-regulated units in CA haven’t had much luck with rate cases, yield
too low, but LNG projects and other unregulated ops should aid growth.
153.00
149.68
0.98
4.80
3.2
4.6
Avg
Leading mall operator goes on raising dividend as taxable income rises,
but even trading a bit below fair value, a low-3% yield is hard to swallow.
R Simon Property Group SPG
QQQ
Sysco SYY
QQQQ
38.00
33.40
0.88
1.12
3.4
5.5
Low
Profit growth stalls as internal restructuring initiatives fail to offset macro
headwinds. Still rated wide-moat, but revival in growth several yrs away.
Texas Instruments TXN
QQ
36.00
42.39
1.18
1.20
2.8
19.1
Avg
Has joined other chipmakers like INTC in offering above-average yield
despite cyclicality and capital intensity. Not a buy here, but worth watching.
Time Warner Cable TWC
Q
84.00
120.14
1.43
2.60
2.2
—
High
Wide moat network generates lots of cash despite occasional strategic
miscues, but valuation inflated by takeover expectations we find unlikely.
QQQQ
52.00
44.93
0.86
1.76
3.9
5.4
Avg
Uncertainty regarding Keystone XL project clouds the medium-term story,
but it’s not great to begin with as gas output falls in Western Canada.
QQ
42.00
49.99
1.19
2.12
4.2
4.0
Avg
Finally buys rest of Verizon Wireless, hefty price tag offset by favorable
financing, net effect on dividend is minimal—but appeal remains mediocre.
QQQ
94.00
88.67
0.94
2.92
3.3
Cut
Avg
Core property portfolio (NYC/D.C.) forms narrow moat/decent growth
potential, shedding noncore assets, but div growth likely to be inconsistent.
Wal-Mart Stores WMT
QQ
74.00
78.90
1.07
1.88
2.4
12.6
Avg
Sales growth has shriveled—law of (very) large numbers applies. Payout
becoming more generous, but erosion of competitive strength a concern.
Waste Management WM
QQ
35.00
44.18
1.26
1.46
3.3
8.1
Avg
No change in view since sale in May: Devoted to its dividend, but subpar
EPS growth/high payout ratio limit growth prospects, stock looks pricey.
Westar Energy WR
QQQ
31.00
31.99
1.03
1.36
4.3
4.1
Avg
Sold in May when SO presented superior long-term opportunity at comparable valuation. Could consider again in future if price becomes cheap.
Williams Companies WMB
QQQ
33.00
34.39
1.04
1.46
4.2
25.1
High
As GP, levered to distribution hikes and unit issues at WPZ. Holds to
aggressive investment 2015 despite near-term commodity price headwinds.
P Williams Partners WPZ
QQQ
55.00
49.77
0.90
3.51
7.1
9.0
Avg
Big fee-based projects diluting commodity px sensitivity, current coverage
weak but should top 1x in 2015 even as distr. continues to rise 6%/yr.
Windstream WIN
QQQ
8.50
8.28
0.97
1.00
12.1
0.0
None
Market clearly pricing in big dividend cut. As cash flow remains in secular
decline, firm will struggle to reduce leverage while maintaining payout.
Wisconsin Energy WEC
QQ
35.00
41.06
1.17
1.53
3.7
19.1
Avg
Still looks pricey, but 4%–6% EPS growth in a favorable regulatory environment and the phasing-in of a more generous payout ratio are pluses.
Xcel Energy XEL
QQQ
28.00
28.51
1.02
1.12
3.9
3.2
High
Diverse, low-risk utility in fairly-regulated jurisdictions. Div hikes planned
in line with EPS growth (4%–6%), lower px could trigger Harvest buy.
F TransCanada TRP
Verizon Communications VZ
R Vornado Realty VNO
5 REIT
Boardwalk Pipeline Partners BWP
Josh’s View
While the yield is alluring, I’m not enthused by the
exposure here to natural gas industry conditions.
Core Harvest holding AmeriGas Partners APU offers
a slightly higher yield and better growth prospects.
Boardwalk Pipeline Ptrs BWP
Economic Moat
Uncertainty Rating
QQQQ
Wide
Low
Fair Value ($)
30.00
Current Price ($)
27.80
Price/Fair Value
0.93
Dividend ($)
2.13
Yield (%)
Est’d Coverage
7.7
0.95x
5-Yr Growth (%)
4.2
Credit Rating
—
33Before You Buy: MLP Taxation
While MLPs have unique tax
characteristics that may benefit
some investors, others—particularly those dealing in tax-deferred
accounts such as IRAs, 401(k)
plans, and Roth accounts—may
find these securities to be unsuitable. Before investing in BWP
or any other MLP, we urge you to
consult a tax professional.
Boardwalk BWP operates 3 interstate pipeline
systems and 11 underground storage facilities spanning from Texas to Ohio. The firm’s 14,000 -plus miles
of pipelines weave among many of the nation’s top
tight oil and gas plays, including the Barnett, Haynesville, Fayetteville, Woodford, and Eagle Ford. Proximity to emerging supply sources dovetails nicely with
Boardwalk’s access to myriad pipeline interconnects,
local distribution companies, industrial end users,
power plants, and others on the demand side. In
particular, forecast growth in natural gas-fired power
generation in the Southeast will benefit Boardwalk.
Despite generally favorable fundamentals, Boardwalk
faces several challenges. For one, it must avoid cost
overruns that have affected certain growth projects,
hurting returns on capital and diluting limited partners.
The firm has also expressed concern about contract
renewal rates, which are affected by currently poor
basis spreads and the available capacity among
Boardwalk Pipeline Partners: Unit Price and Distribution Rate ($)
p Unit Price
p Distribution Rate
32
2.28
24
1.71
16
1.14
8
0.57
2006
2007
2008
2009
2010
2011
2012
17
various markets. While we expect gas prices to
improve long term, basis spreads between delivery
points have also fallen since a few competing
large-scale interstate pipelines came on line in recent
years. This detracts from interruptible and short-term
firm transportation revenue.
The Dividend Drill | Josh Peters, CFA, and Connie Hsu, CFA
Star Rating
December 2013
2013
The Distribution: Is It Safe?
Although Boardwalk derives about 80% of its revenue
from capacity reservation fees that don’t depend
on near-term commodity prices or volume, the more
volatile remainder of revenue and cash flow has
been a disappointment in recent years. Cash coverage
of distributions has slipped below 1.0 times twice
in the past four years; we estimate coverage of 0.95
times for 2013. We don’t believe this shortfall raises
the risk of a distribution cut: Though the balance
sheet is more highly leveraged than most peers (net
debt about 4.5 times EBITDA), Boardwalk enjoys
a solid underpinning of contracted cash flow as well
as the support of a very well-heeled parent in Loews
L. Instead, we see view poor coverage primarily as a
hindrance to distribution increases.
The Distribution: Will It Grow?
We expect distributable cash flow to increase at a
10% average annual rate through 2017, as cash flows
from current pipeline and storage investments in
the Gulf Coast region come through and an improved
commodity price environment brings better longterm contract rates, renewals, and interruptible parking
and lending volume. We are cautious, however,
on the pace of the ramp-up of the recently acquired
midstream services operation, as its partner in the
Marcellus recently slows its drilling plans. Furthermore, as additional equity is raised to fund expansion
and the burden of general partner incentives remains
heavy, we see per-unit distributions rising at a meager
2% annual rate over the next five years.
The Distribution: What’s the Return?
Though Boardwalk looks slightly undervalued relative
to our $ 30 fair value estimate, and its 7.7% yield
makes it one of the highest-yielding midstream partnerships we cover, its per-unit distribution growth
potential is among the lowest. This leads to expected
long-run total returns averaging 9% –10% annually. œ
18
Vornado Realty Trust VNO
The Dividend Drill | Josh Peters, CFA, and Todd Lukasik, CFA
Josh’s View
Vornado’s VNO recent moves toward simplifying its
portfolio are encouraging, and I wouldn’t rule out a
purchase if the stock got cheap, but I generally prefer
more-predictable real estate investment trusts.
Vornado Realty Trust VNO
Star Rating
Economic Moat
QQQ
Narrow
Uncertainty Rating
Medium
Fair Value ($)
94.00
Current Price ($)
88.67
Price/Fair Value
0.94
Dividend ($)
2.92
Yield (%)
We like the characteristics of Vornado’s core office and
retail properties, situated mainly in and around New
York and Washington, D.C. These markets benefit
from constraints on building competitive supply, local,
national, and foreign demand for space, and favorable
demographics. However, a 32-year streak of uninterrupted cash flow growth from Vornado’s core portfolio
ended in 2012 amid weakness in the D.C. market,
where federal spending cuts have sharply decreased
occupancy. Uncertainty surrounding the federal
budget in D.C. and the potential for increased supply
from new developments in New York may damp
the leasing environment in these markets. We expect
Vornado to perform below its potential in the near
term, but longer term we think its quality properties
will generate moat-worthy levels of internal growth
that slightly exceeds inflation.
3.3
Payout (%)*
87
5-Yr Growth (%)
Cut
Credit Rating
—
*Based on funds available for
distribution (FAD); see text.
A portion of Vornado’s value is attributable to investments in debt and equity of other companies with real
Vornado Realty Trust: Stock Price and Dividend Rate ($)
p Stock Price
The Dividend: Is It Safe?
Vornado is in fine financial health, with plenty of
liquidity and a manageable debt maturity profile. By
our measure, debt is 7.4 times consolidated EBITDA—
reasonable for an office REIT, even though this does
not consider the contribution from Vornado’s $3
billion of nonconsolidated investments. The dividend
is running at about 87% of funds available for distribution, a measure of recurring cash flow. Like most
REITs, Vornado reduced its dividend in early 2009 to
preserve liquidity, but barring another crisis of comparable magnitude, we would not expect another cut.
The Dividend: Will It Grow?
The dividend rate has recovered 92% from what was
paid in 2009, but has yet to reattain its precrash
rate of $3.80 a share. Vornado’s stated policy is to pay
out its taxable income, supplementing regular dividends with one-off payments if necessary to maintain
compliance with the tax rules for REITs, but otherwise
retaining cash flow in excess of taxable income.
Based on the prospects for its core portfolio, we estimate the dividend can grow at a roughly 5% annual
rate going forward. However, despite a steady pattern
of advances until 2008, we doubt that future dividend
increases will be consistent from year to year.
p Dividend Rate
104
3.24
78
2.43
52
1.62
26
0.81
95 96 97 98
estate exposure, as well as joint ventures. Among
these holdings, the company owns chunks of retailer
Toys ‘R’ Us, two publicly traded REITs, and mezzanine
and mortgage debt securities. It recently liquidated
a stake in J.C. Penney JCP at a loss. These ancillary
investments divert management’s attention from
its core business and make it more difficult to analyze
and value the shares. Along these lines, Vornado
has embarked on a strategy to simplify its balance
sheet and sell noncore assets, particularly in retail.
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13
The Dividend: What’s the Return?
With the shares trading at a modest discount to our
$94 fair value estimate and yielding 3.3%, Vornado
offers the potential for long-run total returns slightly
exceeding our 8% cost of equity assumption. But
given the complexity of the organization and its
historical disposition to making nontraditional investments, many investors seeking consistent income
and growth will find other REITs more attractive. œ
Seems Reasonable, So Let’s Carry On
ratio for the S&P was 53%. By 2010 and 2011, dividends disposed of only 27% of operating earnings.
Lately, however, I can see some signs of improvement.
In the past two years, dividends have grown faster
than earnings, lifting the operating payout to 34%.
Excluding periods of depressed earnings in 2001–02
and 2008 –09, that’s the highest payout since 1998.
rise significantly faster than earnings, the P/E could
move into historically overvalued territory, and even
longer-term investors could have reason to worry.
Share repurchases are still larger than dividends
in terms of total dollars, but the mix is shifting in favor
of dividends. Since buybacks are easier to dial
up and down than dividend rates, this nascent trend
expresses confidence on the part of big corporations
in the durability of profits going forward. The 2% yield
of the S&P is still low by historical standards, but
if—as I expect—the market gradually demands more
generous dividends, at least companies have ample
resources with which to supply them.
S&P 500: Operating Payout Ratio (%)
60
December 2013
19
So what’s the pitch for a more or less fairly valued
stock market? From a starting point around fair value,
investors can expect fair returns—8% to 10% a year
on average over lengthy time horizons—along with the
usual volatility in shorter periods. For long-term
investors holding diversified portfolios, low purchase
prices are advantageous. But I don’t think it’s necessary
to hold out for bargains, particularly when the ready
alternatives to stocks—bonds and cash—provide
either very low or nonexistent returns. From there, our
playbook is simple, and it continues to serve us well:
p Reliable dividends with above-average yields and
solid growth potential. Leaning more on dividends
within our desired total returns lessens our reliance on
capital appreciation, but I still require both safety and
consistently rewarding dividend increases.
50
40
30
20
10
97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Gray bars reflect recessions. Data from 1997 through the four quarters ending
Q3/2013. Source: Standard & Poor’s.
Strategy for a Fairly Valued Market
Combining these factors—historically justifiable P/Es,
sustainable levels (in my view) of corporate profits,
and more generous dividends—gives me comfort that
the current level of the stock market is reasonable.
This is reflected in our bottom-up fair value estimates
as well: The median stock that Morningstar covers is
now priced at a 4% premium to fair value, which I
would describe as within the margin of error.
Of course, if the economy tips into an unexpected
recession (is there any other kind?), profits will slump
for a time, and so will stock prices. Recessions aside,
the market also seems overdue for a correction: It’s
been over two years since the S&P fell 10% or more
from its most recent peak. And if prices continue to
p Wide and narrow economic moats. Identifiable and
sustainable competitive advantages protect the
profits that fund our dividends during downturns and
encourage long-run dividend growth.
p A tilt toward economically defensive businesses.
Sectors like staples, utilities, telecoms, and energy
tend to underperform the S&P during bull markets, but
they make up for the lagging stretches with far less
downside in tough times.
p A long-term commitment. Over the years I’ve often
been bearish on the market as a whole. I noted
earlier that I didn’t realize at the time how attractive
the market’s P/E was in 2011; I figured it deserved
to be low. But I didn’t need to be overtly bullish then
to do well, and I don’t now. Dividends give us the
luxury of focusing less on the market and more on our
strategy and the stocks it helps us select. If the
S&P hops up to 25 or 30 times earnings—historically
perilous levels—the time may come to shift gears.
But unless and until that happens, I’ll stick with our
policy of remaining fully invested, and manage our risks
by holding high-quality, highly reliable dividend payers
whatever the market or economic trend may be. œ
22 W. Washington Street
Chicago, Illinois 60602
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(ISSN 1557-2099)
This publication is printed on Cascades
Rolland Enviro 100 Satin paper,
which contains 100% postconsumer
waste fiber and is manufactured
using biogas energy.

DividendInvestor - rebel Financial

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