Morningstar’s Dividend Playbook
Josh Peters, CFA
Director of Equity-Income Strategy
Editor, Morningstar DividendInvestor
©2015 Morningstar, Inc. All rights reserved.
Introduction to Morningstar DividendInvestor
g Josh Peters, CFA is Morningstar’s director of
equity-income strategy, the founding editor of
DividendInvestor, and manager of its Dividend
Select model portfolio
g Launched in January 2005
g Released companion book in 2008:
The Ultimate Dividend Playbook
g Received over 1,200 dividends thus far from
our active portfolio holdings—all of which
reflect actual, trades in real money,
Morningstar-funded brokerage accounts
g Received 398 dividend increases since
inception; just 16 dividend cuts
2
Why Dividends?
gPractical advantages for investors
/For retirees, cash to fund regular portfolio withdrawals without having to sell shares
/For savers, cash funds income growth/wealth accumulation through reinvestment
/Better class of companies—typically well-established, defensive, financially healthy
/Makes stocks easier to analyze and easier to own
gMuch-needed discipline for issuers
/Demonstrates ability willingness to reward shareholders directly
/Represents a long-term commitment, enabling investors to return the favor
/Helps block potentially self-serving or dubious allocations of capital
gDividends are the ultimate source of security values
/Bottom line is cash flow—not just to the firm, but directly to the investor
3
Best Reason of All: Superior Performance
g Numerous academic studies show that high-yielding stocks outperform the market over the long run
g Our study: Highest 30% of yields beat the market in 53 of 60 rolling 10-year CAGRs beginning in 1945
/Average beat of 206bp per year—or an extra $575 after 10 years on each $1,000 invested
U.S. Market Total
Return
30% Highest
Dividend Yields
24%
19%
14%
9%
4%
-1%
1955
1965
1975
1985
1995
Annual data 1945-2014. Source: Data from Kenneth R. French (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html), Morningstar analysis.
4
2005
Step 1: Defining an Investable Universe
g While the S&P 500 pays only 2.0%, much higher yields are available, especially in certain sectors—
consumer staples (2.6%), energy (2.9%), utilities (3.6%) and telecommunications (4.9%)
g Heavy share buybacks and/or rapid dividend growth without a decent yield are no substitute for
adequate current income
g Our basic stock screening parameters:
Premium Stock Screener available at http://screen.morningstar.com/AdvStocks/Selector.html#AnchorSelector, results as of 3/19/2015.
5
Step 2: The Dividend Drill
6
The Dividend Drill: Is It Safe?
g Dividend safety is the number-one
priority for income investors—
more than interest rates, changes in
economic trends, even valuations
g How to avoid dividend cuts:
/Economic moats, which defend
profitability and cash generation
/Healthy balance sheets
/Payout ratios that balance income
against internal reinvestment
needs and a cyclical safety margin
/Continued dividend growth is the
best indicator of safety, though
even this isn’t perfect ...
Our Record: Outcomes by Dividend Action
Increased
Dividends (89%
positive returns)
Flat Dividends
(71% positive
returns)
350%
300%
250%
200%
150%
Reduced
Dividends (19%
positive returns)
100%
50%
0%
-50%
-100%
Outcomes reflect realized total returns for full holding periods of each active DividendInvestor portfolio position. Data through 3/19/2015. Source: Morningstar
7
The Dividend Drill: Will It Grow?
g Dividend growth drives total return by:
/Furnishing additional income over time
/Encouraging long-term capital appreciation
g Key drivers of dividend growth:
/Earnings growth: Consider volume expansion,
pricing power, future for operating margins,
role of acquisitions/share repurchases
/Dividend policy: Will dividends rise
faster/slower/equal to per-share earnings?
g Useful approach: “extend the trend”
/Latest 5- or 10-year rate as a stepping-off point
for consideration of future performance
Data as of 3/19/2015. Source: Morningstar, company reports
8
General Mills GIS
Stock Px (LH)
Div. Rate (RH)
60
1.90
48
1.52
36
1.14
24
0.76
12
0.38
1995
2000
2005
2010
2015
10-Year Earnings and Dividend Summary
CoreEPS DivPaid Payout
CoreEPS DivPaid Payout
FY04
1.43
0.55
39% FY11
2.48
1.12
45%
FY05
1.37
0.62
45% FY12
2.56
1.22
48%
FY06
1.45
0.67
46% FY13
2.69
1.32
49%
FY07
1.59
0.72
45% FY14
2.82
1.55
55%
FY08
1.76
0.79
45% CAGR: 7.1% 10.9%
FY09
1.99
0.86
43%
FY10
2.30
0.96
42% FY15e
2.82
1.67
59%
The Dividend Drill: What’s the Return?
g Total return is always the bottom line, not
income alone or growth/capital gains alone
Realty Income O
60
3.70
g Is the absolute return indicated by a safe current
yield plus sustainable long-run dividend growth
acceptable?
48
2.96
36
2.22
24
1.48
12
0.74
/Hurdle returns of 7.5% for low risk companies
with above-average yields;
g Am I paying a sustainable valuation: will
total return = dividend yield + dividend growth?
/Consider valuation: Our main indicator is
price/fair value (preferred below 1.0)
g Preferred outcome is total return > yield+growth,
valuation discipline necessary to avoid shortfalls
1995
2000
Stock Px (LH)
2005
Johnson & Johnson JNJ
2010
Stock Px (LH)
Div. Rate (RH)
2015
Div. Rate (RH)
140
2.80
112
2.24
84
1.68
56
1.12
28
0.56
0.00
1995
Data as of 3/19/2015. Source: Morningstar
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2000
2005
2010
2015
Dividend Drill in Action: Verizon Communications
g The Dividend: Is It Safe?
/Free cash flow is the best indicator; covers
dividends about 1.5 times
/Economically defensive business;
narrow moat and BBB credit rating
g The Dividend: Will It Grow?
Verizon VZ
Stock Px (LH)
Div. Rate (RH)
70
3.10
56
2.48
42
1.86
28
1.24
14
0.62
1995
2000
2005
2010
2015
/Dividend increases each year since 2005
/Modest but accelerating growth recently
g The Dividend: What’s the Return?
/Trading slightly below $50 fair value
/4.5% yield plus 4%-5% estimated dividend
growth suggests roughly 9% total returns
Data as of 3/19/2015. Source: Morningstar, company reports
10
10-Year Earnings and Dividend Summary
CoreEPS DivPaid Payout
CoreEPS DivPaid Payout
FY04
2.59
1.54
59% FY11
2.15
1.96
91%
FY05
2.56
1.60
63% FY12
2.32
2.02
87%
FY06
2.54
1.62
64% FY13
2.84
2.08
73%
FY07
2.34
1.65
70% FY14
3.35
2.14
64%
FY08
2.54
1.75
69% CAGR: 2.6%
3.3%
FY09
2.40
1.86
77%
FY10
2.21
1.91
87% FY15e
3.66
2.22
61%
Step 3: Portfolio Management
g What drives an individual stock’s returns works even better for a portfolio as a whole
/Our Dividend Select portfolio targets 3%-5% yields, 5%-7% dividend growth, 9%-11% total returns
/Currently yielding 3.9% with 6.1% long-run income growth profile
g Earning yields that are double the market average requires embrace of different results:
We go where the (safe and growing) dividends are ...
S&P 500
Dividend Select
30
25
20
15
10
5
0
Data as of 3/18/2015. Source: Morningstar
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Our Results: Beating the Market Without Even Trying
Cumulative Total Return: DividendInvestor Portfolios vs. S&P 500
200
150
100
Standard & Poor's 500 (CAGR: 7.9%)
Combined DividendInvestor Portfolios (CAGR: 9.2%)
50
0
-50
2005
2006
2007
2008
2009
2010
2011
Cumulative Price Appreciation
80
60
40
S&P 500
DividendInvestor
19.4 percentage point
disadvantage (-1.2%/year)
2012
2013
2014
2015
Cumulative Dividend Return
80
60
40
S&P 500
DividendInvestor
20
20
0
0
-20
-20
-40
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
-40
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Data from inception (1/7/2005) through 3/19/2015. Source: Morningstar
12
32.8 percentage point
advantage (2.4%/yr)
Josh Peters, CFA, owns all of the stocks held in
the Dividend Select portfolio, including GIS, JNJ,
O, VZ.