Find Companies with Wide Moats

07/05/2011 11:30 am EST

Focus: MARKETS

Josh Peters

Editor, Morningstar DividendInvestor

It has become increasingly challenging to find companies that can consistently pay solid, inflation-beating dividends, but it's not impossible, writes Josh Peters of Morningstar DividendInvestor.

Ever hear the phrase, “to a hammer, everything looks like a nail?”

It recently occurred to me that for most investment challenges, I have the same solution day in and day out. All you need is to trust in high-quality common stocks that pay large, reliable, and growing dividends.

They may not always be popular, and they may not always be cheap. They’re no substitute for cash or short-term bonds in your financial safety net. Yet for long-term investment dollars, they play well in a remarkably wide variety of circumstances.

You might say that “nails” are everywhere. Many investors need to generate income to meet living expenses and other recurring financial obligations. Virtually all of us want to build lasting wealth, but hopefully without having to take too much risk.

And then there is the singular problem that confronts investors today: how to preserve the purchasing power of our capital and wring some positive returns out of an environment that seems determined to rob savers and risk-averse investors of fair treatment.

We’re talking about the pursuit of real return—not just the nominal total return that combines income and capital gains (or, alas, losses), but also incorporates the effect of inflation over time. Unfortunately, avoiding risk in the usual sense of the word now all but guarantees loss.

For serious long-term investing, high-payout stocks are far better positioned than cash, long-term bonds, and stocks with low or no dividend yield. They may even be the only way to get a decent real return.

Although I make a practice of keeping my portfolios fully invested (or nearly so) at all times, I generally have a lot of respect for cash. Ordinarily it won’t earn much of a return, but it always trades at par, it comes in handy during a crisis, and in prudent hands cash can have extra value by being ready for attractive opportunities that come along.

Yet even as I type, cash is being trashed—and so are all risk-free, near-cash investments, like money-market funds, short-term bonds, and certificates of deposit.

In the 12 months through May 2011, consumer price inflation ran at 3.4%. With one-year Treasury bills furnishing a return of only about 0.2%, their holders have suffered a 3.2% loss of purchasing power.

Worse, the pace of inflation is accelerating: during the last six months, inflation has run at an annualized rate of more than 5%.

By itself, this would be cause for some concern…but since interest rates have not risen in tandem with inflation, the purchasing power of cash-like investments is falling at an unusually steep rate.

Bill Gross of PIMCO (you might know him better by the moniker “Bond King”) believes this lamentable situation is actually a key objective of US monetary policy. He believes the Federal Reserve is determined to hold short-term interest rates below the rate of inflation for perhaps 15 or 20 years to come.

In his view, relentlessly “picking the pockets” of savers is the only way—short of outright default—that the excessive debts of governments and households can be reduced to more sustainable levels.

I’ve been formulating a similar view, but from a different direction. The world is awash in debt, yes, but for every dollar of debt there is also a dollar that someone else is calling an asset. We now have a massive, global oversupply of paper value chasing insufficient flows of return.

Creditors—corporations, households, and governments—all benefit from ultra-low financing costs at investors’ expense. Virtuous savers compete for scarce returns while the imprudent borrowers either prosper or get bailed out. Pocket-picking indeed!

The biggest potential pitfall in owning high-yielding stocks is that no dividend is guaranteed to keep up with inflation. The ability of a company to raise its dividend at least as fast as inflation depends on the economic attributes and management acumen of the business itself.

Not just any dividend—not even a big one—stands an equal chance of preserving the purchasing power of the shareholders’ paychecks.

What we need is not all that complicated: businesses that can raise prices at least as fast as their costs are rising, so that profits at least hold steady in real terms—and dividends can, too. This concept is neatly wrapped up in what we at Morningstar call economic moats: identifiable and sustainable advantages that a business may have relative to its rivals.

A moat can take the form of patents, strong brands, natural cost advantages, customer switching costs—anything that boosts profits and is hard for competitors to replicate.

Economic moats serve several purposes: One is the protection a moat provides to profitability during downturns, reducing the risk of a dividend cut. Another is a moat’s encouragement of dividend growth, as it suggests that retained earnings stand a good chance of producing high returns on capital.

But in today’s environment, perhaps the best aspect of a moat is its ability to protect profits from inflation and preserve real returns for shareholders.

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