The Dividend Sweet Spot

02/17/2012 8:45 am EST

Focus: INCOME

Josh Peters

Editor, Morningstar DividendInvestor

The best stocks combine a generous yield suitable for retirees with enticing dividend growth prospects for younger investors, says Josh Peters, editor of Morningstar DividendInvestor.

Josh, I know you have two portfolios, the Harvest Portfolio and the Builder Portfolio. Can you explain what they are and why you have two of them?

Well, both of the portfolios are managed off of the same underlying strategy, which is I want to get a good dividend yield from any stock that I'm going to be interested.

I want that dividend to be safe. I want it to grow, and the lower the yield, the faster I want that dividend to grow. Then I just evaluate the total return.

The way it separates into two different portfolios is really to help subscribers manage their own personal circumstances, where for somebody who's already retired really looking to maximize the income from their portfolio from the equity piece of their portfolio, the Harvest, that's what it's designed to do. We don't go into the market and buy mortgage REITs that yield 10% or 15% or 20%.

And then have risk associated with it.

And then have risk. I mean you almost are guaranteed that those dividends come down at different points in the cycle. I'm not interested in that.

What I want is the maximum amount of yield that I can get safely from each individual company. I want the dividends to grow at least as fast as inflation, which is really valid. You get a 6% or 7% dividend yield from something that the dividend's going to grow at least as fast as inflation.

It's like owning a bond almost or a TIPS bond, Inflation Protected Securities. Now it's not got the same government backing, but it's got that inflation covered in the security itself. You can actually live off of all of the income. It's your real return, and then also enough diversification that I can sleep at night.

It's really about fundamental diversification. It's not about trying to hug the market indexes and not get too far out of line with the S&P weightings of different sectors.

I don't need to own any tech stocks if I can't find any that pay the dividends that I want. I may own lots of utilities and pipeline partnerships, but as long as I've got enough diversification that I can feel comfortable with the safety of the income, then that's really a total return machine with a high-income component.

Josh, what about the Builder Portfolio?

Well, this portfolio again uses the same kind of stock picking and same underlying strategy, but is designed with perhaps a younger investor in mind-who doesn't need to maximize their income for living expenses today-or somebody who just doesn't need as much income as the Harvest would provide. The idea here is to perhaps give up the bird in the hand or part of the bird in the hand, but get the two in the bush.

Just to use an illustration here, Procter & Gamble (PG)-one of my favorite companies. Lately, the stock's been yielding around 3%, a little bit better than 3%, but they don't pay out all their earnings. They don't pay out as much as say a pipeline partnership or a utility does.

They reinvest a lot of their earnings back into the business, and instead of getting say a 2% or 3% type of growth rate for the dividend because you're really maxing out on the current income, you're getting what I think is 7%, 8%, or 9% long-term dividend growth. In fact, Procter & Gamble has raised its dividend for 55 straight years at a 9.5% compounded rate over that time.

Now to me, that's the opportunity to build a lot of wealth over such a long period of time if you don't need the income right away. If you can reinvest the dividends as we do actually in both of our portfolios, you'll compound your income and your earning power even faster.

So I hear you almost saying that dividends are not just for widows and orphans, that it doesn't have to be for those that are retired and just looking for income to live off of.

Yeah, it's amazing. I mean, people have this association with dividends being for old fogies. Dividends are for anybody who's interested in total return. And if you're an investor, total return is the only thing you should be interested in.

When I say total return, I'm combining the yield component that you get from the dividend on a stock, as well as the growth component. The earnings and the dividends of the company are going up over time, and that's translating into capital appreciation. Those two components working in tandem provide a very good machine for building compounding wealth and generating income.

To me, it doesn't much matter. If I can get something that yields 5.5%-a company like Realty Income (O), another one of my favorites-and the dividend's growing 4% or 5% a year, I might actually prefer that to a company that pays only 1% yield but is claiming to grow 15% a year. It's very hard to keep up that kind of growth rate. That balance in the middle can really be powerful at building up wealth.

At the other end of the spectrum, somebody who's looking to flat-out maximize their income, if there's no growth that can be kind of a problem too. I point back at Consolidated Edison (ED).

I think it's actually quite a good utility, but it's had a very hard time raising its dividend faster than inflation. In fact, over the last 15 years none of the dividend increases have been able to exceed the rate of inflation. I want to get both of those components working for them.

And find that sweet spot.

That sweet spot in the middle. I really think of it as being 3%, 4%, 5%, some 6%, even an odd 7% yield. There you're getting very good total return potential without needing a huge amount of growth or income that's so large that it's risky.

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