Income Investing for the Long Term

03/16/2012 11:45 am EST


Josh Peters

Editor, Morningstar DividendInvestor

Morningstar’s Josh Peters thinks investing for dividends is the best long–term strategy. Here, he explains how he recommends establishing an income portfolio.

Josh, the dividend trade became pretty popular in 2011. Is that still an area that you believe investors should be in?

I really don’t think it’s a trade at all. One of the most important things that I think people have to understand about dividends is that they’re really about you as an investor.

It’s very important I think as part of a long–run strategy in stocks to have companies that are going to share their profits directly with investors. But as an investor, I think it’s about taking the opportunity to plan around real–world financial goals, and generating income from you portfolio of stocks, while still getting the long term growth, and still getting that hedge against inflation, and still getting the overall total return that you should expect from stocks to beat that of bonds.

I think especially going forward from here, it’s not a trade. It’s something that I think is part of a very, very long trend that we’re going to talk about in decades as opposed to days. And I think that it’s a place that people want to be for the long run.

Let’s talk a little bit more about how investors should be doing that.

Well, I think it really comes down to the Bs right now.

There are some people who are literally of the opinion that dividend–paying stocks are in a bubble, which I think is kind of ridiculous, in the sense that if a stock price goes up and the dividend doesn’t follow, the yield goes down in tandem. High–yield stocks become low–yield stocks when they’re overvalued, so it’s almost like a self–pricking bubble. We’re really not looking at that kind of a problem, not massive overvaluation.

But the other B—the B that I like—bargains, those are pretty scarce right now. So I think that where you want to position yourself as an investor right now is recognize dividend–paying stocks that were very good in 2011, especially compared to the market that was kind of flat. They are kind of in the fairly priced range, we think, right now, which means I think you can expect a fair, 9% to 10% type of total return over the long run.

But there is certainly some potential for prices to pull back. I think you want to average in. You chart out your course. You identify what it is you’re trying to accomplish over five, ten, 15 years, and what you need for income from your portfolio, and start looking for the best companies that are able to deliver those high and growing dividend payments over time.

Then you average in. You move a little more money in every month, and the market takes a little dip and you move a little bit more money in. Over a period of a year or two, you wind up with a fully invested portfolio.

You did your dollar cost averaging. You did your dividend reinvestment. You didn’t have to take the risk of jumping in all at once.

Josh, are there any particular sectors or even stocks that you believe investors should be taking a look at?

Right now, there aren’t any sectors that actually look like they provide bargains across the board. That is just kind of tough.

In particular, REITs and fully regulated utilities look kind of expensive. That’s an area that it’s very difficult to find stocks and buy right now, at least in the United States.

But one idea that I like a lot is a transatlantic utility company called National Grid (NGG). It’s based in the UK and has ADRs here that trade on the New York Stock Exchange. They are going through a major rate change right now for their UK businesses, which are about 60% of the business. The other 40% is in New England.

Those UK assets are really attractive because customer bills are automatically adjusted for inflation. So one of the biggest risks that you take with a traditional regulated utility in the United States, that inflation could come along and really clobber you, that doesn’t really present itself as so much of a risk for National Grid operating in the UK.

And its stock right now yields about 6%. I mean, you can’t get 6% from a fully regulated utility in the United States.

But when we run through the numbers, we look at a situation of regulatory relationships on both sides of the Atlantic. We think this dividend is sustainable and better than that, can actually grow at mid single digits or better, maybe over the next five to ten years.

To me, that’s a very compelling type of total return—6% yield, mid–single–digit growth or better.

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