Grow with Your Dividends

05/17/2012 10:30 am EST


Josh Peters

Editor, Morningstar DividendInvestor

Stocks with steadily rising payouts are a much better bet than low-yielding bonds, says Josh Peters, editor of Morningstar DividendInvestor.

Josh, how should investors be balancing growth and income in a portfolio?

Well, I think what you have to do in my area of the market, dividend-paying stocks, is remember that you want both. Every time, you want both.

Especially when people are new to dividends, they'll see some stocks that are quoted with yields of 10% or 12% and in some cases 20%. You don't want those.

Those are situations where the market is signaling and jumping up and down and screaming that the dividend is not safe. And there's no point in buying a stock whose dividend is going to get cut. You're not going to get the income and you're probably going to lose money.

At the other end of the spectrum, you can find lots of companies-even big, prominent ones like IBM (IBM)-where the yields are so tiny that even if there's a lot of growth, it's not going to generate a whole lot of income for you. There's not that balance.

What I like to find are stocks that yield 3%, 4%, 5%, 6%, but are also growing their dividends at least as fast as inflation, hopefully, 5%, 6%, 7% a year for a portfolio as a whole. That's what I manage to do for the model portfolios I manage in DividendInvestor and it's actually worked out extremely well for us. We've gotten to beat the market without even trying, and the difference is the incremental income that we're getting.

Now, does that also apply to, say, some of these master limited partnerships or trusts that have some of these outsized dividends?

Well, you have to look at it on a case-by-case basis with the master limited partnerships. Most of them are pipeline operators. They're just toll takers, and the fees that they charge shippers are very stable. And they throw off a huge amount of stable cash flow. They can pay out a lot to investors.

In the cases of some other MLPs that are in exploration and production, or royalty trusts that are just receiving royalty payments from production, now those you may not see so much stability. I think that those can play a role in somebody's portfolio, but they're more speculative. They'll throw off income, but that income is going to go up and down with energy prices. You may not get the check you're hoping for when you need it.

Great to know. Now let me ask you about balancing equity income and fixed income in a portfolio. How should people do that?

Honestly, I think long-term bonds right now are an extremely tough case to make, that you would really want to have any significant exposure there. Start looking at a ten-year Treasury bond paying less than 2%. What are the odds inflation is going to be less than 2% over the next ten years?

With all of the moneyprinting going on everywhere in the world, I mean, that's very, very low. I'm not looking for hyperinflation, but chances are there is no real return on that bond at all.

So, what I look at in equity income is you have the opportunity to pick up higher yields right now-3%, 4%, 5%-with good reliability and good safety metrics around the dividend, as well as the growth that can drive a good long-term total return. I think that's really the best place to have the workhouse of your portfolio, is in that area.

Use fixed income on the very short end, you know, for your safety blanket, for your emergency funds. But when it comes to actually generating the income that you're going to want to live on, I think you really have to look at dividend-paying stocks to do the bulk of that right now.

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