How to Find the Best Dividend Stocks

02/04/2013 10:15 am EST


Josh Peters

Editor, Morningstar DividendInvestor

Learn where to find the best dividend-paying stocks from Morningstar's director of equity-income strategy, Josh Peters.

Where are the best dividend values today? We’re here with Josh Peters, who is going to tell us.

Yeah, there’s an awful lot of interest in dividend-paying stocks right now, in part because people are still nervous about the economy. It doesn’t really seem to be growing.

There’s still a lot of risk out there—whether it’s Europe, the US fiscal cliff, you name it. Interest rates are so low people don’t want to stick with bonds. They can’t get a decent inflation hedge or any kind of real return there, even though bonds are still very popular.

Dividend-paying stocks really offer you the best of both worlds. You can get income that in a lot of cases is better than what you can get on high-grade bonds, and you’re also getting that hedge against inflation. Your income can grow as fast or faster than inflation over time with some of your better dividend-paying stocks.

It seems that back before in the era, people were always talking about growth as the new income. Now you have income as the new growth to a certain extent, because you have a lot of stocks, especially in the tech sector now, that have gone from these traditional roles as growth companies into more fiscally responsible dividend-paying stocks like Microsoft (MSFT).

Yep, they’ve had to mature, they’ve had to grow up. Some of these companies I think of as being kind of overgrown teenagers where maybe they’ve bulked their businesses up into their final form, but maybe the emotional maturity isn’t quite there yet.

You know, you look at a company like General Mills (GIS) paying dividends for 114 years. You don’t have to wonder what their corporate priorities really are. They’re there to pay that dividend, keep raising that dividend. A lot of the tech sector companies, you wonder whether they really get it yet, because even back in the 1990s dividends were still important.

Dividends have never lost their value because that’s how stocks pay their owners back and provide a real return. Historically they’ve been very important parts, accounting for the bulk of equity returns. They’re going to be that way in the future.

What you want to do is just follow the Baby Boom generation. Their priorities as they have moved through their chapters in American history explain what’s going on in the market. You know, the 80s and 90s, that was their peak earning and savings years. They wanted growth, capital appreciation, and capital accumulation.

Now they’re retiring. They want income. The stock market is going to respond to that. It’s going to be less about growth. There’s still going to be growth, but it’s going to be less about growth and more about income, and that’s how you want to position yourself.

Are there any income stocks that you like out there in particular at this point? I know this has been quite a trend, so some of them are overvalued, and some of them you just have yield hunters that are out there looking for the biggest yield, which isn’t the best way to go.

Yeah, you don’t want the highest yield. You look at some stocks, like specialty financials or mortgage REITs claim to have 15% yields. That’s a market telling you that either there’s a huge amount of risk that the dividend is going to be cut or it’s almost a foregone conclusion. You know, there’s no free lunch.

Then you get into safer dividend yields, let’s say those that are kind of in the 4%, 5%, 6% range. There’s some great companies like Altria Group (MO), Realty Income (O), and the Real Estate Investment Trust sector. Those stocks are looking a little expensive right now. I think you want to keep an eye on them, but wait for a pullback.

Where I’m finding the best value right now is with very solid companies that are paying 3% to 4% yields that are raising their dividend every year or almost every year, raising it at a good 7%, 8%, 9%, 10% type of long-term average rate. You’re not getting the fattest income yield upfront, but you’re going to get the best total return.

So you have sustainability. Do you have an example of one of those companies?

General Mills is one; it yields about 3.3%. I think that dividend continues to grow 7%, 8%, 9% a year going many years in the future.

When you think about that rule of 72—If it grows 8% a year, in 9 years, the yield is doubled on your original investment. So that 3.3% becomes 6.6%. Bonds are not going to do that for you. Even a lot of these higher yielding stocks that might be 5%, 6% aren’t going to do that for you either. General Mills can drive that total return.

Chevron (CVX), similar type of math. You know, yielding in the low 3% range, but they’re investing a huge amount of the earnings of the company, which are really high right now because of where commodity prices are at. Back into growing production for many years in the future; that’s going to enable Chevron to keep raising that dividend year after year after year. You’ve got a lot of growth to compensate for a little bit lower yield than you might be able to get in some other areas of the market.

So those are two of my favorites right now. The areas I think where you want to be careful—REITs look pretty expensive, most fully regulated utilities look a little expensive. You have to be a little bit creative and think in terms of where am I going to be five years out. Am I going to look back and be happy with the total return and not just the income?

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