About the Editor
Equities strategist Josh Peters is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks.

Josh manages DividendInvestor's model dividend portfolio, the Dividend Select Portfolio. Josh joined Morningstar in 2000 as an automotive and industrial stock analyst. After leaving in 2003 to join UBS Investment Bank as an equity research associate, he returned to Morningstar in 2004 to develop DividendInvestor.

Peters holds a BA in economics and history from the University of Minnesota Duluth and is a CFA charterholder. He is also the author of a book, The Ultimate Dividend Playbook, which was released by John Wiley & Sons in January 2008.

 
Investment Strategy

Dividends are for everyone regardless of age. The outcome of owning dividend-yielding stocks is the key variable-higher-yielding stocks with safe payouts being less risky while affording investors who don't need current income the ability to reinvest/reallocate the capital.

The goal of the Dividend Select Portfolio is to earn annual returns of 9% - 11% over any three-to-five year rolling time horizon. We further seek to minimize risk, as defined by the probability of a permanent loss of capital. For our portfolio as a whole, this goal is composed of:

3% - 5% current yield
5% - 7% annual income growth

 
 
Jun 25, 2016
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Josh Peters, CFA
Equities Strategist and Editor
Equities strategist Josh Peters is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks.Josh manages DividendInvestor's model dividend portfolio, the Dividend Select Portfolio.
Featured Posts
Stunned is the Right Word -- The Week in Dividends, 2016-06-24

As an event being covered far and wide, there's not a whole lot that I can add about the politics, or even the economics, of Britain's stunning vote to leave the European Union. "Stunning" seems to be the word of choice on the matter, and though the polls were close, I have to admit that I am stunned too. Considering the outcome, it's fortunate that our portfolio has very little direct exposure to the United Kingdom. Indeed, as a matter of coincidence rather than design, we don't own any foreign-domiciled stocks at the moment. It was a lofty valuation, not foresight regarding "Brexit," that led me to sell National Grid NGG in November 2015.

Our portfolio's market value is holding up very well in today's selloff, but that doesn't mean we will feel no effect. The instant effects of Brexit are plunging interest rates and a soaring U.S. dollar, neither of which are welcome. Long-term rates that are again approaching all-time lows are giving a boost to stocks with the most reliable cash flow streams (Realty Income O, Altria Group MO, American Electric Power AEP and so on), but they were already overvalued. As for the dollar, I figure 66% of our portfolio's value is in businesses that operate predominantly or exclusively in the U.S.; this figure rises to 77% if we include our current cash balance. But the other 23% is lodged in stocks like Coca-Cola KO and Johnson & Johnson JNJ that earn a lot of their profits overseas, and the headwind posed by a strong dollar has already hurt their ability to grow dividends. More broadly, Brexit seems unlikely to trigger a genuine crisis on its own, but it definitely fits into a pattern of global instability and uncertainty that continues to weigh on economic growth as well as investment returns.

I think we can assume that the financial markets will remain volatile for a while, but it's too early to characterize what has happened thus far as a buying opportunity. At midday on Friday, the post-Brexit decline had merely reversed the gains made by the S&P 500 since late May, and the index was barely off 1% for the week. For that matter, with all that seems to be going wrong in the world, the U.S. market is still less than 4% away from a new record high. While I'll be pleased to take advantage of any stock-specific opportunities that present themselves, I suspect we're a long way from a "pound the table" situation for the market at large.

Looking ahead, two of our Dividend Select holdings with offbeat fiscal calendars are scheduled to report year-end results next week: General Mills GIS on Wednesday and Paychex PAYX on Thursday. I also expect that Wells Fargo WFC will follow yesterday's release of strong stress-test results with details on capital return plans for the year ahead.

Best regards,

Josh Peters, CFA
Director of Equity-Income Strategy
Editor, Morningstar DividendInvestor

Disclosure: I own all of the holdings of the Dividend Select portfolio in my personal accounts.


News and Research for Dividend Select Portfolio Holdings

The Brexit Vote Will Have Wide-Reaching Implications for European Financials
Analyst Note 06/24/2016 | Stephen Ellis

The Brexit vote will have wide-reaching implications for our European financials coverage universe. We plan to lower the fair value estimates for several U.K. banks such as Barclays, Royal Bank of Scotland, and Lloyds, and we will review others such as Banco Santander, which has U.K. exposure. We believe this raises the strong possibility that we may change our moat trend ratings for Lloyds, Royal Bank of Scotland, and Barclays to negative from stable. We do expect the U.K. system and the broader European Union to experience substantial uncertainty and volatility going forward, as the U.K. seeks to renegotiate trade agreements with other countries, unwind other legal agreements with the EU over the next several years, and deal with the political aftermath of Prime Minister David Cameron’s resignation. We also now see the strong possibility of Scotland seeking independence, causing further turmoil to the overall system, particularly the Edinburgh-based banks Lloyds and Royal Bank of Scotland, which may need to re-domicile. While the impact of Brexit is far reaching, we do see an undervalued opportunity with HSBC, primarily due to its relative lack of U.K. exposure and its pivot toward Asia.

There are several fairly immediate considerations for banks. We would expect to see higher funding costs for U.K. banks, sharply lower loan growth, as we expect anywhere between a 3%-6% impact to U.K. GDP, and a significant drop-off (potentially 40%-50%) in investment banking fees. Asset management and trading operations will be impacted by the stock, bond, and currency volatility, and we expect trading losses as well as lower asset management fees. Foreign banks, such as JPMorgan Chase, will likely incur millions of dollars in legal and personnel costs as they move employees to other countries from London to facilitate capital markets activity. Again, we see particular risks for Barclays and Royal Bank of Scotland, as these banks have large investment banking operations and are wholesale funded. We would expect to see lower scale and cross-firm synergies for banks in London and ultimately a negative impact on profitability.

Over the longer term, we also see largely negative impacts. We would expect a lower level of normalized GDP growth for the U.K., as it has been one of the strongest beneficiaries of GDP growth in the EU since it was formed. We also believe the reorganizations that will take place at many U.K. banks will lower the overall importance of London as a key financial center, making it harder for banks to compete for talent and the relationships that drive fee income and help retain deposits. There are also renewed concerns regarding several countries in the European Union such as Italy, France, and Spain, where citizens have expressed strong interest in holding in their own referendums and seeking to leave the European Union. Again, the impact for the banks we cover within those systems, such as UniCredit, Intesa Sanpaolo, and Societe Generale would likely result in higher costs and slower growth, which combined with weak capital levels would be quite concerning.

Once Again, Banks Breeze Through Federal Reserve's Annual Quantitative Stress Tests
Analyst Note 06/23/2016 | Dan Werner

Late on June 23, the Federal Reserve released the results from the supervisory stress tests conducted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The tests serve to inform regulators, financial markets, and the general public how institutions’ capital would withstand a hypothetical set of adverse economic conditions.  

This year, the stress test was similar to last year’s in that the Fed used two scenarios, adverse and severely adverse, with the latter characterized by a substantial global weakening in economic activity, including a severe U.S. recession, large reductions in asset prices, significant widening of corporate bond spreads, and a sharp increase in equity market volatility. In addition, the severely adverse scenario included negative yields for short-term U.S. Treasury securities.

All 33 of the banks subject to the stress test passed as all of the banks had common equity Tier 1 ratios above 5% under both the severely adverse and adverse stress-case scenarios. The results are no surprise to us, as they are generally in line with our own analyses.

Cumulatively, the stress tests under the severely adverse scenario projected loan losses of $385 billion over two years, with total losses of $526 billion when including trading and counterparty losses. On average, the aggregate common equity Tier 1 capital ratio would be 8.4%, improved from 8.3% a year ago. These solid results are not surprising given that banks have been adding capital, approximately $700 billion since 2009, to strengthen their balance sheets. Overall, we think the combination of rising capital levels and rising payout ratios across the banking industry means that the importance of the annual stress tests to investors will continue to decrease in importance over time.

The Fed noted in its press release that for all 33 banks as group, the cumulative loss rate for all accrual loan portfolios is 6.1% over a nine-quarter period, lower than the loss rate from the 2015 stress test. This reflects a “continuing a trend of declining loan loss rates under the severely adverse scenario over time, as borrower and loan characteristics have continued to improve,” the Fed said.

While three banks under our coverage, Zions Bancorp, KeyCorp, and Huntington Bancshares, were below the average post-stress capital levels, all three banks have no moat indicative of our view of the banks as lower-quality.

Next on the calendar for the Fed is the June 29 release of the results from the Comprehensive Capital Analysis and Review. The CCAR takes into account each company's capital plans, such as dividend payments, stock repurchases, or planned acquisitions, along with a qualitative assessment of the bank’s capital planning process. The Fed basically evaluates whether each bank would still pass the stress test even after planned capital releases. We think the capital return plans of the U.S. banks we cover will be accepted by the Fed, given these banks’ experience with the process.

We would not be surprised to see certain companies approved for dividend increases at that time. Given that all companies would maintain adequate capital buffers under a severely adverse scenario, we think firms with exceptionally low payout ratios like Bank of America and Citigroup could easily boost payout assuming their qualitative processes have improved. We note that Citigroup would maintain a 9.2% common equity Tier 1 ratio even in a severely adverse scenario, supporting our thesis that the firm’s stability—and its relationship with regulators—are much improved over the last decade.

Uralkali and Belaruskali May Make Amends, Restoring Potash Cartel
Industry Note 06/23/2016 | Jeffrey Stafford, CFA

On June 23, potash producer stocks gained on news that Belarus and Russia may amend their broken relationship and work together to limit the amount of potash they produce. A prior cartellike marketing agreement between the two countries disintegrated in the summer of 2013, causing a steep fall in global potash prices and potash producer stocks.

We see this as a positive development for potash producers, but we're holding steady on our fair value estimates at this point. Even before talk of the two sides making amends, Uralkali (Russia) and Belaruskali (Belarus) have shown a tendency to pursue a price-over-volume strategy in certain instances. For example, Belaruskali, a company that many have worried will look to grab market share without regard to price, recently guided that it may export 18% less potash in 2016 compared with 2015. So, although a explicit remarriage of Russia and Belarus would represent a positive step for future pricing, we wouldn't view a new marketing agreement as representing a dramatic shift from current marketing strategies. As such, we would expect the effect on our long-term price outlook to be limited.

Further, we would be hard pressed to say that a new deal between the two countries would be likely to stick for the long term, given that we've already seen this relationship break down once before (complete with the Uralkali CEO being detained in Belarus). For now, our long-term potash price outlook remains $260 per tonne (real terms) on a delivered basis to China.

Duke Energy DUK
Valuation 06/21/2016 | Andrew Bischof, CFA

Our fair value estimate is $82 per share. Our estimate includes $2 per share of value dilution related to Duke's $60 per share cash offer for Piedmont Natural Gas. We assume a 100% probability that the deal closes and incorporate $0.50 per share of value from estimated synergies.

On a consolidated basis, we expect 5.5% long-term normalized earnings growth, as regulated earnings driven by rate base growth are partially offset by weakness at the company's international unit. Our 2016 earnings per share estimate is $4.54, in line with management's guidance.

We estimate Duke will invest about $42 billion through 2020 on a stand-alone basis primarily at its regulated utilities and continue to benefit from constructive regulatory rate increases to support its investment. This excludes incremental investment opportunities in 2017 and beyond if Duke closes its Piedmont acquisition in 2016. Based on this investment budget, we anticipate consolidated rate base could grow as much as 6% annually. We don't expect a material change in the companywide average allowed returns.

Our forecast of 1% average power demand growth for Duke's Carolina, Indiana, and Ohio subsidiaries and 1.5% for Florida from 2016 through 2020 should alleviate the need for near-term rate relief even with Duke's huge investment plan.

We discount our cash flows using a 5.9% weighted average cost of capital, which is based on a 7.5% cost of equity, 2.25% inflation, and a 4.5% normalized risk-free rate.

Philip Morris International PM
Valuation 06/20/2016 | Philip Gorham, CFA, FRM

We are nudging our fair value estimate for Philip Morris International a little higher, to $95 per share from $92 to account for the time value of money since our last update. As most of the firm's earnings are currently being paid out as dividends, the impact is very small, and this is reflected in the very limited magnitude of our valuation increase. Our valuation implies a 2016 P/E multiple of 22 times and a 2016 EV/EBITDA multiple of 15 times. It also implies a 2016 dividend yield of 4.5%, at the high end of international tobacco manufacturers.

Our fair value estimate is based on three key valuation drivers: volume, pricing, and margins. We have lowered our 2016 estimates slightly to account for the strengthening U.S. dollar and now expect revenue to fall by 1.5% and operating income by 1.6% this year. Our 2016 earnings per share forecast of $4.34 is at the high end of guidance. Beyond 2016, we project revenue growth in the mid-single-digits for the remainder of our explicit forecast period. Our revenue assumptions are driven primarily by pricing, as global volumes continue to decline. We assume a long-term gross margin of 65.5%. Revenue growth is being driven by pricing, not volume, so the procurement advantage of growing scale is limited. In the absence of acquisitions, and given that raw tobacco prices are fairly stable, we see little opportunity for Philip Morris to expand its gross margin on a sustained basis. However, we do believe there is an opportunity at the operating margin for greater profitability. We forecast Philip Morris' operating margin to grow by 320 basis points over the 2015 margin of 40.3% (to 10 basis points below its 2012 peak of 44.4%), mainly driven by cost leverage from pricing, but also because we believe there is some operational fat to trim. This is a key variable in our scenario analysis.

Despite higher costs of borrowing in the later years in our forecast period, we model an average of 7% EPS growth, driven by earnings growth with some support from share buybacks in the outer years.

United Parcel Service UPS
Investment Thesis 06/20/2016 | Keith Schoonmaker, CFA

UPS is the giant among global parcel shipment companies, and we consider its economic moat to be the widest among all freight transportation firms. The company crafted its moat by assembling an integrated international shipping network unlikely to be matched by any but a few global players. Despite its extensive unionization and asset intensity, UPS produces returns on invested capital about double its cost of capital and margins well above its competitors'; we credit the firm's leading package density and outstanding operational efficiency, enhanced by years of consistent and extensive technology investment. UPS has turned to health care markets and developing nations for growth, and we think the company has ample runway left to build speed. Even existing operations have revenue expansion potential via pricing power because UPS operates within a somewhat rational oligopoly in its largest market, U.S. high-service parcel delivery.

UPS normally earns higher margins than its peers, by its mix (FedEx has expanded ground operations, but still earns a majority of its revenue in its low-margin express segment) and by funneling substantially greater package volume through its efficient assets. In the U.S. parcel market, FedEx's express and ground units together handled about 11.0 million average parcels daily in fiscal 2015, but UPS moved on average 18.3 million daily in calendar 2015. Within this total, the disparity is even greater in U.S. ground, where UPS moved on average 13.0 million parcels per day and FedEx on the order of half of that: 6.9 million including SmartPost. Another aspect of UPS' margin advantage lies in its use of integrated assets to transport U.S. urgent and ground shipments through the same pickup and delivery network. In contrast, FedEx uses parallel networks of drivers and trucks to separately handle ground and express shipping. In addition to the greater efficiency of UPS' single system, clients appreciate the convenience of using the same driver to handle both express and ground packages. However, during periods of tremendous volume volatility, FedEx ground's variable cost model shows merit.

United Parcel Service: Economic Moat 06/20/2016
UPS earns its wide moat from efficient scale, cost advantage, and the network effect. Extensive express, ground, and freight networks demand a huge quantity of trucks, trailers, terminals, sorting equipment, drop boxes, IT systems, and skilled labor. Replicating these assets in the absence of ample package flow would be costly, and few entities would endure the financial losses during the necessary density-building phase. As evidenced by DHL's worthy effort, such a project would require at least a decade of effort. Even a global shipping powerhouse like DHL failed to displace UPS and FedEx on their massive home turf--these two competitors comprise the efficient scale in high-service U.S. domestic parcel delivery. In this high-fixed-cost business, the substantial parcel volume handled by the incumbents provides a cost advantage that makes competing at market prices difficult for low-volume entrants. Compared with FedEx, UPS produces superior margins via greater package volume, concentration on high-margin ground shipping, and use of a single network rather than parallel air and ground operations. The firm produces attractive ROICs averaging around 15% despite its intensely asset-intensive operations. The firm does have substantial asset-light operations in its freight forwarding and contract logistics operations, and the former boast network effects typical of this model--additional offices make the entire system more valuable to shippers. We believe with near certainty that the firm will outearn its cost of capital for the next 10 years, and consider excess normalized returns more likely than not two decades from now; we consider UPS' economic moat to be one of the widest in the transportation universe.

United Parcel Service: Valuation 06/20/2016
Our fair value estimate for UPS is $101 per share. We assume that the firm achieves long-run 13.2% consolidated margins as early as 2017, in line with the 13.1% reported margin in 2015. Our long-run margin estimates in three operating segments--14% in domestic package, 16% in international package, and 8% for supply chain and freight--drive consolidated margin projections. UPS' performance is tied to the health of the global economy, and we believe shipping volume will stay strong for several quarters at this point in the economic cycle, and in the long run we believe overall global parcel shipping market expansion and consistent price increases will enable UPS to increase its top line at about a 5% compound annual rate during the next five years. The firm expects to expand international package shipping faster than the broader market through internal growth and by adding assets, particularly within the health care vertical. UPS generated an impressive high-teens average return on invested capital during the past five years and produced strong free cash flow of 5%-10% of sales. The firm reinvests heavily (we model 4% of sales) and earns consistently high returns on its assets.

United Parcel Service: Risk 06/20/2016
Rapid changes in shipping demand during the recent recession demonstrate that the cone of uncertainty surrounding modeling estimates can widen quickly because of macroeconomic factors. UPS derives nearly a fourth of its total revenue from international sources, but it still relies heavily on the U.S. market. The UPS driver team is unionized, but UPS recently minimized the risk of service disruption by signing the current labor contract well before the expiration of the previous agreement.

 

 
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