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

Jul 27, 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
Magellan's 26th Hike in a Row -- The Week in Dividends, 2016-07-22

DividendInvestor focuses on the activities of portfolios of Morningstar, Inc. that are invested in accordance with the Dividend Select strategy. These portfolios are managed by Morningstar Investment Management LLC, a registered investment adviser, who manages other client portfolios using these strategies.

From the DividendInvestor news file this week:

* Magellan Midstream Partners MMP raised its quarterly cash distribution to $0.82 a unit, up 2.2% from the previous quarter and 10.8% from a year ago. This represents a 26th consecutive quarter of rising pay, and while the pace of growth has slowed, the current pattern of 1.75 cent sequential quarterly increases keeps the partnership on track to meet management's target of 10% distribution growth for 2016 and at least 8% for 2017.

* Beyond that, the week's news flow on Wall Street was dominated again by quarterly earnings reports. Four of our portfolio holdings released results: General Electric GE, Genuine Parts GPC, Johnson & Johnson JNJ, and Philip Morris International PM. Morningstar analyst notes for all four stocks are included below.

* Next week stands to be the busiest of the season for second-quarter earnings reports with 10 of our 25 holdings scheduled to announce results. Compass Minerals CMP and Verizon VZ are scheduled for Tuesday, followed by Altria MO, Coca-Cola KO and Southern SO on Wednesday; American Electric Power AEP, Enterprise Products EPD, and Realty Income O on Thursday; and United Parcel Service UPS and Ventas VTR on Friday.

Best regards,

Josh Peters, CFA
Senior Portfolio Manager, Morningstar Investment Management
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

Fastenal FAST
Valuation 07/20/2016 | Kwame Webb, CFA

We are lowering our fair value estimate to $41 from $42 per share, which represents 24 times and 22 times our 2016 and 2017 earnings per share projections, respectively. On an enterprise value/EBITDA basis, our fair value estimate represents 13.4 times and 12.0 times 2016 and 2017 EBITDA, respectively.

Under our base case, we believe Fastenal's revenue will grow at an 8% average annual rate over the next five years. Our growth estimate is based on a 1% net annual increase in stores and an 7% annual increase in same-store sales growth. Although at first glance this appears to be an aggressive growth figure, we highlight that between 2010 and 2012, same-store sales growth was 12%-17% before decelerating to 3% in 2013 and returning to a low-teens growth rate in early 2014. We expect a sales acceleration because Fastenal has continued to expand its store based salesforce. The business model is also increasing its large store count and emphasizing national accounts, which is increasing average order size and sales per store.

Higher sales growth should expand operating margins approximately 30-40 basis points per year during the next five years, relative to the last decade's median 60 basis points of annual operating margin expansion. We use a three-stage discounted cash flow model to value Fastenal's share price. In the next five years, we expect free cash flow to equityholders to grow at a 7% average annual rate to $1.89 per share.

General Electric GE
Analyst Note 07/22/2016 | Barbara Noverini

We’re maintaining our $30 fair value estimate and wide-moat rating for General Electric following second-quarter earnings that really held no surprises. The industrial behemoth continued to face a challenging global backdrop, particularly in resource-driven industries, which once again translated to steep declines in sales activity in GE’s Oil and Gas and Transportation segments. As such, GE's industrial segment revenues declined nearly 1% year-over-year on an organic basis, despite otherwise healthy sales in Power, Aviation, and Healthcare.

Despite sluggish organic revenue growth, industrial operating margins (excluding Alstom) managed to remain flat year over year at 14.2%, reflecting ongoing progress in GE's cost-cutting initiatives as well as some benefits from pricing outpacing inflation. These factors helped improve gross margins by 110 basis points since the prior period, which offset some of the negative impact of product mix in the quarter. As GE continues to work excess cost out of both its legacy industrial businesses, as well as within newly acquired Alstom, we expect stronger future operating leverage as volumes improve across the portfolio.

Although organic revenue growth has trended slightly negative through the first half of 2016, the healthy, but backhalf loaded backlog in Power and Aviation, combined with growing momentum in Healthcare, still makes it possible for GE to reach its 2%-4% organic industrial revenue growth target for 2016. That said, even if GE misses this target because of ongoing volatility in the global macroeconomic environment, we still believe that GE's balanced portfolio is positioned quite well for the long run. Ongoing Alstom integration, a growing digital business, and increasing focus on aftermarket services, in our view, continues to offer GE shareholders a long runway for high quality industrial earnings in a slow-growth industrial world.

Genuine Parts GPC
Analyst Note 07/19/2016 | Zain Akbari

We do not plan to make a material change to our $86 per share fair value estimate for narrow-moat Genuine Parts after languid second-quarter earnings. Revenue slid 1% and net income fell 2% in the quarter as demand softness continued in the industrial and electrical/electronic units (consistent with industry trends) and the automotive group posted a disappointing 0.7% sales decline. While the results will lead us to revise our short-term expectations modestly, our long-term outlook is intact, calling for 4% top-line and 9% EPS growth on average over the decade ahead.

The decline in second-quarter automotive revenue (down 1% excluding acquisitions and foreign exchange) leaves the unit behind our full-year 2016 sales projection through the first half (0.5% growth versus our 4% expectation). However, we expect a recovery as warm summer temperatures lead to part failures, offsetting the impact of a mild winter that has depressed results to date. We expect rejuvenated revenue growth to reinvigorate segment margin growth, which has been stagnant as flat sales have left operating leverage unchanged. Our forecast calls for 15 basis points of segment operating margin expansion in 2016, with a long-term 10% estimate versus 2015’s 9.1%.

While the firm’s performance lagged, we were encouraged to see continued progress in improving payables as a percentage of inventories, which ended the quarter slightly above 100% from 91% at the same point last year. Leading auto-parts retailers (as well as industrial distributors in select sectors) can achieve attractive financing terms from suppliers due to their scale and ability to move centralized stores of slow-moving items through a large distribution network. This constitutes a significant working capital advantage versus subscale peers, and we are encouraged that Genuine Parts has continued to progress toward leading pure-play automotive parts retailers such as O’Reilly (99% in fiscal 2015) and AutoZone (113% in fiscal 2015).

Johnson & Johnson
Analyst Note 07/19/2016 | Damien Conover, CFA

Driven largely by outperformance in its drug group, Johnson & Johnson reported second-quarter results exceeding both our and consensus expectations, and we plan to slightly raise our fair value estimate. Nevertheless, we continue to view the stock as slightly overvalued, with increasing concerns for generic or biosimilar competition for complex drugs Concerta, Invega Sustenna, Risperdal Consta, and Remicade, which collectively represent over $10 billion in annual sales. Despite these concerns, we remain confident in the company’s wide moat, driven by steady innovation in the drug and device group coupled with solid brand power in the consumer group.

While partly supported by reserve adjustments in the quarter, the drug group continues to lead the company, with 13% normalized growth supported by both mature and new drugs. However, we expect this growth to decelerate in 2017 as branded competition increases and generics launch on complex older drugs. On the branded side, new competing immunology drugs (Novartis’ Cosentyx, Eli Lilly’s Taltz, and Takeda’s Entyvio) are likely to take market share from Johnson & Johnson's largest drug segment of immunology drugs. Further, we expect biosimilar Remicade to cause close to 20% annual declines in J&J’s branded Remicade sales by 2018.

While older drugs face increased competition, new drugs are mitigating the pressures. In particular, recently launched cancer drugs Imbruvica and Darzalex are posting rapid growth supported by excellent clinical data. Further, we expect immunology drug guselkumab will help J&J maintain its leadership in immunology based on the drug’s superior efficacy profile to AbbVie’s Humira in psoriasis.

Further helping support the bottom line, cost-reduction programs in consumer and device divisions should lead to almost 500 basis points of margin expansion for the company. As the consumer group finally fixes its manufacturing issues, we expect strong leverage from this segment.

Johnson & Johnson: Valuation 07/19/2016
We are increasing our fair value estimate to $112 per share from $109 because of stronger margin expectations based on cost-cutting initiatives and the growth outlook for high-margin drugs. In particular, we hold high expectations for immunology drugs guselkumab and sirukumab, both of which carry strong margin profiles. After reviewing the clinical data generated by guselkumab in psoriasis, we believe the drug will post peak sales of more than $3 billion based on strong efficacy and a safe side effect profile. We continue to hold a strong outlook for diabetes drug Invokana, cardiovascular drug Xarelto, HIV treatment Endurant, and cancer drug Imbruvica. Overall, we expect annual earnings-per-share growth will average 4% during the next three years, as strong growth in new pipeline drugs should offset some patent losses in the pharmaceutical division. We expect operating margins to increase in the near term as a result of waning cost-remediation efforts in the consumer group and increasing cost-containment efforts throughout the firm. However, by 2018-19, we expect margin pressure due to the loss of patent protection on several high-margin drugs, including immunology drug Remicade.

Philip Morris International PM
Analyst Note 07/19/2016 | Philip Gorham, CFA, FRM

Philip Morris International missed our earnings forecast by a penny in the second quarter, representing the second consecutive narrow quarterly miss, but a deteriorating headwind from currency allowed management to raise its full-year guidance range by $0.05. The results give us increased confidence that the firm will meet our full-year EPS estimate of $4.47, which implies impressive currency-neutral earnings growth of over 10%. We are maintaining our $95 fair value estimate, and we believe the strong price/mix of over 6% achieved this quarter is evidence of the pricing power that underpins our wide economic moat rating. In our opinion, Philip Morris is a high-quality business that should deliver stable, if not spectacular, cash flows and earnings growth in the medium to long term. Nevertheless, we think the stock has become a little frothy, and we recommend that investors wait for a more attractive entry point.

PMI narrowly missed our second-quarter revenue forecasts on volume, particularly in the Eastern Europe, Middle East and Africa segment, where volume growth slipped almost 5 percentage points sequentially over the first quarter to negative 4.0%. PMI underperformed the industry in several key markets, including North Africa, where Marlboro 2.0 failed to gain traction. Globally, adjusted volumes fell 4.3%, a sequential deterioration and worse than our long-term forecast by around a percentage point. We remain confident that this decline rate will moderate, particularly because the 6% pricing taken year over year is unlikely to be sustained in the long term.

Following a steep margin decline in the first quarter, PMI again reported an 80-point contraction in its second-quarter EBIT margin, which fell to 41.4%. The firm is investing in both heat-not-burn and vapour platforms, and we expect margins to recover in the second half of the year as that spending eases slightly. In addition, we think organic growth is likely to reaccelerate to the high single digits as PMI cycles slightly softer reports from a year ago. For the full year, we still expect low-double-digit organic earnings per share growth, a faster growth rate than most of the companies in PMI's large-cap consumer staples peer group.

The incremental spending on iQOS is significant for the long term, not just the second half of the year, and this was demonstrated in the product's impressive second-quarter growth. The heat-not-burn product now has a 2.2% market share in Japan, while global shipments of heatsticks have soared to 1.2 billion. We expect Philip Morris to accelerate the rollout of iQOS in new geographies this year, which could provide a long-term boost to the top line. We think heat-not-burn is the category most likely to emerge as the long-term winner in the fragmented e-cig industry, so we view Philip Morris' investments as justified, although its success is likely to be dependent upon regulators' acknowledgement of reduced-risk benefits. At a time when e-cigs pose a risk to Big Tobacco's economic moats, heat-not-burn allows manufacturers to continue benefiting from procurement cost advantages and leverage the strong brand equity of their cigarette brands. For this reason, we believe Philip Morris may be one of the manufacturers most protected as smokers migrate to e-cigs.

©2016 Morningstar, Inc. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc. The information contained in this document is the proprietary material of Morningstar, Inc. Reproduction, transcription, or other use, by any means, in whole or in part, without the prior written consent of Morningstar, Inc., is prohibited. All data presented is based on the most recent information available to Morningstar, Inc. as of the release date and may or may not be an accurate reflection of current data.  There is no assurance that the data will remain the same.

The commentary, analysis, references to, and performance information contained within Morningstar® DividendInvestor(SM), except where explicitly noted, reflects that of portfolios owned by Morningstar, Inc. that are invested in accordance with the Dividend Select strategy managed by Morningstar Investment Management LLC, a registered investment adviser and subsidiary of Morningstar, Inc.  References to “Morningstar” refer to Morningstar, Inc.

Opinions expressed are as of the current date and are subject to change without notice. Morningstar, Inc. and Morningstar Investment Management LLC shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use.  This commentary is for informational purposes only and has not been tailored to suit any individual.

The information, data, analyses, and opinions presented herein do not constitute investment advice, are provided as of the date written, are provided solely for informational purposes and therefore are not an offer to buy or sell a security. Please note that references to specific securities or other investment options within this piece should not be considered an offer (as defined by the Securities and Exchange Act) to purchase or sell that specific investment.

This commentary contains certain forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.   

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All Morningstar Stock Analyst Notes were published by Morningstar, Inc. The Week in Dividends contains all Analyst Notes that relate to holdings in Morningstar, Inc.’s Dividend Select Portfolio.

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