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 07, 2015
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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
Solid Results from Paychex -- The Week in Dividends, 2015-07-02

The deepening crisis in Greece drove the S&P 500 to its biggest one-day loss in more than a year on Monday, though a rebound on Tuesday and Wednesday kept the index trapped in the range that has characterized the stock market for much of this year. Our portfolio has very little direct exposure to events in the comparatively tiny Greek economy, but unlike recent weeks, there were several noteworthy company-specific developments among our holdings.

On Tuesday, Emerson Electric EMR announced plans to divest businesses accounting for one-third of current revenues. The Network Power unit, which has been a significant drag on profitability, will be spun off to shareholders. Several other operations with weak performance will probably be sold. Those operations that remain--dominated by process control and industrial automation--enjoy what we think are the widest economic moats in the portfolio, so a leaner Emerson stands to generate higher returns on invested capital. The company also expects to maintain its dividend policy, which after 58 consecutive years of growth is also one of the more generous in the industrial sector. However, the transactions will probably act as a short-term drag on earnings growth (similar to the portfolio pruning at General Electric GE and Procter & Gamble PG). By freeing up a lot of capital, the plan also raises questions regarding how those funds will ultimately be deployed by a management team that hasn't been particularly effective at selecting acquisitions in the past.

Emerson is our second-smallest holding after the troubled GlaxoSmithKline GSK, and for the last few months I've been on the fence about whether to increase our stake to a more meaningful level or simply let the shares go. I think these plans are a net plus on balance, and the stock continues to trade at a fairly attractive discount to our fair value estimate. But the market's muted response to Emerson's effort matches my own, and I plan no immediate change to our stake. Improved growth in Emerson's existing markets would do a lot more for my level of enthusiasm than this round of financial engineering.

On Wednesday, core holding Paychex PAYX reported as-expected but still healthy results for fiscal 2015. Earnings per share rose 8% as revenues expanded 9% and operating income grew 7%. The company expects another solid performance in the fiscal year that ends in May 2016, including total revenue growth of 7%-8% and net income growth of 8%-9%. Modest share repurchases could add slightly to EPS growth, and while this outlook assumes that interest rates will merely hold flat at today's rock-bottom levels, the company should enjoy a nice boost to profits from higher rates down the road.

Positive leverage to interest rates, a rare attribute for a stock yielding well above the market average, helps explain why I consider Paychex a core holding. Its wide economic moat, resilient cash generation, and minimal internal reinvestment requirements are similarly attractive, and the firm's dividend policy is simply outstanding. On the conference call, management reaffirmed plans to grow the dividend in line with earnings, even though dividends already account for a far higher proportion of profits (82% in fiscal 2015) than most firms with similar growth rates. Though modestly overvalued at present, I'd consider adding to our stake should the price drop below our reaffirmed fair value estimate of $45 a share.

Also reporting on Wednesday was General Mills GIS, which eked out a 1.4% gain for operating earnings per share in its 2015 fiscal year. This came in a bit ahead of consensus estimates and, after a brief selloff, Wall Street appeared satisfied by what the company had to say about recent results and near-term prospects. I have no immediate plans to change our stake, and I still think that even the mid-single-digit underlying EPS growth General Mills plans to achieve in fiscal 2016 would be adequate as a long-term trajectory--at least in the context of the stock's yield in excess of 3%. But after waiting through several years of dwindling EPS growth, I'm beginning to wonder if my long-term dividend growth rate of 7% can be met in a world where Betty Crocker and the Green Giant increasingly seem like relics of the past. Fortunately, the firm's product lineup is broad enough to provide offsetting growth opportunities elsewhere.

Speaking of packaged foods, this is our last day as shareholders of Kraft Foods Group KRFT. With the merger of Kraft and H.J. Heinz closing today, we will own shares of the Kraft Heinz Company--ticker symbol KHC--when trading opens on Monday. As a result, our fair value estimate is presently under review. Among other things, we'll be adjusting for the $16.50 a share special dividend that current Kraft shareholders (including us) will receive as part of the deal--both the stock price and our fair value estimate will automatically drop by that amount. That said, Kraft is maintaining its current $0.55 a share quarterly dividend rate on the post-merger shares, which is tantamount to a significant dividend increase: All else being equal, the shares' current yield will rise from 2.5% to 3.1%.

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

Supreme Court Overturns MATS; No Impact to Coal or Utilities FVE, but CPP Looks Less Certain
Industry Note 06/29/2015 | Kristoffer Inton

On Monday, the Supreme Court ruled 5-4 on Michigan v. EPA, throwing out the environmental regulator's Mercury and Air Toxics Standards. MATS was intended to regulate mercury and other hazardous air pollutants from power plants, and most significantly had an impact on heavy-emitting coal plants. Finalized in 2012, utilities have already largely implemented the EPA rule, installing scrubbers on surviving plants and shutting down other plants where economics made implementation cost prohibitive. In addition, with low-cost natural gas continuing to drive the construction of new natural gas generation, we think the ruling is too far past to necessarily undo the impact of MATS. However, we do think the ruling signals a difficult road for the EPA's proposed Clean Power Plan, which intends to drive carbon emission reduction, with coal generation being a prime target. The court ruled the EPA failed to appropriately consider compliance costs when it interpreted the Clean Air Act to implement MATS.

With MATS largely and permanently implemented, we maintain our fair values and moat ratings across our coal coverage. Although we think the Supreme Court ruling will force the EPA to more carefully push future regulation and will make the industry more fervent in its claims of EPA overreach, we caution investors that regulatory risk still remains a key risk to coal stocks.

We also are reaffirming our fair value estimates and moat ratings for all utilities. We don't expect this to have a material impact on power producers' investment plans or near-term cash flow. If this ruling sets a precedent that invalidates the CPP, it would reduce the potential upside for nuclear and renewable energy producers such as Exelon and NextEra Energy. We don't include carbon regulations in any of our fair value estimates.

Emerson Electric
Analyst Note 06/30/2015 | Barbara Noverini

Trading at a 15% discount to our fair value estimate of $65, we believe that shares of wide-moat Emerson represent a compelling opportunity now that management confirmed the intent to strategically reposition its portfolio in support of higher-return businesses. On Tuesday morning, Emerson announced plans to spin off its $5 billion Network Power business, a tax-free distribution of new shares that is likely to occur in 2016. In addition, management continues to review exit options for a number of smaller business units, such as Motors and Drives and Power Generation, which have struggled to add value to the overall portfolio in an increasingly commodified competitive environment. Upon successful completion of this plan, Emerson expects the remaining company to generate approximately $16 billion in annual revenue and more than $3 billion in operating profit, and will operate under two main segments aligned by key end markets: Process & Industrial and Commercial & Residential.

We believe the move will ultimately create greater long-term value for shareholders, as the repositioning will allow Emerson to use capital, talent, and time much more efficiently. Moving away from a progressively challenging Network Power marketplace will allow Emerson's management team to continue building on the strengths of the company’s vast installed bases in Process Management and Climate Technologies, while reaping the brand recognition benefits afforded by products such as RIGID, ClosetMaid, and Insinkerator. Furthermore, this strategic shift provides more leeway for M&A, as excess capital will likely be deployed toward enhancing or expanding the footprint of the remaining portfolio, which we believe houses Emerson's moatiest businesses. We believe there is considerable opportunity for a stronger, more nimble opportunity to emerge, although transaction and corporate rationalization costs will undoubtedly weigh upon near-term earnings as Emerson executes this new plan.

General Mills GIS
Analyst Note 07/01/2015 | Erin Lash, CFA

Overall, narrow-moat General Mills' fiscal 2015 sales performance was tepid, with organic sales--adjusting for the extra week--essentially flat with a year ago. While center-of-the-store categories continue to be challenged as consumer shop the perimeter of the store, we think the firm is making progress in its efforts to tailor its offerings to meet consumer needs and tout its fare in front of consumers in an effort to support its brand intangible asset, as evidenced by the more robust sales posted in U.S. snacks (up 7%) and yogurt (up 5%). However, some areas of the portfolio, such as dessert mixes and frozen vegetables, are still struggling, and we contend that the firm has room to improve its innovation cycle to more adeptly respond to changing tastes and preferences or risk losing out to peers.

In fiscal 2015, adjusted gross margins slipped 70 basis points to 34.7%, while adjusted operating margins ticked down 30 basis points to 15.9%. Despite this, we've been encouraged that the firm is continuing its work to extract costs from its operations--savings that we expect will be realized over the next few years--to fund further brand investments. We still expect General Mills to expand operating margins to 18% over our 10-year explicit forecast while spending to support its brand equity.

We may modestly bump up our fair value estimate to account for recent results and additional cash generated since our last update. However, our long-term forecast, which calls for low-single-digit annual sales growth, mid-single-digit annual operating income growth, and high-single-digit adjusted earnings per share growth, remains in place. Although the shares generally trade in line with our fair value estimate, we would require only a modest margin of safety before recommending that investors build a position in the name.

In acknowledgement of the challenges facing the frozen vegetable business (which has been losing out as consumers maintain a penchant for fresh fare), the firm incurred a $260 million impairment charge on its Green Giant brand. Speculation has circulated of late that General Mills is looking to sell the struggling brand, which we estimate accounts for less than 6% of annual sales. While it is tough to say whether a deal will be inked, several consumer product firms (including Unilever, Procter & Gamble, Kraft, Mondelez, and Campbell Soup to varying degrees) have been taking more pronounced actions to focus resources on the highest-return opportunities, which we have tended to view favorably. Ultimately, we understand the potential motivation to offload the vegetable business, a category where share degradation persists, down 168 basis points to 15.8%, particularly as General Mills looks to free up resources to extend its reach in the organics space (similar to the Annie's deal penned in 2014).

General Mills' convenience and food-service segment (11% of sales and 17% of operating profit) garners little attention relative to its consumer sales. However, we think the segment's margin improvement realized over the past several years (more than 300 basis points of operating margin expansion to nearly 18% since 2012) as part of its efforts to improve its product mix (by eliminating unprofitable offerings) and focus on expanding its distribution (within quick-service restaurants, fast-casual, and convenience stores) is quite notable. It indicates the potential profit opportunities when the firm scrutinizes its product mix and focuses on its highest-return opportunities.

Kraft Foods Group KRFT
Analyst Note 07/02/2015 | Erin Lash, CFA

We're placing our fair value estimate for narrow-moat Kraft under review in advance of the close of the merger with Heinz, as we adjust the share count, incorporate the $16.50 per share special dividend to be paid to Kraft shareholders (which is being treated as part of the total consideration for the deal), and reassess our expectations for the combined organization. Kraft shareholders will own 49% of the combined firm, with Heinz's shareholders (3G Capital and Berkshire Hathaway) owning 51%.

Our initial take is that the deal stands to enhance Kraft's narrow moat, which is derived from the firm's solid brand intangible asset and economies of scale on its home turf. As a combined firm, Kraft-Heinz will leapfrog Coca-Cola to become the third-largest food and beverage firm in North America behind PepsiCo and Nestle and the fifth largest in the world, boasting more than $22 billion in sales in 2014 and $29 billion on a consolidated global basis. From our vantage point, its brand strength will be sound, with eight brands generating more than $1 billion in annual sales and another five garnering $500 million-$1 billion in sales each year.

We think the bigger opportunity lies in the cost efficiencies that can be gained. Management plans to cut $1.5 billion in costs from its operations, representing 10% of Kraft's annual cost of goods sold and operating expenses. We view this as achievable given the success Heinz has realized--its EBITDA margins soared to 26% at the end of fiscal 2014, up from 18% pre-deal in mid-2013. Unlike others in the market, though, we don't suspect that a merged Kraft-Heinz is merely interested in extracting costs from its operations, but think it will also maintain a bent toward investing behind its core brands and extending the distribution of Kraft's primarily North American brands over Heinz's global distribution network, which derives 60% of sales outside North America, including 25% in emerging and developing markets.

Paychex PAYX
Analyst Note 07/01/2015 | Brett Horn

Paychex's fiscal fourth-quarter results contained no significant surprises. Total service revenue was up 8% year over year, driven by a 4% increase in payroll services and a 16% increase in human resources services. Operating margins for the quarter increased modestly to 36.3% from 35.9% last year, as the positive impact of top-line growth was partially offset by increased compensation expense. Paychex's fiscal 2015 results and expectations for fiscal 2016 are in line with our expectations, and we will maintain our fair value estimate.

The human resources services business hit a milestone this year, surpassing $1 billion in revenue, and now accounts for almost 40% of service revenue, showcasing how material the positive trend in this area is to the overall business.  In our view, the opportunity to cross-sell human resource services into Paychex's payroll base effectively expands the wide moat around its traditional payroll business. While these ancillary services are not as moaty as the payroll business on a stand-alone basis, in our opinion, the trend is not dilutive to the company's moat due to the significant synergies inherent in providing a broader range of services. We expect these services to make up an increasing portion of revenue over time and allow for strong overall growth despite the maturity of the company's core payroll operations.

Interest income ticked up slightly year over year, suggesting pressure on yield has bottomed out, although interest income remains muted. While the timing of any improvement in interest rates is uncertain, we estimate that a 1-percentage-point increase in yield would increase Paychex's operating income 4%, providing significant leverage to any improvement in this area. For reference, yields in the precrisis period were about 2 percentage points higher than the current level.

Procter & Gamble PG
Analyst Note 07/01/2015 | Erin Lash, CFA

Procter & Gamble stands out as an attractive undervalued investment, in our view, trading at a price/fair value of 0.88 and a forward price/earnings multiple of 19 times. The firm’s pricing and brand power have been under pressure following a stream of lackluster innovation, but we think P&G’s reignited focus on winning with new products could be gaining some traction. However, we suspect the market fails to share our view the firm can return to posting mid-single-digit annual sales growth and maintain the percentage of sales spent on research and development (which stands at roughly 2.5% of sales and is in line with peers).

For instance, despite maintaining a solid portfolio of leading brands, P&G has operated as the number-two player in the U.S. diaper market for the past 20 years. However, as a result of new product launches and efforts to get in front of new moms early on with increased sampling in hospitals, Pampers (P&G’s largest brand with $10 billion in annual sales) has overtaken Huggies (a Kimberly-Clark brand) and now controls around 38% share of the U.S. diaper market, about 300 basis points above its leading competitor. We think this highlights the gains that can be realized when product innovation aligns with consumer trends. Further, P&G is working to shed about 100 brands, which equates to more than half of its existing brand portfolio, but in aggregate posted a 3% sales decline and a 16% profit reduction the past three years. We don't anticipate P&G will sacrifice its scale edge (maintaining around 90% of its sales base, or more than $70 billion in annual sales), but will be able to better focus its resources (both personnel and financial) on its highest-return opportunities, enhancing its brand intangible asset and cost advantage.

Our $90 fair value incorporates our expectations for 4% annual top-line growth--with a more balanced contribution from price and volume--and 23% operating margins by the end of our 10-year explicit forecast.

Globally, P&G's categories grow roughly 3% annually, so the firm would have to grow 1%-2% faster than the markets and categories in which it competes, which we view as achievable, particularly in light of recent strategic efforts. Further, we contend that the firm possesses growth opportunities for its brands in many overseas markets, as it works to tailor its mix to meet the preferences of local consumers. We're also encouraged P&G is realizing some margin improvement from its ambitious initiative to shave $10 billion from its cost structure (while investing behind its core brands) and think more improvement is likely in the cards. Beyond reinvesting in the business, we expect dividends will remain a priority of cash (as the firm has paid a dividend to its shareholders consistently for more than 120 years), and we forecast mid- to high-single-digit dividend increases over the next 10 years.


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