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

Oct 10, 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
On the Doorstep of Earnings Season -- The Week in Dividends, 2015-10-09

The S&P 500 gained 3.3% this week—the best one-week performance for the index thus far in 2015. With dividends included, the market's preeminent benchmark is close to breaking even for the year-to-date period. Equity bulls were encouraged by the rebound in commodity prices, but I wonder if stock buyers might be missing a key point. If the price of oil or other raw materials were rising because underlying demand improved, one could fairly regard that as a welcome sign of economic health. Unfortunately, it seems likely that the recent bounce is attributable to cutbacks in supply, which don't just signal economic weakness but help cause it: Reduced commodity output means lost jobs and smaller capital budgets. Commodity producers' profits may be a bit less bad as a result, but it's still a net drag on GDP, with effects spread across other sectors of the global economy.

Despite the bounce in stocks, I think a cautious stance remains in order, but that's not at all incompatible with our strategy. I try to maintain a cautious stance at all times while remaining fully invested. Since I can't hope to predict turns in the economy, I manage our Dividend Select portfolio on the premise that the next recession could begin soon--or, perhaps, that it's started already. That means (1) making a commitment to stay invested in our strategy for a very long period of time, enough for economic cycles to average out, and (2) buying and holding only those stocks that I can continue to own through the bottom of the next downturn and on the way back up. This in turn helps explain the economically defensive bias of our individual stock and sector exposures--not only do these companies fare better in downturns, but they're the ones that can and do provide the above-average dividend yields we seek. And to the extent we own some cyclicals, it's only because I'm confident that their dividends will be preserved during a recession and that their likely total returns offer adequate compensation for additional economic risk.

Company-specific news was thin this week. General Electric GE ranked as our biggest winner with a gain of 10.2%, at least part of which can be put down to the fact that a famed activist investor has taken a substantial stake in the stock. This news had no impact on our $30 fair value estimate: GE is awfully large to be shoved around by outsiders, and it seems this activist has no immediate plans to push for a significantly different strategic course. The stock is still buyable here, but I don't expect to buy more as the valuation discount has narrowed a lot. That said, I'd like to think this is an instance--one of hopefully many to come--of investors noticing the sweeping progress taking place inside the company.

In a routine, post-earnings review, our fair value estimate for Paychex PAYX got a $1 boost to $46 a share. The business remains one of my long-term favorites for its wide economic moat and generous dividend policy, but with the stock price finishing Friday just over $50, I regard it as a strong hold rather than a buy.

Speaking of earnings, the third-quarter reporting season shifts into high gear next week. Five of our holdings are slated to report: Johnson & Johnson JNJ and Fastenal FAST on Tuesday; Wells Fargo WFC on Wednesday; Philip Morris PM on Thursday; and General Electric on Friday. Out of this group, I'm particularly curious to see what Fastenal's results will say about the health of the industrial sector of the U.S. economy and what Philip Morris and GE can tell us about economic conditions in emerging markets.

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.

Morningstar Market Outlook Q3 2015, available free to DividendInvestor subscribers at this link: http://mdi.morningstar.com/PDFs/Mkt_Outlook_Q3_2015.pdf

News and Research for Dividend Select Portfolio Holdings

General Electric GE
Analyst Note 10/05/2015 | Barbara Noverini

On Monday morning, Nelson Peltz’s Trian Fund confirmed a $2.5 billion stake in General Electric, securing an ownership position of nearly 1%. While the move is consistent with our belief that GE is undervalued at these levels, we don't plan to alter our $30 fair value estimate or our wide moat rating based on this news. Earlier this year, at the Electrical Products Group industry conference, Peltz discussed the fund’s interest in owning industrial businesses with strong installed bases and a high percentage of recurring, highly profitable aftermarket revenue streams. In our view, GE’s global installed base of mission-critical equipment and robust service businesses fit that profile, and these are both factors that underpin our wide moat rating for the stock.

Peltz’s playbook often includes working with management to eliminate operating inefficiencies throughout the organization and sell underperforming business units. Although GE is already in the midst of a comprehensive portfolio-transformation strategy, with CEO Jeffrey Immelt scrutinizing selling, general, and administrative expenses and selling the majority of GE Capital assets, we believe there is still room for additional upside. With approvals for the Alstom acquisition granted, we expect that Trian Fund will attempt to influence the GE-Alstom integration, which will likely be complex due to its size and geographic reach. Furthermore, with nearly $100 billion of GE Capital asset sales announced in the year to date, we expect Trian will keep a watchful eye on capital allocation, as GE earmarks proceeds from these sales for use in future acquisitions.

Paychex PAYX
Investment Thesis 10/06/2015 | Brett Horn

While Paychex's core payroll business remains highly profitable, it has struggled a bit to find growth in recent years. Paychex is exposed to macroeconomic conditions, and its focus on serving small businesses magnifies the effect. A pullback was understandable during the recession, but payroll client growth has been fairly meager even as this headwind has abated. In our view, the company has reached a point of maturity in payroll processing that will limit payroll processing growth.

Fortunately, the company has other factors working in its favor. Its growth in recent years has come mainly through cross-selling ancillary services centered around human resources, employee retirement plans, and insurance. Further, we think the company's PEO services, a model that helps small businesses better negotiate employee benefit plans, is positioned to expand as health-care costs rise. We expect the company's growth to continue to shift in this direction, and believe that its small business focus is a benefit as the limited resources available to small businesses should make them more likely to look for bundled solutions like those offered by Paychex, as opposed to searching out best-of-breed applications. Paychex, with its broad product portfolio and dominant position in the small-business space, is best-positioned to exploit this trend. As such, we think the company can maintain healthy earnings growth even as the addition of new payroll clients begins to diminish.

Paychex should have another factor working in its favor in the coming years, although the timing is difficult to predict. Its payroll business generates float income, and the low interest rate environment has hampered profitability on this side. Although its float income is small in relation to total revenue, it drops almost completely to the bottom line, and we estimate that a 1-percentage-point increase in the yield on the portfolio would increase operating income by about 4%. For comparison, yields in the pre-crisis period were about 2 percentage points higher than current levels.

Paychex: Economic Moat 10/06/2015

Paychex has a wide economic moat due to high customer switching costs, and cost advantages due to scale within its small business niche. Paychex is the second-largest player within the payroll outsourcing market (based on revenue), and its scale has allowed the firm to leverage its 580,000 clients and spread out costs associated with its servicing infrastructure. Switching from one payroll processing vendor to another is a difficult task, and a customer's hesitancy to do so has allowed Paychex to build a sticky client base. Annual client retention rates are about 80%, with most attrition due to client failures. Paychex's retention rates are similar to those experienced by ADP in the small business space.

Paychex is dwarfed by its larger competitor, ADP, which generates about 5 times as much revenue in the payroll area, but we think Paychex's small client focus is a positive from a moat standpoint. More than 80% of its clients have fewer than 20 employees, which lowers their bargaining power, and Paychex holds a leading market position in the small-business segment (employers with fewer than 50 employees). The difference can clearly be seen in operating margins, with Paychex generating margins close to 40%, compared with a high-teens level for ADP. So although ADP has a scale advantage across the entire payroll processing market, we think Paychex has dug out a strong position in the most profitable area.

Paychex: Valuation 10/06/2015
We are increasing our fair value estimate to $46 from $45 per share primarily due to the time value of money since our last update. Our fair value estimate equates to a fiscal 2017 price/earnings multiple of 20.7 times and a fiscal 2017 EV/EBITDA of 11.3 times. Lackluster client growth impeded Paychex's growth following the financial crisis, but the situation has been improving modestly, and we expect this to continue. But we believe that growth in ancillary lines will continue to be the main engine in coming years. Further, an increase in interest rates should allow float income to bounce back over time. Adding these factors together, we project a 7% revenue CAGR over our projection period, with a 5% CAGR in the payroll segment and a 10% CAGR in ancillary services. We expect margins to improve over time, as a result of higher float income and some modest scale benefits, and project operating margins to improve from 39% in fiscal 2014 to 43% by the end of our projection period. Roughly half of this improvement comes from improved yields on the float portfolio. Although our projected margins are higher than the company's historical range, we would note that the company achieved significant margin improvement prior to the recession and the drop in interest rates, and we expect a bounceback as these headwinds recede. We use a cost of equity of 9%.

Paychex: Risk 10/06/2015

Paychex is exposed to macroeconomic conditions. Its results can take a hit during periods of high unemployment, and its concentration in the small-business market exposes it to increased client failures during recessions. The management of client funds could create problems if the company were to experience material impairments in its portfolio. The company handles sensitive information and its brand could be damaged if its systems were breached. Regulatory changes could also pressure margins and revenue.



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