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 of DividendInvestor's model dividend portfolios, the Dividend Harvest and the Dividend Builder. 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

The goal of the Builder Portfolio is to earn annual returns of 11% - 13% 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:

2% - 4% current yield
8% - 10% annual income growth

The goal of the Harvest 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:

6% - 8% current yield
2% - 4% annual income growth

 
About Josh Joshs Photo
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, and manager of DividendInvestor's model dividend portfolios, the Dividend Harvest and the Dividend Builder.
Featured Posts
Markets Gyrate as Earnings Roll In -- The Week in Dividends, 2014-10-17

The S&P 500 dropped another 1% this week, but not before gyrating wildly in both directions, often within a single day. At the low on Wednesday, the S&P came tantalizingly close to a full 10% drop from its intraday high of Sept. 19. Stocks then rebounded as the market's attention finally seemed to shift toward corporate profits and--quite improbably, in my view--the possibility of renewed monetary stimulus by the Federal Reserve. (I think short-term traders had best be careful what they wish for in this regard. If the Fed comes to the rescue, it might be because underlying economic conditions are worse than we'd rather think.)

As far as I can tell, recent market behavior tells us less about what's going on in the economic world at large than about how a relative handful of investors seem to have been operating behind the scenes. Until the past few weeks, stocks had been rising in a nearly straight line since late 2012. For certain players--including a lot of hedge funds--this was read as a signal to increase their risk profiles, particularly through leverage. But the nature of a leveraged investment is that while it will magnify your gains, it will magnify your losses as well--and there's only so much loss a lender will tolerate before calling in the chips.

This makes the wild volatility of late in midstream master limited partnerships a lot less mysterious. Not everyone owns them to collect a large and rising stream of cash distribution over a series of many years, as we and I suspect most MLP investors do. Some look at their hefty yields, spot an opportunity to borrow money at a lower rate, and pocket the spread. That's the kind of trade that works fine as long as MLP prices never go down, but when prices start to fall, the margin calls roll in. Furthermore, since the natural buyers of MLPs are long-term investors who probably aren't staring at their Bloomberg terminals all day, big sell orders in this group are often met with large price declines. (Just as in retailing, that's how you move the merchandise in a hurry.) The net effect of this phenomenon thus far on the Harvest has been close to nil--Magellan Midstream MMP and AmeriGas APU are down less than the S&P in the last two weeks and Spectra Energy Partners SEP is actually up since its close on Oct. 3--but woe to leveraged, short-term traders in this area!

At the same time, taking advantage of the chaos in MLPs, or elsewhere in the market, would not have been easy either. If you weren't paying attention on a minute-by-minute basis, you may have missed the big lurches. Others might have grabbed one of the early bottoms only to suffer losses (even if only temporary ones) at still lower levels later on.

So this was a good week to follow the old adage: Don't just do something, stand there! Or, as I put it to a good friend of mine this week, it's not necessarily a bad thing to be caught like a deer in the headlights--just as long as you're not standing on the road! Recent swings feel that much more frightening because we've gone a long while without much volatility, but as far as great buying opportunities go, these bumps in the road don't come anywhere close. The only trade I've made lately was Monday's add-on buy of Spectra Energy Partners, and since I'd already been thinking about it for a while, I went ahead and pulled the trigger despite the recent volatility, not because of it.



This week we received our first four reports of third-quarter earnings season, none of which I regarded as particularly surprising, but the lack of surprises had a soothing quality in this turbulent period.

* On Tuesday, Johnson & Johnson JNJ beat consensus earnings expectations by a nickel and raised its full-year profit forecast. Yet the stock, which is usually a rock of stability in volatile markets, saw larger-than-usual fluctuations and ended the week with a loss of 2.5%. Recently launched hepatitis C treatment Olysio has been a strong contributor to earnings growth this year, but it is already running into tough competition in a suddenly crowded therapeutic space. Combined with unimpressive results in the device and consumer products units, there's a sense that the company's overall growth might have hit a short-term peak. Even so, I still like the stock for the long haul: Broad diversification and disciplined capital allocation should continue serving shareholders quite well. With our fair value estimate holding steady at $99 a share, Johnson & Johnson ended the week in buy territory--if only by a hair--for the first time since April.

* Wells Fargo WFC also reported results on Tuesday, though for a second quarter in a row it merely met Wall Street's expectations rather than beating them. The bank is doing a good job growing its loan portfolio and especially its deposit base, but without higher short-term interest rates it's been difficult for Wells to generate the kind of revenue and earnings growth that we hope to see over the long run. Our fair value estimate held steady at $50 a share. While expectations for the timing of interest rate increases are being pushed back, I still think Wells makes a solid long-run holding. I'd call it a marginal buy at Friday's closing price, and if it trades low enough to provide a 3% yield--as it did briefly in Wednesday's panicky trading--I would consider adding to the Builder's stake.

* The key investment considerations right now for Philip Morris PM, which released its quarterly report on Thursday, are currency trends and the threat of plain cigarette packaging. The first masked decent operational performance: Excluding currency effects, Philip Morris is on track for roughly 7% growth in operating earnings per share as volumes stabilize, prices rise, and costs remain under control. But with the decline in foreign currencies relative to the dollar, operating EPS including currency effects will likely drop 6%-7% this year. This is a slightly larger decline than the company expected three months ago, and with the dividend increase announced in September, we're looking at a payout ratio this year in the 76%-77% area compared to a long-term target of 65%. But while an elevated payout ratio may take a toll on dividend growth in the next few years--at least unless the dollar retreats relative to most other currencies--I do not believe the dividend itself is in danger.

As for plain packs, this novel policy has taken a steep toll on profitability in Australia and is one of the very few developments we can think of that could seriously erode the company's wide moat. However, it's not at all clear that plain packs actually discourage smoking; instead, it may simply lead to consumer trade-downs that hurt industry profitability and, if anything, make smoking more affordable in the aggregate. In addition, the industry's trademarks represent valuable intellectual property that--at least in most countries--can't be taken away on a whim or without legal recourse. I'm comfortable with the risk at present, though we plan to keep a close eye on various proposals around the world. Our fair value estimate remains $90 a share, and with a current yield of 4.7%, Philip Morris remains one of my top buy recommendations.

* General Electric GE provided both its own shareholders and the market with some welcome relief on Friday. The company reported consensus-beating earnings per share, a rise in profit margins, a big jump in new orders, and a relatively optimistic appraisal of the U.S. economy. The stock, which has been beaten down in recent weeks on widespread fears for the global economy, gained 2.3% on the week thanks to the market response to Friday's release. The company doesn't necessarily face an easy road ahead: As a global business, it faces a variety of macroeconomic headwinds, not least for a large unit that provides equipment and services to the oil and gas industry. But as with Philip Morris, I think GE is doing a good job executing on the choices that are within its control--particularly in its shift of capital and earnings power away from financial services and into wider-moat infrastructure businesses. Friday's closing discount of 14% from our reaffirmed fair value estimate of $29, plus a current yield of 3.5%, are easily enough for me to continue calling the stock a buy.

Aside from earnings, there was no news of note except for a $3 drop in our fair value estimate for GlaxoSmithKline GSK; we now think the American Depository Receipts are worth $48 apiece. Most of the change relates to the drop in the British pound versus the U.S. dollar since our last update; a slight downgrade in our expectations for top-selling product Advair accounted for a decline of less than 1% in our valuation of Glaxo's London-listed ordinary shares.

Glaxo is also scheduled to report third-quarter results on Wednesday. This is traditionally the time of the year that the company has raised its quarterly dividend rate, but with falling earnings Glaxo's prospective payout ratio has pushed past the 80% mark. This may be the most critical report of the season for any of our holdings. Naturally I'm very interested to see if they'll maintain at least some growth or hold the dividend flat, but it's also important for management to lay out a clearer plan for restoring profitability and growth. Despite a modest amount of fear regarding risks to the dividend over the next few years, I haven't been inclined to sell, and indeed I think Glaxo is cheap at this price. However, unless results show a sustained turnaround over the next few quarters, I doubt I will consider pushing the Harvest's exposure beyond its current 3.2% weighting.

In addition to Glaxo, eight other DividendInvestor portfolio holdings are scheduled to report next week: Coca-Cola KO and McDonald's MCD on Tuesday; AT&T T on Wednesday; American Electric Power AEP, Rogers Communications RCI and Unilever UL on Thursday; and Procter & Gamble PG and United Parcel Service UPS on Friday.

Best regards,    

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

Disclosure: I own the following stocks in my personal portfolio: AEP, APU, CLX, CVX, EMR, GE, GIS, GSK, HCN, JNJ, KO, KRFT, MCD, MMP, NGG, O, PAYX, PEG, PG, PM, RCI, RDS.B, SE, SEP, SO, UL, UPS, WFC, XEL.



News and Research for Builder and Harvest Portfolio Holdings

General Electric GE
Analyst Note 10/17/2014 | Barbara Noverini

General Electric's third-quarter results reflected progress in the company's efforts to streamline costs and reposition its portfolio in support of core industrial businesses. The industrial segment exhibited 4% year-over-year organic growth, contributing nearly $26 billion in revenue in the quarter. While this represented a sequential decline in organic sales growth, emerging-market distributed power project delays were largely to blame. Nevertheless, assuming fourth-quarter power and water shipments remain robust, GE should still meet its 4%-7% organic growth guidance for 2014.

Operating margins expanded 90 basis points year over year to 16.3% in the quarter, as ongoing corporate cost reductions largely offset the negative impact from weakness in the power and water segment. This year's initiatives to simplify the selling, general, and administrative cost structure have generated nearly 160 basis points of margin improvement, with GE on track to deliver nearly $1 billion savings by the end of 2014. In addition, service margin improvement of nearly 170 basis points year to date supports GE's rationale to invest in analytics, which we believe can drive long-term profitability as service capabilities expand. The quarter's results support our belief that GE's efforts to strengthen its core business are working, and we reiterate our $29 fair value estimate.

With GE's wide moat resting squarely in its industrial business, we're pleased to see that recently announced transactions support the firm's long-term goal of increasing its industrial earnings contribution. In our view, divesting appliances reduces GE's exposure to a notoriously cyclical, consumer-driven business segment. Furthermore, while supporting the growth of a GE Capital business unit appears counterproductive, the Milestone Aviation acquisition increases GECAS exposure to GE-powered helicopters, creating additional synergies between GE Capital's existing aircraft leasing arm and the aviation segment.

General Electric: Analyst Note 10/13/2014
GE Capital Aviation Services announced on Oct. 13 its intention to acquire Dublin-based Milestone Aviation Group for $1.8 billion. Milestone brings 168 helicopters to GECAS' aircraft portfolio, which historically focused on leasing commercial jets. In our opinion, the move is consistent with General Electric’s ongoing efforts to dispose of noncore financing assets and concentrate on its industrial businesses. We believe that adding helicopters to the fleet increases the industrial relevance of the company’s legacy aircraft business, allowing GE to further penetrate sectors such as emergency services, mining, and fast-growing oil and gas. With our view that the acquisition largely complements GE’s competitive advantages, we reiterate the firm’s wide moat rating and don’t expect a material impact to our fair value estimate of $29 per share based on this news.

GlaxoSmithKline ADR GSK
Valuation 10/16/2014 | Damien Conover, CFA
 
We are reducing our fair value estimate to $48 from $51 per share largely due to the change in currency rates with the dollar strengthening. As a reminder, the fair value estimate for this share class is derived using a model in the firm's reporting currency, and applying the applicable exchange rate for the share. Any differences between the fair value estimate shown in the valuation section and the fair value displayed elsewhere in this report is a function of a more recent exchange rate.

On a more fundamental note, pricing pressure and increased competition in the respiratory area led us to reduce our forecasts for Advair recently. The reduced sales outlook has an amplified impact on earnings given Advair's high margins. Following the completion of the restructuring with Novartis (2015), we forecast average annual sales growth of 2% during the next decade, with new products offsetting patent losses. Further, growth in emerging markets should mitigate the patent losses in developed markets, as brand names are more important in emerging markets and give products a much longer life cycle. Also, steady growth from vaccines and consumer health-care products should reduce the volatility from patent losses in the prescription drug business. We expect steady operating margins over that period as cost-cutting efforts help to offset expansion into lower-margin geographies and lost sales from the high-margin drug Advair. For the discount rate, we estimate Glaxo's weighted average cost of capital at 8%, in line with the company's peer group.

Johnson & Johnson JNJ
Analyst Note 10/14/2014 | Damien Conover, CFA  

Led by strength in the drug unit, Johnson & Johnson posted solid third-quarter results, slightly exceeding our expectations and those of consensus. While both the device and consumer segments continue to generate tepid growth, new drug launches are buoying overall results, leading to 6% overall top-line growth and a faster 10% earnings growth rate as the drug division carries stronger margins.

However, we don't expect any changes to our $99 fair value estimate or wide moat rating. Part of the outperformance was attributable to strong sales of hepatitis C drug Olysio (4% of the quarter's sales), which will likely decline significantly in late 2014, since Gilead's Harvoni was recently approved in the U.S. and carries a best-in-class profile. Nevertheless, J&J has several other recently launched drugs that should support solid drug division growth in 2015, albeit decelerating growth. Potential risks to growth in 2015 are sales declines for Risperdal Consta and Invega Sustenna because of generic competition, but we don't project generics until 2016 and 2018, respectively, because of the complexity in manufacturing the drugs.

The brand power in the consumer business and power of switching costs in the device segment showed signs of weakness in the quarter. While product divestitures and manufacturing issues make comparisons more complex, we believe the flat growth in these divisions in the first nine months of the year is signaling a minor deterioration in the competitive positioning of J&J. This is more acute within the hip business, where prices fell 5% in the quarter.

J&J's strong drug sales boosted overall margins. While the company reinvested some of the gains, a good portion fell to the bottom line as shown by operating costs as a percentage of sales falling 180 basis points year over year. We expect margins to fall slightly in 2015 as the drug division's sales growth decelerates and the high-margin U.S. sales from Olysio decline rapidly.

Philip Morris International PM
Analyst Note 10/16/2014 | Philip Gorham, CFA, FRM

Philip Morris International, our pick in the global tobacco space--on both valuation and business quality--reported strong third-quarter results that beat consensus estimates on both the top and the bottom lines for the second consecutive quarter.

Although unfavorable foreign exchange movements remain a near-term headwind, we think this was a good quarter for Philip Morris and one which supports our long-term thesis that the firm has the strongest competitive positioning in the global tobacco industry.  Management has tightened full-year guidance slightly, and as we were at the high end of previous guidance, we may lower our 2014 EPS estimate very modestly. This is unlikely to affect our $90 fair value estimate, which is based on the discounted future cash flows of the business. We are reiterating our wide economic moat rating in light of a decent underlying performance in which currency-adjusted profitability improved despite a drop in volumes.

In our second-quarter earnings note, we suggested that an improvement in Europe and Asia would be catalysts for Philip Morris' stock. In the third quarter, there were signs of both beginning to occur, but the challenges in these segments are ongoing. In the EU, volume grew by 0.5%, despite an industry volume decline of around 4.0%. Some favorable trade inventory movements provided a temporary boost to volumes, but Philip Morris took share in several key markets across the EU. However, conditions remain quite fragile and currency-neutral revenue growth 0.5% was sequentially lower than the first half of the year as European smokers continued to trade down. Most of Philip Morris' volume gains came from Chesterfield, a brand positioned at the lower end of the price spectrum. Although industry volumes appear to have stabilized to a level we believe is a reasonable assumption for long-term declines, we would prefer to see a more balanced profile of price increases and trading up before becoming more optimistic on Europe.

In Asia, the news was a little better. In the Philippines, where Philip Morris' dominant market share position has been modestly eroded for several quarters as a result of some predatory pricing strategies by a local competitor, market share grew by 1.3 percentage points. Indonesia, the world's fourth-largest cigarette market by volume, continued its recovery. Industry volumes grew by almost 5.0%, but Philip Morris again lost share due to the shift from hand-rolled to machine-made kretek products. We expect the sequential market share performance in the third quarter (Philip Morris' share fell by 0.9%) to continue, particularly as the firm will cycle the elimination of some low-priced products in that market next year.

With the exception of Indonesia, we regard Philip Morris' operational problems--namely a strong U.S. dollar, macroeconomic weakness in parts of Europe, and the share loss in the Philippines--as mostly temporary in nature. We still regard the firm as the best-positioned business in the global tobacco industry, as we believe it possesses a wide economic moat through a cost advantage over local manufacturers and strong brand loyalty to Marlboro in developed markets. With the stock trading at around a 10% discount to our fair value estimate, we suggest that investors who can accept the risk of standardized packaging and exposure to volatile currencies should take a close look at Philip Morris.

Wells Fargo & Company WFC
Analyst Note 10/14/2014 | Jim Sinegal

Interest rates continued to weigh on Wells Fargo's results in the third quarter, even as net interest income rose to $10.9 billion from $10.8 billion thanks to higher deposit and loan balances. Low-cost core deposits--the key source of Wells Fargo's narrow moat--grew at an 8% annualized rate during the quarter, an indication that the company's competitive advantage continues to grow. Yields continue to pressure results, though, and net interest margin was 3.06% during the quarter, down from 3.39% in the third quarter of 2013 and 4.79% five years ago. We're still reluctant to incorporate a rebound of similar magnitude, as the timing and extent of rate increases are difficult to predict. Our current valuation forecast incorporates net interest income growth averaging 5% annually over our five-year forecast period, stemming from both loan growth and an increase in net interest margin. However, current futures data from CME Group implies a 43% probability that the target fed funds rate will not exceed 0.25% by September 2015, supporting our cautious outlook. We don't expect to alter our $50 fair value estimate.

While Wells Fargo is poised to benefit from rising interest rates in years to come, part of this benefit is likely to be offset by rising credit losses. The bank charged off only 0.32% of loans in the third quarter, well below our long-term forecast of 0.55%. We note that the bank experienced recoveries in both its commercial real estate and construction lines of business and charged off less than 3% of credit card loans, results we believe are not sustainable.

Finally, management confirmed that an increasing regulatory burden is likely to continue weighing on costs. Salaries and incentive compensation both reached their highest levels in five quarters--offset by declining employee benefits--and litigation accruals and outside professional costs again ticked up, consistent with our thesis and forecasts.

 

 
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