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 29, 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
Midstream Meltdown Losing Touch with Fundamentals -- The Week in Dividends, 2015-07-24

Momentum is often a powerful force in the financial markets, and lately the market has been a momentum-driven parade. Never mind that the S&P 500 remains trapped in a very tight trading range for a sixth straight month; the inertia of the overall market belies the stark strength and weakness of various sectors.

In one of the market's more extreme examples, consider the drop in the midstream energy sector, which is starting to look like a meltdown. The Alerian MLP Index, a good benchmark for unit price action in the group, had fallen 5.3% in the first four days of this week alone before staging a small rebound on Friday morning. At Thursday's close, the index had a year-to-date loss of 20% and stood 32% below its all-time high of Aug. 29, 2014.

Some of this retreat strikes me as a rational response to a more difficult commodity price environment. A decline in drilling activity will at least hurt the growth of cash flow for certain operators--particularly those focused on the gathering and processing end of the midstream transportation chain. More recently, though, we find high-quality midstream names with defensive cash flow profiles and resilient growth prospects--like our holdings Magellan Midstream Partners MMP and Spectra Energy Partners SEP--falling just as fast as the index. In the past two weeks, AmeriGas Partners APU has joined in the plunge, which makes no sense from a fundamental perspective. AmeriGas is organized as an MLP for tax purposes, but a propane distributor is not much different than a natural gas utility--and lower propane costs will encourage rather than discourage growth in gross profits.

What makes sense out of this situation is a wholesale and increasingly indiscriminate exodus of investor dollars from MLPs. These securities tend to be less liquid than ordinary stocks due to their unusual tax circumstances and traditionally high ownership by long-term individual investors; worse, the institutional money in the group often uses leverage, which adds to returns when unit prices are rising but exacerbates losses as well. I can't know when the selling will stop, and I think conservative investors should stick to a small handful of well-established, financially secure entities. However, as prices fall, the opportunity for buyers is becoming more lucrative.
 
This brings me to my favorite news of the week: another distribution increase from Magellan, whose forthcoming disbursement of $0.74 a unit is up 3.1% from last quarter and 15.6% from a year ago. As recently as May 5, these units sold at $85 each, at which point we thought they were slightly undervalued (then, as now, our fair value estimate was $88) with a current yield of 3.4%. By Thursday's close, the unit price had fallen just over 20%, bringing Magellan's current yield up to 4.4%.

To put that in perspective, a mid-4% yield is about what you can get from run-of-the-mill regulated utilities with less than half of Magellan's long-term distribution growth potential, yet Magellan's business model and balance sheet are no riskier than utility peers. Most of cash flow is still earned from its refined products transportation system, which is utilitylike in terms of risk. Further investments in crude oil pipelines may slow along with drilling, but existing cash flows are largely protected by contracts, and Magellan hasn't overextended itself financially the way some midstream peers have. High excess distribution coverage, low leverage, and no general partner incentives continue to serve partners well.

My increasingly favorable view of the group is limited to just a few individual names. My insistence on adequate distribution/dividend coverage rules out the Williams (WMB, WPZ) and Oneok (OKE and OKS) entities as well as Kinder Morgan KMI. In addition to what we own, I'd only give Enterprise Products EPD the green light in terms of quality, though in a head-to-head matchup I continue to prefer SEP for its almost total lack of direct commodity-price exposure. But it may not be necessary to add new names at this point. Until very recently Magellan had been our top holding for years, though the falling price has shifted that honor to Philip Morris PM. It's been a long time since I considered adding to our position in Magellan, but I'm definitely thinking about it now.

Speaking of utilities, negative momentum is on display there as well, but the fundamental case for it is missing. Investors may be right to be concerned about the effect of rising interest rates if and when the Federal Reserve finally moves its short-term lending benchmark off the zero mark. We continue to think long-term investors are well protected against an eventual normalization in rates by current valuations, but even over the short term, are utility shares really more vulnerable to interest-rate fears than long-term bonds? Consider action in the group this week: The PHLX Utility Index dropped 2.6% through Thursday's close, more than doubling the 1.2% drop for the S&P--even though long-term interest rates were falling, not rising. The 10- and 30-year Treasury yields dropped 7 and 10 basis points, respectively.

Of course, there are still areas of the market performing well--technology, healthcare, financials, and consumer staples. Much to the detriment of our recent returns, only the staples sector offers much for investors who insist on hefty dividends. But the divergences between the leaders and the laggards are growing wider, and in particular I note how the economically-sensitive industrial and transportation sectors are making lows not seen since last October. Naturally, the S&P will eventually break out of its range, and I have no short-term forecasts to offer. But I can say that I'm very comfortable with our economically-defensive, income-rich stance whichever way the market goes. Moreover, it's not too soon to take advantage of what has already become a decent pullback for high-quality, high-yield stocks--whether the rest of the market as a whole finally gets its correction or not.

Analyst notes for the four portfolio holdings that reported quarterly results this week are included below. As was the case last week, the numbers and the outlooks are coming in largely within our expectations, and none of our fair value estimates have changed as a result. Looking ahead, next week stands to be the busiest of this earnings season for our roster. United Parcel Service UPS leads off on Tuesday, followed by Altria MO, GlaxoSmithKline GSK and Southern SO on Wednesday; Procter & Gamble PG and Realty Income O on Thursday; and Chevron CVX and Public Service Enterprise Group PEG on Friday. The only upcoming release that makes me nervous is Glaxo, whose dreadful financial performance in the past year has put its continued presence in our portfolio on very thin ice.

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

American Electric Power AEP
Analyst Note 07/23/2015 | Andrew Bischof, CFA

We are reaffirming our $59 per share fair value estimate, narrow economic moat, and stable moat trend ratings after AEP reported second-quarter operating earnings of $0.88 per share, compared with $0.80 in the same year-ago period. Management narrowed and slightly increased its 2015 earnings guidance range to $3.50-$3.65 from $3.40-$3.60, in line with our forecasts. Management reaffirmed the company's 4%-6% EPS growth rate.

Management continues to identify attractive regulated investment opportunities, increasing its 2015 capital investments $200 million to $4.6 billion. All newly identified capital investments are wide-moat transmission projects, which garner higher allowed return on equity and favorable regulatory treatment. Management plans to use approximately 70% of the company's $12.3 billion three-capital plan on distribution and transmission, moving the company more toward a fully regulated utility. We believe these investment opportunities, particularly capital investments in wide-moat transmission, and cost efficiency gains will support earnings growth offsetting capacity revenue headwinds.

AEP finalized constructive rate cases in West Virginia and Kentucky, which will help return on equity at the units, particularly Kentucky, which earns a meager 0.6% return on equity. At the company's vertically integrated utilities, rate changes at SWEPCo, APCo and I&M helped quarterly results. Management continues to exert impressive cost discipline across all subsidiaries

AEP Generation earnings decreased slightly compared to the same year ago quarter, with favorable hedges partially offsetting lower capacity revenue. Management continues to undergo a strategic review of the unit. Management continues wait for further market indicators, mainly PJM market design and Ohio PPA request outcomes, to determine the fate of the unit. We ultimately believe management will decide to divest the no-moat unit, along with non-core AEP River Operations.

Coca-Cola KO
Analyst Note 07/22/2015 | Adam Fleck, CFA

Wide-moat Coca-Cola's second-quarter results keep the company on track to meet our full-year expectations, and we don't plan major changes to our $43 fair value estimate. Although reported revenue declined from a year ago, currency headwinds drove the entirety of this fall; the firm enjoyed continued positive contributions from both volume and price/mix. End-market shipments increased 2% year over year, accelerating from the first quarter's 1%, while price/mix was a bit slower (at 1%, versus 3%) because of poor geographic mix, as the firm enjoyed faster volume growth in lower-priced countries. Year to date, Coke has generated 1% end-market volume growth and price gains of 2%, and is tracking toward our full-year target of similar volume growth and a slightly higher 3% price/mix contribution.

We're encouraged that both carbonated and noncarbonated beverages saw positive volume gains in the quarter, with still drinks in particular enjoying a solid 5% growth rate (on top of similar gains in the same period a year ago). Coke enjoyed the strongest growth in its Eurasia and Africa segment, where sparkling beverages climbed 4% and non-carbonated leaped 7%, while still drinks climbed 5% in both Latin America and Asia Pacific. We continue to believe developing and emerging regions offer the highest long-run growth potential given lower per-capita consumption rates and faster-growing economies, and expect Coke to capitalize on its already-strong share position and sizable distribution network in these markets.

Coke's profitability also improved in the quarter after excluding sharply negative currency effects, with adjusted operating margins (excluding productivity and impairment charges) climbing 6% compared with the firm's 4% organic sales growth. Although we expect foreign exchange headwinds to persist for the full year, management's guidance for currency-neutral earnings per share growth in the mid-single-digit range mirrors our forecast.

During the quarter, Coca-Cola also completed its announced purchase of a 16.7% equity stake in Monster Beverage, and the increased distribution in the U.S. netted Coke about a point of volume growth in the North American segment. We believe this deal was a major positive for Monster, but was also struck at positive price for Coke; when the deal was structured, Monster's shares were trading at about $71, versus $144 per share today (and our fair value estimate on Monster of $96). While the ownership stake isn't enough to materially move the needle for Coke (roughly worth about $5 billion versus Coca-Cola's market cap of $180 billion), we think minority deals such as this and Keurig Green Mountain (about a $2 billion holding) make sense, as they offer the company avenues for growth without needing to commit substantial capital or take on outsize regulatory risk.

Philip Morris International PM
Analyst Note 07/24/2015 | Philip Gorham, CFA, CRM

A Canadian Appeal Court has ruled that three tobacco companies will not have to pay a preliminary deposit of CAD 1.13 billion (USD 870 million) as part of the appeals process against a CAD 15 billion award against them. We are maintaining our GBX 3,750 and $116 fair value estimates for British American Tobacco's ordinary shares and ADRs, respectively, and $92 fair value estimate for Philip Morris International. Japan Tobacco (not covered) is the third tobacco company involved in the lawsuit. In the near term, this removes one of the risks to fiscal 2015 earnings for both BAT and PMI. BAT would have had to lower its earnings guidance by around 9% and PMI by 2% if the preliminary deposit had been required.  In the long term, it gives us greater conviction in our initial reaction to the ruling that the size of the damages will be lowered during the appeals process. Thus, we doubt that excess returns on invested capital will evaporate as a result of this particular judgment, and we are reiterating our wide moat ratings for both BAT and PMI.

In June of this year, the Quebec superior court awarded punitive damages to former smokers totaling CAD 15.6 billion against British American Tobacco (CAD 10.5 billion), Philip Morris International (CAD 3.1 billion), and Japan Tobacco (not covered, CAD 2 billion) on the grounds that tobacco manufacturers concealed the risk of smoking. Litigation like this is not new, and neither is the award's magnitude. Large awards such as this, both in the tobacco industry and outside, are often revised significantly downward during the appeals process. The Engle class action suit, which awarded $145 billion in punitive damages against the industry in 2000, was decertified and the award set aside in 2006.

Ventas VTR
Analyst Note 07/24/2015 | Todd Lukasik, CFA

Ventas reported solid second-quarter results that are consistent with our growth thesis for the firm. After a sluggish first quarter, internal growth reaccelerated at Ventas' senior housing operating portfolio, and internal growth on Ventas' entire portfolio is tracking slightly ahead of our 2.6% expectation for the year. Overall growth was further boosted by cash-flow-accretive acquisitions and developments nearing $4 billion in total, year to date, with normalized funds from operations per share increasing 5.4% year over year.

We are maintaining our $90 fair value estimate and narrow moat rating for Ventas, which remains on our Best Ideas list. We continue to think Ventas' current 6.8% cash flow yield (based on our 2015 adjusted funds from operations estimate) plus mid-single-digit growth prospects (at least) offers investors a compelling double-digit total return opportunity in the current environment.

Although headline financial metrics were strong, share issuances to fund external growth investments crimped per-share growth metrics. Our reckoning of revenue and adjusted EBITDA (from which we exclude interest income and acquisition- and merger-related expenses) increased 17.5% and 16.5%, respectively, driven by a 20% year-over-year increase in property investments. Adjusted EBITDA per share and NFFO per share increased just 3.4% and 5.4%, respectively, reflecting the negative impact of recent share issuances to fund external investments. We expect full-year per-share NFFO growth of roughly 7.5%, compared with the 5.6% growth embedded in the midpoint of management's raised guidance. Although Ventas, like all real estate investment trusts, generally needs to issue incremental capital for external growth initiatives, we continue to think it remains better positioned in this regard than peers due to its lower dividend payout ratio, which allows it to retain relatively more cash to fund growth investments.

Internal growth at Ventas' senior housing operating portfolio assets reaccelerated in the second quarter after a slow start to the year. Cash-based same-store net operating income increased 3.4%, consistent with our expectation that growth in this portion of its portfolio is likely to exceed that at its triple-net leased assets and medical office buildings. We think growth here can remain robust, provided the backdrop remains favorable, with continued growth in the economy, steady values in the stock market and housing market, and limited construction of incremental supply. To the last item, Ventas pointed out that construction in its markets remains below the level for the broader senior housing industry. Construction is picking up generally, but we expect there to be incremental demand over time as the population ages.

Although SSNOI growth at Ventas' triple-net leased portfolio was a tepid 1.4% in the quarter, this doesn't overly concern us. We expect lower growth for this portion of Ventas' portfolio, and this segment had a tough comparison due to some nonrecurring revenue from the prior year. SSNOI at Ventas' medical office building assets increased 2.3%, near our expectations.

Ventas' external growth story also remains intact. The firm has invested nearly $4 billion to date at an initial cash yield of 6.1%, which when combined with inflation-plus growth prospects should add incremental cash flow and value for shareholders. The real story here, though, is the long runway of potential external growth. We continue to believe Ventas (as well as its peers) has one of the best industry consolidation opportunities among REITs. Plus, incremental health-care demand from the increased number of insureds under the Affordable Care Act and (most important) the growing and aging population should provide a meaningful opportunity for Ventas to invest in the real estate its operating partners need to expand their service capabilities. An additional $1.4 billion of external growth related to Ventas' acquisition of Ardent is slated to close in the third quarter, and we expect more deals to be announced over time.

Concerns about the potential negative impact of rising interest rates have weighed on REITs generally recently, with health-care REITs among the hardest hit. With potentially higher interest rates in the future, we think investors should focus on REITs with solid balance sheets, competitive advantages, well-covered dividends, and identifiable growth prospects. Ventas fits the bill nicely, in our opinion, and we expect its exemplary management team to continue to find ways deliver incremental cash flow and value to shareholders.

Verizon Communications VZ
Analyst Note 07/21/2015 | Michael Hodel, CFA

Verizon continued to weather the competitive environment in the wireless industry nicely during the second quarter. The firm returned to postpaid phone customer growth, adding 321,000 net new customers during the quarter, up from 304,000 during the same period a year ago. Verizon’s customer loyalty remains exceptionally strong, with the rate of postpaid customer churn dropping to the lowest level in three years. We believe Verizon remains the best-positioned wireless carrier in the industry, worthy of a narrow economic moat rating. We don't expect to make a material change to our fair value estimate at this time, leaving the shares modestly undervalued.

While the competitive environment hasn't materially dented Verizon’s customer base, growth in average revenue per customer continues to slow despite massive increases in wireless data consumption. Adjusting for the adoption of Edge phone installment plans, average billings per postpaid account increased 1.0% year over year, down 1.5% last quarter, 3.5% in late 2014, and around 8% growth during the first half of 2014. We continue to believe the mismatch between revenue growth and increasing consumption is an area that bears careful watching as an indicator of pricing power in the wireless business.

On the fixed-line side, customer growth retreated to multi-year lows as Verizon added only 26,000 television customers and 72,000 FiOS Internet access subscribers. Total Internet access customers served declined 25,000, the first quarterly net loss since 2012. The firm noted that it saw stronger than expected demand for its Custom TV packages and that it was unable to market these packages in some markets. We view the Custom TV experiment as an indication of the future direction of the television business.  The fact that this product is gaining momentum indicates that the level of pent up demand for slimmed down television packages is likely fairly high

Free cash flow was again solid during the quarter, totaling $4.2 billion versus $3.3 billion a year ago. This increase came despite capital spending ramping up to normalized levels as Verizon makes progress on its effort to add additional wireless cell sites. Included in free cash flow, however, was the receipt of $1.2 billion in proceeds from the factoring of Edge receivables. Verizon completed the AOL acquisition late in the quarter, spending $4 billion. As a result, net debt increased $2.2 billion during the quarter to $110.7 billion, or 2.5 times EBITDA.

 

 
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