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

 
 
Apr 18, 2014
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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, and manager of DividendInvestor's model dividend portfolios, the Dividend Harvest and the Dividend Builder.
Featured Posts
Momentum Is as Momentum Does -- The Week in Dividends, 2014-04-17

I don't mean to insult momentum investors; momentum can be a powerful force propelling stock prices. Yet I can't resist paraphrasing Forrest Gump: Momentum is as momentum does. In the past month or so the former momentum stocks--biotechs, social networks, the 3-D printer outfits, and so on--have turned into what they call "nomentum" stocks on TV. "Nomentum" would actually suit me fine as long as I get big dividends; maybe "negamentum" would be a more illuminating euphemism for the speed of the losses in names like Tesla TSLA and Netflix NFLX.

Have investors learned anything about the risks of ignoring valuation? Or have they simply taken their game of value-insensitive trading elsewhere? Lately the hottest stocks on the market have been concentrated in one of the oldest and seemingly stodgy industries around. Thus far this year, the S&P 500 Utilities index has a long lead over any other sector with a total return of 12.4% (including today's pullback); the S&P 500 as a whole is up only 1.5%. The recent retreat in interest rates provides some useful context for utilities' outperformance; no word from the Federal Reserve of late suggests an end to easy monetary policies. Still, the big move in 10-year Treasuries ended a month ago--rates haven't really changed since then. Yet utility shares continue to trounce the market, up another 5.6% including dividends since mid-March.

On one level, maybe I should give the momentum buyers some credit. At least with a utility, you know you've got some substance--assets, earnings, and dividends that demonstrate tangible value. The better utilities also provide shareholders with some growth--not a lot, but hopefully enough to stay ahead of inflation. Then again, the momentum crowd isn't buying utilities on the cheap. (When do they ever buy anything on the cheap?) The average U.S. utility stock we cover is now about 10% overvalued and yields only 3.7%. Only a few are trading below our fair value estimates; of these, only Harvest holding American Electric Power AEP is likely to generate any meaningful dividend growth this year. The Harvest's four other utilities (including U.K.-based National Grid NGG) are out of reach for price-sensitive buyers, at least for the moment.

Goodness knows I like a well-run regulated utility, but it's harder to like the stocks when everyone else does too. And what, one may ponder, does it mean for the market when utilities become the most popular ideas? Is this what you'd expect if economic growth was about to surge? I'm not making any macroeconomic or market forecasts here, but I think it's best to buy utilities when at least some fear of rising interest rates is reflected in prices. That was the case a few months back, but not anymore. I plan to hold the utilities we've got, but I'd welcome a short-term retreat in prices as an opportunity to buy more.


Four of our portfolio holdings reported first-quarter results this week:

* Tuesday's report from Coca-Cola KO, the Builder's newest holding, earned the stock a 3.7% jump for the day and 5.4% for the week. Operating earnings per share merely met consensus expectations of $0.44 (down 4% from a year ago on a 9% currency translation headwind), but sentiment around the stock had become so dour that no new bad news was greeted as good news. Global volume growth improved to 2% from 1% in the fourth quarter of 2013: Carbonated beverage volume dropped 1%--headwinds there are now very well known--yet Coke's non-carbonated beverages notched an 8% gain. The shares are now up 6.1% since my purchase on April 3, and with our fair value estimate holding steady at $44 the stock isn't quite as attractive as it was. Still, I think Coke is a respectable purchase at Thursday's closing yield of 3.0%.

* Also reporting on Tuesday, Johnson & Johnson JNJ beat consensus EPS estimates by $0.06 and raised its full-year forecast slightly. We credit the firm's improving performance to accelerating sales of newly-launched drugs with high profit margins; this led us to increase our fair value estimate by $2 to $99 a share. The stock is trading right around our updated appraisal and its yield has slipped to 2.7%, the lowest level since September 2008. That said, if Johnson & Johnson meets my forecast of a 7.6% dividend increase when its annual hike is announced (probably) next week, the yield would bounce back to 2.9% at the stock's current price. In this environment, that's more than enough to continue holding these high-quality shares.

General Electric's GE industrial businesses showed solid progress in the first quarter, boosting the shares 1.7% on Thursday and 4.4% for the week. Organic industrial revenue growth came in at 8% with a 12% increase in operating profit. Total operating earnings per share declined 15%, but would have risen 9% had NBC Universal not still been included in last year's figures, among other one-off factors. Growth led by GE's industrial operations, hindered for the moment by a shrinking financial services unit, continues to support my outlook for high-single-digit dividend growth over the long run. Like J&J, GE is a core holding for the Builder, and I'm considering adding to our stake.

Philip Morris PM got no credit for topping analyst EPS estimates by $0.03 as global cigarette volume dropped 4.4%. Net revenues slipped 8.8%, though without negative currency effects the decline would have been only 1.6%. Fortunately, currency pressures seem to be easing, allowing the company to boost its full-year EPS target slightly. At least for now, the ex-currency operational growth Philip Morris is able to generate comes from cost reductions, price increases and share repurchases. This sounds like a familiar combination: It's what Altria MO has been doing quite successfully for years. Investors are discouraged by falling volumes, but Altria has already shown that it's possible to generate strong shareholder returns sourced mainly from the industry's incredible pricing power. We also think that some of the volume pressures will prove temporary, and our fair value estimate remains $90 a share. I still consider the stock a good long-term buy, and even though we already hold a fairly sizable stake (it's the only stock held in both the Builder and the Harvest), I'm contemplating adding more.

In other news, Harvest holding Health Care REIT HCN announced the unexpected and immediate retirement of longtime chairman and CEO George Chapman; he's been replaced by director Thomas DeRosa. While sudden management changes sometimes raise uncomfortable questions, we see nothing to suggest that Chapman was shoved out the way rival HCP Inc. HCP abruptly dismissed its CEO last year. Health Care REIT affirmed its financial expectations for 2014, and the nine years DeRosa has served on the company's board should serve him well in his new role. In another contrast with HCP, Health Care REIT's stock barely reacted to the news. While the shares have had a nice little run higher of late in the lower rate environment, it remains just one of two real estate investment trusts I consider worth buying at current prices (the other is Realty Income O).

Next week the calendar shows quarterly reports for eight DividendInvestor portfolio holdings: Rogers Communications RCI on Monday; AT&T T and McDonald's MCD on Tuesday; Procter & Gamble PG on Wednesday; Altria, Unilever UL and United Parcel Service UPS on Thursday; and American Electric Power on Friday. The week after that is likely to be our busiest for the season with nine earnings reports.

While the markets will be transfixed by their press releases and conference calls, I'm looking forward to a batch of likely dividend and distribution increases in the next couple of weeks. My list includes the aforementioned Johnson & Johnson as well asAmeriGas Partners APU, Chevron CVX, Unilever, Magellan Midstream PartnersMMP and Spectra Energy Partners SEP. Earnings reports are valuable as an indication of future dividend-paying potential, but you can't buy groceries with a press release--that's what dividends are for.

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.


I’ll be presenting at the BetterInvesting National Convention's free Saturday event on May 17th in Chicago. If you’ll be in the area, please register free as our guest by going to http://www.betterinvesting.org/biconvention.


News and Research for Builder and Harvest Portfolio Holdings

Coal Plant Closures Likely to Continue After U.S. Federal Court Ruling
Industry Note 04/15/2014 | Travis Miller

Tough regulations restricting certain U.S. coal plant emissions cleared what appears to be a final legal challenge with an affirmative D.C. Circuit Court of Appeals ruling April 15. Although most utilities have been preparing for the April 2015 implementation of the Environmental Protection Agency's proposed Mercury and Air Toxics Standards, we expect that the court ruling ensures utilities will go forward with their plans to close smaller, older coal plants and invest substantial capital in emissions controls equipment.

We believe power and gas markets have yet to fully price in the tightening supply-demand conditions we expect from additional coal plant closures. The Energy Information Administration reports 18.7 gigawatts of coal plant capacity have closed since 2011, representing 5% of total U.S. coal plant capacity. We count another 38 GW of capacity that prior to the April 15 ruling utilities had already announced they will close within the next five years.

Key winners are utilities with nuclear, natural gas or renewable energy generation, notably Exelon, Calpine, and NextEra Energy. We already incorporate higher future power prices in our fair value estimates for most U.S. utilities, so we are reaffirming all of our fair value estimates, moat ratings and moat trend ratings.

Large coal plant owners such as American Electric Power, NRG Energy, FirstEnergy, and Southern Company have been planning for tighter emissions regulations for several years. We already incorporate coal plant closures and capital investment for environmental controls in our analyses, so we are reaffirming our fair value estimates, moat ratings, and moat trend ratings. For all regulated utilities with large coal fleets, tighter regulations raise regulatory risk but shouldn't have any direct impact on earnings or shareholder value in the long run since they should be able to recover higher costs through customer rate increases.

Coca-Cola KO
Analyst Note 04/15/2014 | R.J. Hottovy, CFA

We plan to maintain our $44 fair value estimate for wide-moat Coca-Cola following the company's first-quarter results. Continued volume and value share gains, with stronger gains in the latter, indicate that pricing power remains solid. Moreover, recent marketing efforts seem to be taking hold in developing and emerging markets, which enjoyed 3% volume growth from a year ago. China saw total beverage volume jump 12%, while Brazilian volume ticked up 4%--both sequentially improved. In all, revenue fell 4% year over year, though the entirety of this decline stemmed from negative currency headwinds, which is not surprising given management's prior comments on the issue.

However, sparkling case volume declined about 1% year over year. Still drink volume increased 8%, reflecting continued success in nonsoda products, but sparkling beverages represented a larger 74% of total cases in 2013. Management attributed the weakness to a shift in the Easter holiday this year and price discipline in Great Britain at the expense of volume, given new packaging; the company expects the absence of these issues and stepped-up marketing to drive volume growth in line with long-term targets in the low single digits for the full year. Such advertising activities will probably erode the selling, general, and administrative expense leverage enjoyed in the first quarter.

We plan to maintain our Exemplary Stewardship Rating for Coke, as we believe recent investor criticism surrounding the potential dilutive effects of the proposed management incentive plan largely ignores offsetting factors such as proceeds garnered from options transactions, performance standards that still need to be met, and the company's sizable repurchase program. Admittedly, dilution under the new plan may still be slightly higher, but it improves the ownership mentality of more than 6,000 Coke employees, easing our qualms about the mathematics of the equation.

General Electric GE
Analyst Note 04/17/2014 | Daniel Holland

Wide-moat General Electric carried momentum from 2013 into the first quarter of 2014 with industrial organic revenue growing 8% versus the prior year. In addition, industrial operating margins grew 50 basis points, ahead of the 40-basis-point pace the company guided to during the business outlook meeting. After adjusting for gains taken in the prior-year quarter, earnings grew 9% year over year. The company’s performance in the quarter supports our current fair value estimate of $29 per share, which is unchanged.

Strong performance in oil and gas, where year-over-year revenue grew 7%, as well as the power and water segment, where year-over-year revenue rose 14%, drove industrial revenue growth in the quarter, although health care and transportation businesses were a drag on revenue and profit growth. The backlog in the businesses continues to grow, giving decent revenue visibility for the coming quarters. The strength in revenue growth was supported by margin improvement in the industrial business, with both of the power businesses showing robust margin improvement of over 100 basis points. The one sore point for the quarter is the smaller energy management segment, which saw revenue decline 4% and margins decline 60 basis points to 0.3%.

Pre-tax, pre-provision income was down nearly 11%, with ending net investment down 7% over the same period. This performance is consistent with management’s stated intention to shrink the business and in our opinion, moat-enhancing. Within the quarter GE completed the initial regulatory filings for the spinoff of its North America Retail Finance business, to be named Synchrony. GE will retain 80% of the ownership stake in Synchrony and will use all of the proceeds to support the business. As a result, we anticipate the transaction will be slightly dilutive to 2014 earnings, although once GE relinquishes the remainder of its stake, the company will likely return cash to shareholders.

Health Care REIT HCN
Analyst Note 04/15/2014 | Todd Lukasik, CFA

Our Standard Stewardship Rating for Health Care REIT will not change following the announcement that longtime leader George Chapman will retire as chairman, CEO, and president. Tenured directors Thomas DeRosa and Jeffrey Donahue will succeed Chapman as CEO and chairman, respectively, a separation of roles we appreciate. In addition, the company has formed a management committee to oversee day-to-day operations, along with DeRosa.

Given the histories DeRosa (since 2004) and Donahue (since 1997) have as directors of Health Care REIT, we do not expect any major changes in the firm's historically successful strategy. Over the years, Health Care REIT's strategy has resulted in strong total shareholder returns, including dividend increases averaging 2.5% over the past two decades or so (albeit with a few bumps in the road). With solid industry tailwinds in health care, we expect Health Care REIT's strategy to be similarly successful in producing reasonable inflation-plus dividend increases over the long term. We also expect to leave our narrow moat rating and $71 fair value estimate unchanged.

Johnson & Johnson JNJ
Analyst Note 04/15/2014 | Damien Conover, CFA

Johnson & Johnson reported first-quarter results that exceeded our and consensus expectations. We attribute the outperformance largely to strong high-margin drug sales. Based on the solid results, we plan to raise our fair value estimate by $2, to $99 per share, which would put the current stock price close to our estimate. The strength in J&J's most competitive division--pharmaceuticals--reinforces our conviction in the company's wide moat. Based on the strong quarterly results, J&J slightly increased its full-year earnings per share outlook to $5.80-$5.90, which we expect it to easily meet.

New product launches are driving the solid growth in the drug division (up 12% year over year). We expect this trend to continue for at least the reminder of the year. However, in 2015, we expect growth to decelerate as new hepatitis C drugs enter the market, slowing the growth of J&J's hepatitis C drug Olysio, which represented 500 basis points of this quarter's growth. Nevertheless, other recent drug launches (immunology drug Stelara and cardiovascular drug Xarelto) are likely to continue to drive solid growth for J&J's drug division over the next three years. The relatively high margins of the drug unit should continue to provide an amplified impact on the bottom line over the next several years.

Turning to the other key divisions, both medical devices and consumer health care posted largely flat growth in the quarter. Poor health-care utilization and increased competition led to the stagnant performance in the period. While we expect these divisions to return to mid-single-digit growth as a result of new innovative product launches and strong brand power, we anticipate they will remain a drag on overall company growth for the remainder of the year.

Johnson & Johnson: Valuation 04/16/2014 
We are increasing our fair value estimate to $99 per share from $97 largely based on an improving outlook for the company's recently launched drugs. 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 sales growth will average 3% during the next five years, as strong growth in new pipeline drugs and the Synthes acquisition should offset some patent losses in the pharmaceutical division. We expect operating margins to slightly increase over the next five years as the company faces a few patent losses on high-margin drugs and cost-remediation efforts in the consumer group should dissipate. Additionally, the growth of high-margin drugs should outpace lower-margin sales from the device and consumer divisions, which should give margins further strength.

Philip Morris International PM
Analyst Note 04/17/2014 | Philip Gorham, CFA, FRM

Unfavorable currency and trade inventory movements caused noise in Philip Morris International's first-quarter 2014 earnings report, masking the structural advantages that we think should allow the firm to earn excess returns on capital in the long term. The company is on track to meet our full year forecasts, and we do not intend to adjust our $90 fair value estimate. We also reiterate our wide moat rating, although we remain concerned that plain packaging is a threat to Philip Morris' competitive advantages.

Reported revenue fell 4.0% largely due to unfavorable foreign exchange movements, slightly ahead of our full-year estimate of a 4.4% revenue decline. Even excluding currency, however, both revenue (-1.6%) and operating income (-3.1%) declined as Philip Morris failed to offset lower volumes with higher prices. We do not think this is indicative of the long term, and we believe Philip Morris' wide economic moat, particularly through its brand strength, should allow it to grow revenue at a mid-single-digit rate in the long term.

In the first quarter, unfavorable inventory movements in Japan affected volumes and cyclical macroeconomic factors continued to weigh on pricing. We were encouraged to see, however, some stability in the European Union segment, with volume down 3% (in line with long-term trends and a sequential improvement from the 6.5% decline in 2013), and revenue essentially flat in the first quarter. Management raised its 2014 EPS guidance by $0.07 to a range of $5.09 to $5.19, putting our estimate of $5.11 at the lower end. We may raise our near-term estimates slightly to account for the improving visibility in Europe, but we do not expect this to make any impact on our fair value estimate, which is driven by the long-term earnings power of the business.

 

 
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