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
McDonald's Hikes Dividend 4.9% -- The Week in Dividends, 2014-09-19

This could have been a week full of fireworks, but neither voters in Scotland nor voting members of the Federal Reserve's Open Market Committee upended consensus thinking with their much-awaited conclusions. Stocks coasted back into record territory, with the S&P 500 gaining 1.3% for the week.

Since Alibaba BABA isn't on our radar screen (the company doesn't plan to pay any dividends), it wound up being a quiet week for the DividendInvestor portfolios with only two noteworthy developments.

* On Thursday, Builder holding McDonald's MCD announced a 4.9% increase to its quarterly dividend to $0.85 a share ($3.40 annualized), giving the stock a 3.6% yield at Friday's closing price. With 37 uninterrupted years of dividend growth coming into this announcement, I was virtually certain McDonald's would not break its streak, and the size of the increase landed right where I expected--but only because my short- and long-run expectations for dividend growth have been falling in the last year. (At the start of 2014, for example, I forecasted a 7.4% dividend increase from McDonald's.)

It's looking like McDonald's shareholders may have to live with mid-single-digit dividend increases for some time to come. With earnings per share likely to shrink 3%-4% this year, the company's payout ratio will jump to about 61%. On one hand, I don't think this is uncomfortable territory from a reliability perspective. Profits are proving to be quite resilient in an absolute sense during this slump, and over the past decade McDonald's has converted 85% of net income to free cash flow--suggesting only 15% of earnings need to be retained in order to fund a more-or-less normal level of expansion. On the other hand, I doubt that management intended to take the dividend payout ratio north of 60%. That's what happened as the dividend continued to rise after earnings sagged, but I have to believe McDonald's expected more earnings growth than the company has actually produced. Once earnings are expanding at a more normal pace, I won't be surprised if management will look to take the payout ratio back down a bit by keeping dividend growth below the rate of EPS growth.

I'll like McDonald's a lot better once it starts to emerge from its current malaise, but even if the dividend is only growing around 5% a year, that's decent in the context of a 3.6% yield, as long as EPS starts rising at roughly the same pace or better. I still think this is the most likely outcome, so the stock continues to qualify as a buy--in moderate quantities--within our portfolio strategy. That said, if sales and profits haven't ended their slump by this time next year (when the comparisons should be very easy), I wouldn't count on the dividend alone to deliver adequate total-return performance to shareholders.

* Builder holding General Mills GIS reported results for the quarter that ended on Aug. 24, and the company's performance was not well received: the stock dropped 4.4% on Wednesday and 2.9% for the week. Operating EPS dropped 13% year-over-year and missed consensus expectations by almost as much. Management reaffirmed its key financial targets for the year, which include high-single-digit growth in EPS, but getting there will require making up lost ground during the next three fiscal quarters.

I can understand why some investors have soured on General Mills; the company has missed Wall Street's consensus earnings expectations for four quarters in a row. However, I still like the business a great deal and consider it a core holding. Industry conditions are tough, not least because it seems median household incomes still aren't growing even though the economic recovery has entered a sixth straight year. This lack of growth has led to elevated promotional activity in grocery aisles that isn't driving volumes. Yet even when times are tough in this industry, dividends--and usually sales and earnings too--still trend higher, just not as fast as we might prefer.

In the just-released October issue of DividendInvestor, General Mills is profiled on Page 7. Though that profile was written before Wednesday's earnings report, my view is largely the same--the company has a number of ways to create shareholder value and drive total return even without much volume growth. Now that the stock is again trading below our $52 fair value estimate, I'm considering adding to the Builder's stake.

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

Clorox CLX
Analyst Note 09/18/2014 | Erin Lash, CFA  

Clorox has announced that CEO Donald Knauss, 63, who has led the firm since 2006, will retire in November. Benno Dorer, executive vice president and chief operating officer of cleaning, international, and corporate strategy, will assume the reins. Knauss will continue to serve as chairman, which we believe should ensure a smooth transition. Dorer joined Clorox 10 years ago after spending 15 years at Procter & Gamble, indicating that he has not only significant knowledge and experience at Clorox but also within the global household and personal-care industry.

We view Clorox's stewardship of shareholder capital as Exemplary and don’t anticipate that this will change under new leadership. Solid underlying fundamentals, strong cash flow generation, and a commitment to returning excess cash to shareholders (in the form of healthy dividends and stock buybacks) all point to management running Clorox for the long term and not the quarter, which is a plus, from our perspective. This announcement will not affect our $96 fair value estimate or our wide moat rating, which is based on Clorox’s brand intangible asset and its cost advantage. We view the shares as modestly undervalued and would recommend that investors interested in gaining exposure to the consumer products landscape consider Clorox.

General Mills GIS
Analyst Note 09/17/2014 | Erin Lash, CFA

If General Mills’ first-quarter results are any indication, the state of the U.S. packaged food space is quite bleak. On a consolidated basis, first-quarter sales slipped 1% (after excluding the impact of foreign currency movements) and profits were eaten up, reflected in adjusted gross margins that sank 210 basis points to 34.8% and adjusted operating margins that contracted 240 basis points to 14.5%. We intend to reassess the assumptions underlying our discounted cash-flow model, but we anticipate holding our $52 per share fair value estimate in place, which incorporates 3%-4% annual sales growth and mid-single-digit operating profit growth longer-term. Despite its fall in early-morning trading (down around 3%), we view the stock as fairly valued and would suggest that investors wait for a more attractive entry point, but we wouldn’t require a significant margin of safety before recommending the name.

Most alarming was the pronounced retreat in sales and profitability at home, down 5% and 15%, respectively, from lower sales of dessert mixes, meal products, and frozen vegetables. We’ve long believed General Mills’ portfolio of solid brands and its expansive global footprint (the basis for our narrow economic moat) are a plus, and we haven’t wavered from this stance. We further think the firm’s focus on eliminating costs from its business, which includes taking a hard look at its domestic manufacturing and distribution network, should fund continued investments behind its core brands--this is essential spending particularly in light of the ultracompetitive environment in which it plays. With 250 new products launched in the first quarter (145 in the U.S. alone), we think the firm recognizes that innovation is what will ultimately prop up sales longer-term. However, promotional spending, which has proved ineffective, is still being used as a means to drive volumes (although management again stressed that the depth of discounts has not expanded).

We were encouraged by management’s reference to improvements within its yogurt business (a category that has plagued the firm for some time), with market share up around one half point to 24.4%. This could indicate that the firm’s product innovation and marketing are beginning to resonate with consumers, but it will take more than one quarter before we can view this performance as sustainable.

Following the acquisition of Annie’s (a natural and organic manufacturer), we think the firm still maintains a penchant for further deals, with a desire to grow its reach in the U.S. natural and organics space as well as its distribution in faster-growing emerging markets like Indonesia and India. However, the rich price tag of its recent buy (around 4 times sales and 29 times on an enterprise value/trailing-12-month EBITDA basis) indicates the degree to which management is willing to pay up to increase its presence in attractive segments of the market. Because General Mills plans to fund the $820 million purchase entirely by taking on additional leverage, we will likely revisit our issuer credit rating (which currently stands at an A), with the potential for a downgrade.

Spectra Energy SE and Spectra Energy Partners SEP
Analyst Note 09/16/2014 | Travis Miller

Northeast Utilities and Spectra joined a growing list of wanna-be pipeline developers in the Northeast with their proposal for the $3 billion Access Northeast project, a 1 bcf/day pipeline aimed at easing the winter gas deliverability constraints for power producers in New England starting in 2018. The project's size and location could make it a material earnings growth driver and enhance each company's economic moat, but we're skeptical it will go forward. Therefore, we are not yet including it in our forecasts. We are reaffirming our $38 per share fair value estimate, narrow moat rating, and stable moat trend for Northeast Utilities; $43 per share fair value estimate, wide moat rating, and stable moat trend for Spectra Energy; and $58 per share fair value estimate, wide moat rating, and stable moat trend for Spectra Energy Partners.

Access Northeast joins two other proposed Northeast gas pipeline projects--Spectra's Atlantic Bridge and Kinder Morgan's Northeast Direct--that are trying to serve the growing retail and power generation demand in the Northeast. All three projects are counting on gas generators to sign firm commitments. However, gas generators are hesitant without some guarantee. The New England States Committee on Electricity has proposed subsidizing gas generators, but we think FERC is unlikely to approve the NESCOE proposal. Therefore, we think all three projects will have difficulty securing financing.

New England is in dire need of a gas infrastructure buildout, especially with growing gas generator demand alongside the retirements of Salem and Vermont Yankee plants. ICF is projecting less than 500 mmcf/day for 20 days this winter, which will force most gas generators in New England to go on outage and possibly cause severe reliability issues. We think the best hope of gaining FERC approval and financing for a gas infrastructure build-out is to implement market design changes in ISO-NE capacity market to cover the costs of firm gas.

 

 
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