Josh Peters is director of Equity Income Strategy for Morningstar, and has been for over 10 years. He is also the writer and editor of Morningstar DividendInvestor, the newsletter that is built around the portfolio that he manages. He is also the author of The Ultimate Dividend Playbook. His strategy is to emphasize the production of income, rather than trying to beat a benchmark index. He believes that income is what investors are looking for, particularly because interest rates are so low, and because baby boomers are now beginning to retire and have a greater need for income than growth.
His goal is to get a good fundamental total return, which includes a steady dividend income, plus some capital appreciation that comes from investing in strong companies that can pay such dividends to their investors. In the past 10 years, his fund has turned in an annualized return of 9.4%, compared to 7.6% for the S&P 500, even though the fund underperformed the S&P 500 in six out of those 10 years.
Why Not Just Put Your Money Into a S&P Index Fund?
Josh believes that the problem with index funds, or any type of primarily growth oriented investment, is that when it comes time to take income you are put in the position of needing to sell off shares. This works as a form of reverse dollar cost averaging, since you are now selling into a changing market, rather than buying into it. That is, you will often be selling stocks at declining prices, and locking in your losses permanently.
With income oriented investments, you’re living off of the dividend income alone, and never selling the underlying assets. This will also help you to better match your income and expenses, since dividend income is much more reliable than capital appreciation (which can also go negative). Dividend yields, based on your investment in a stock, will remain constant even if the price of the stock changes after you buy it. And a decline in the stock price may also be the signal to buy more shares of company, but now with higher yields.
Every stock that Josh holds is a dividend paying stock, but he buys strong companies at advantageous prices. His secret is not to focus on the growth of the stock, but rather on the growth of the stock’s income. He may beat the index, or he may not – but that is not his goal. With his dividend portfolio, he’s currently earning twice the yield of the S&P 500 while having an opportunity to also earn capital appreciation.
To find out how Josh Peters is beating the market, focusing on dividend stocks alone, listen to the podcast. This is not a “just buy high dividend paying stocks” discussion either. Josh has some interesting observations about how Wall Street collectively functions, why he’s been able to beat the market, what kinds of stocks he invest in (hint: it’s not tech stocks!), share buybacks, and why not every high yielding dividend paying stock is a candidate for his portfolio.
Josh Peters Interview Transcript
Rob: Josh, welcome to the show.
Josh: Nice to be here today with you.
Rob: I’m so glad that you took time out of your busy schedule. For folks that might not know who you are, tell us who Josh Peters is and what you do.
Josh: Well, my title is Director of Equity Income Strategy for Morningstar. It’s just as easy to go by Morningstar’s bearded, dividend guy. I’ve had this position now for a little over 10 years. Actually, in January I just celebrated the 10-year anniversary of the model portfolio I manage as well as the newsletter, Morningstar Dividend Investor that I write and edit which is built around that portfolio. My animating spirit— what is behind my interest in dividend paying stocks and the strategy we have in the newsletter, the way I write about and think about the financial market—it’s all about very practical, real-world, useful results from stocks. Almost all of Wall Street is geared around this idea of a horserace. That it’s all about trying to beat your benchmark, beat the S&P 500— to do it every quarter regardless of whether that quarter is up or down. That’s not what most people are looking to do. That’s only how money managers evaluate each other, maybe. But that’s not necessarily what’s going to serve the actual financial requirements or financial needs of people who are out there. The biggest demand out there is for income and it’s not just because interest rates are low, it’s because baby-boomers are retiring and most of them don’t have those defined benefit pension plans to count on. They have to figure out how to turn their own 401ks and various nest eggs into income. And the first thing you have to do is forget about this competition you have with the market and instead, focus on the businesses and how they’re delivering value to you, the shareholder, directly, through cash. So I figure, since I’ve still got a big and safe dividend from a company that is able to grow over time. And with the growth of that dividend on a per-share basis, I’ve also got a good reason to expect some capital appreciation of a lasting type over the long run. If I put these things together, I’m getting a good fundamental total return—
Josh: Whether the market reflects that in any one month, quarter or year, I honestly can’t let myself worry much about it. I said more than 10 years ago that I’m not trying to beat the market. Don’t expect me to try and beat the market every year. Since then, we’ve only beaten the S&P 500, 4 out of the 10 years. But, cumulatively, we’ve out-performed the S&P by I think it was 9.4 percent annualized return to 7.6 percent for the S&P over the same time. So we essentially beat the market without trying by just having a good strategy and focusing on what matters for the portfolio, results we’re looking at and what’s going on in the individual companies. Beating the market was just a bonus. And after the fact of what’s otherwise a very good and sound investment process.
Rob: Well that’s great. My goal for today is for you to share your wisdom on how folks who might be interested in investing in dividend paying stocks should go about it. But before we get into that, let me play devil’s advocate for just a moment. A lot of people will say, “Wait a minute. Why even bother with all of this stuff? Just put your money in a S&P 500 index fund.” In fact, that’s something I preach at people in this podcast. So why not just do that, and are there some folks who, for individual dividend paying stocks make sense? And are there other folks that think they should just stick with index funds?
Josh: I think it really comes back to what you’re trying to accomplish. There’s two main characteristics that I think would point you in the direction of a dividend orientation and then to express that with individual stocks. The first is just the income preference. If you actually have current expenses, current withdrawals that you’re making from your portfolio, Wall Street’s solution is to just sell off however many shares you need in order to have the cash that you want to withdraw from your portfolio. You call that “living off the pile.” Well, if you’re familiar with a mathematical trick called, dollar cost averaging, you know that as an investor, when you’re putting money into the market— a fixed dollar amount over time, that actually increases and enhances your return because you’re automatically buying fewer shares when the price is high, but disproportionately more shares when the price is low. Your average cost to get in, will be lower than the average stock price over that period or the average level of the market— let’s say, in an index fund. The problem with living off the pile (once you go into withdrawal mode) is that it’s dollar cost averaging in reverse. When the market plunges as it does from time to time, all of a sudden you’re selling off a large number of shares to meet even small withdrawals. You’re eating through the principle value, the capital value of your portfolio very quickly to try to maintain your lifestyle. So to have an orientation toward income, within a total return context, but to try to get a portfolio that throws off independent of what is going on with stock prices— say a 4 percent yield— I think of it as a $100,000 account that provides $4,000 a year in annual income. If the market value drops to $75,000 but none of the dividends get cut, you’ve still got your income. You can still fund your withdrawal and you’re not having to be a seller at low prices. So there’s this very practical value associated with being able to fund portfolio withdrawals. Now you might say, “Not everybody is funding withdrawals. Most people are still in saving mode. What about them? Shouldn’t they just be in index funds?” Well, here too, there are risk characteristics that I think are very attractive, associated with high quality dividend paying stocks and you buy them at good prices. Every stock that I own personally pays a dividend. And I’ve got quite away to go— maybe a couple decades to go before I finally decide to hang it up. Why do I want that dividend income even though I don’t need it for spending purposes? It’s because they’re just a better class of companies that are going to deliver me good returns with less risk, less headaches, fewer sleepless nights. And I have the opportunity to definitely increase my income over time by reinvesting those dividends. The difference, you might say, is that if the company keeps all the cash and has to reinvest it all inside the business and then hopefully that forces the stock price up, the company may or may not be able to pull that off. Lots of companies destroy shareholder value and just throw the value of the cash away with bad investment decisions. As an investor, when I get that dividend… If I take my dividend income and buy more shares of dividend paying stocks, my income automatically goes up. I can track my personal financial progress— the progress of my portfolio over time by how much dividend income it throws off. That’s a big part of my strategy. Don’t focus so much on the market value. Focus on the income— the growth of income. Are you avoiding dividend cuts? Are you getting the growth you expect? Eventually that will drive the market value up and you’ll get the pile, too. But focus instead on the income. So there’s certainly a place for index strategies and passive strategies, but you have to be able to draw the line between the investment products or investment strategies you have and the actual financial goals you’re trying to reach. For a lot of people, they have specific income requirements either now, or expected in the future, and dividends are going to be more useful in meeting those future needs than just an income agnostic strategy.
Rob: What about for those who say, “Yes you’re right. I want some dividend income,” either because they need it now to live on or as you said— they just like the companies that pay dividends because they show an attitude toward shareholders and cash management that I think is ideal for a shareholder. So if I buy in whether I’m 30 or 65, then yes, dividends are good. What about someone who says, “Yeah, but I’ll just get it from a Vanguard fund that focuses on dividend paying companies?”
Josh: That’s a good debate, too. This is really surged the headlines in this business over the last couple of years and it’s a real tough one for active managers. Now I’m an active manager, so obviously I believe there’s value in active management or I wouldn’t be doing it. I also have this orientation that says, ” I don’t need to beat the market every year. This is not a horse race.” Hopefully over the next 10 years, I’m going to beat the index without trying. I’m going to focus on the income. and that’s going to get me a very good result in both an absolute and a relative sense. But it’s still a very fair question to ask, “What am I doing that you can’t get from, say, VIG, Vanguard Dividend Appreciation ETF?”
Rob: Right, right.
Josh: That’s a very cost effective, tax efficient product. And I think it may be the most popular of the dividend ETF’s out there. But here’s the problem— it only yields 2 percent. And that is basically the yield of the market average. The S&P 500 yields 2 percent right now. So now I’m thinking, “Okay, well it says dividend and has dividend in the name. All of the companies in their pay dividends,” which means, hopefully, they do care more about shareholders and hopefully they are making better capital allocation decisions because they have these dividends to pay. But me as a shareholder, I’m still not getting a distinctive result. I’m getting the same income from VIG that I would get from Spider, right? I kind of take issue with this idea that there’s such a thing as dividend growth investing. It’s actually very scarce to find companies that have very rapid growth but also distinguish themselves on the basis of dividend yield that’s in the mid to high 2 percent range or better. There just aren’t a whole lot of companies like that. So a dividend growth strategy just kind of becomes anything that is not oriented toward yield. The portfolio that I put together is currently 28 individual stocks. There’s nothing funky in there. I own a couple of very high quality midstream master limited partnerships, but other than that there’s some property REITs. There are no mortgage REITs. There’s no BDCs. None of these exploration and production partnerships that try to juice people’s income and now all of their distributions have been cut because the price of oil has plunged. These are like predictable risks that have manifested themselves here recently. My portfolio yields almost 4 percent, so I’m getting double the income of the market average by having had the ability outside of an index setting to pick these individual stocks. One thing I would add to that, is that there are lots of ETFs out there that also are oriented around those high yields. And some of those products I’ve even had a hand in helping develop. The problem is, that they’re still largely quantitative. They’re looking backward or maybe looking at today’s performance of the company. But those are not going to necessarily tip you off to the dividend that gets cut 6 months or a year from now and clobbers the stock price, you know, down 50 percent. And your income gets cut too. To have that qualitative and quantitative combination of forward looking, fundamental analysis, to weed out the obvious losers or even some of the not so obvious losers that are going to go on and cut your dividends— that, I think, adds a lot of value relative to just a passive index strategy that even is oriented around those high yields.
Rob: Yeah. What accounts for your ability to have beaten the S&P 500 over the past 10 years? Studies tell us most active management, at least in a mutual fund context, on average, the odds of them beating the S&P 500 over 10 years is not so good. How did you manage to do it?
Josh: Part of it is that the portfolio I manage— the only expenses it has are the commissions that we pay. All those years ago when we booted up, originally it was two accounts we recently we consolidated into one, but with each of those, Morningstar actually opened a discount brokerage account and deposited $100,000 for me to trade those stocks that I was buying and selling, with real money. So our performance record is crystal clear. It’s as clear and transparent as it gets. When I say buy, I actually did buy it or am buying it. If I say sell, it’s because I did sell it. With that, I pay $9 every time I make a trade but there isn’t that 100 basis points of management fees and other expenses that you have in mutual fund product. So that accounts for some of the favorable performance relative to actual products. In our first 10 years we did 9.4 percent annualized while the S&P did 7.6. Well, S&P has no transaction costs in it, so it’s a pretty close apples to apples comparison. The big variant there was income. I went through all of our performance data and I separated just the effect of changes in stock prices— just the capital gain and loss component, and then looked separately at the dividend income component of our total return since inception. What I found is, that just on stock prices we’ve actually lagged a little bit. The market went up more just because of the value of our capital gains. But this whole time, the S&P is yielding around 2 percent and our portfolio actually yielded at the average north of 4. That accounted and made up for the capital gains that we didn’t get as well as now put us well into the black on the relative comparison. What’s interesting is that it’s the kind of a decision that I think anybody can make— to prioritize income. Then you get a much more reliable source of return that gives you a lot of personal financial flexibility. But there’s still a lot of built in bias against these companies. Especially among institutional money managers. They don’t want to be too different than the S&P 500 because then they might perform differently and it might not be in their favor. I figure, if you want a differentiated result, you have to have a differentiated strategy so I’m willing to be different. I have much more exposure to utilities and REITs and staples than the market average. At this point, I don’t own any tech stocks.
Rob: What? No tech stocks?
Josh: I have zero weight in tech ( which is the biggest sector of the S&P 500) because I just can’t find companies that I really have a lot of confidence both in their capital allocation practices, their dividend policies. And their ability to maintain their businesses, their earnings power and cash flow indefinitely into the future when things change so much. There’s a reason why General Mills has gone 115 or 116 years without having to cut its dividend. And you can count on something like that because it’s just not a business that changes very rapidly. People are still going to be eating cereal, granola bars and yogurt and things like that in another 100 years so I’m not going to have to worry about that. Any of these tech companies— I just don’t know. I can’t develop that same level of confidence. I’m not saying I wouldn’t consider owning a tech stock, but boy, the hurdle is a little taller and I just don’t need it. I don’t have to have a tech exposure so that I don’t look too different from the index. I want a different result so I’m going to look different.
Rob: Well, and I’ll tell you, I own shares of Apple and I’ve been very happy with it. But that’s my concern for Apple. Yes, they’ve had hit after hit after hit, but that can’t last forever. It just can’t. The odds of that happening for the next 100 years… On the other hand, Pepsi is not going to have the same challenge. It will have its own challenges. But not the same as a technology company. Even one as strong as Apple.
Josh: Yeah. I’m a huge fan of Apple. I’m sitting here on my desk with my big iMac here, I’ve got my iPhone right next to me. There’s got to be three iPads in the house. I’ve had iPods. I’ve got an Apple TV. I mean, I’ve got it all. I don’t think I’m going to go for the watch because I don’t wear a watch, but I’m a huge fan. And it was a very big deal when Apple initiated a dividend because the company is so big and so profitable right off the get-go, that it actually (just by itself) moved the yield of the whole market a little bit. Billions and billions of dollars. But I put it in this mental framework— if you had Apple trading with a 3 percent yield, which at one point the yield did get kind of close to that when the stock was in a funk here, a year or two ago. If you put a yield of 3 percent on Apple, is this the same as a 3 percent yield on General Mills? No. I can’t look out 5 years and have much confidence that Apple is going to be able to just continue to be the hit factory and maintain these incredible profit margins. And if they don’t, then the stock is not going to do well. The dividend is going to be a rounding error in the performance of the stock. General Mills on the other hand, they’re in kind of a funk right now too, people are not buying quite as many of the ‘center of the store’ grocery items. There’s a little bit more health consciousness and the competition has ramped up a little bit. These things come and go, even the food industry has little cycles to it, but in 5 years it’s going to be a bigger, more profitable company that will raise the dividend a good 7-8 percent a year over that time. Chances are very good that’s going to correlate to stock price appreciation in that general range on average. No matter how good the dividend is, it doesn’t turn a bad business into a good investment. Apple is a great business, the question is, can it sustain that? And boy, I am the last person who should be allowed to answer a question like that.
Rob: [Laughs]. Well, you and me both. I mean I’m sticking with it for now but I have the exact same concern. Okay well, let’s kind of get practical then. For folks listening, they say, “Okay, I may want to invest in some dividend paying stocks,” or maybe they already do. How does one go about approaching this? Is there a framework that someone can use? Is there some criteria that you look to when you’re picking companies that you want to possibly invest in?
Josh: Well it starts with having a basic read of the market. What can I get in terms of a dividend yield? What’s the sweet spot? I think right now where we’re at, in a very low interest rate environment, in a period here where stock prices and evaluations are at pretty high levels in a historic context, you don’t want to be thinking in terms of, “I need to get a 6,7, or 8 percent yield for my portfolio.” You push up that high and there are stocks out there that have double digit yields but they’re there for a reason. That yield is telling you that the dividend is very risky whether it seems to be sustainable or not. It could be a mortgage REIT where every time the shape of the yield curve changes, the dividend rate is going to change. If you don’t understand what I’m talking about then definitely don’t own one of these things. They’re basically complicated bets on interest rates. These aren’t businesses that most people can readily understand and be able to predict the performance of. But at the same time, I think you want more than the run of the mill, pedestrian, 2 percent yield that you get from the market. My sense of where that sweet spot is somewhere in the high 3 to 4 percent. My portfolio yields about 3.9 percent right now. Once you’ve got that, then it’s, “Okay, how do I put the collection of companies together that can meet that?” My basic screen is dividend yields over 3 percent. That’s not to say that I’m not occasionally willing to make an exception and go a little bit lower if there’s a lot of growth. But basically, 3 percent is where I start and I look up to as high as I can go without having a lot of risk. These are proprietary metrics for Morningstar but I look for economic moat ratings that we have of narrow or wide. And what that just implies that we think the company has a very strong competitive position. Wider being stronger than narrow. But both of those being better than none. Every so often I have somebody ask me, “Well, why don’t you own DuPont or Dow? These are companies that have paid dividends for hundreds of years.” Look at how poorly the dividends have grown over time. They’re either cyclical businesses that can’t really control their costs or what they’re able to charge for their products. Dow Chemical used to brag about how it has never cut its dividends since they went public very early in the 20th century. And they cut the dividends then in 2009! The dividend bounces back. But it’s just cyclical. It’s not steadily creating value for shareholders like you would hope to see in conjunction with the large and growing dividend. That’s an excellent proxy for quality too, to find a business that has a good chance of maintaining a strong competitive position over a very long period of time. From there, I start digging into individual companies and it’s just all about the dividend. It’s weird. They say I’m the bearded dividend guy but it’s really true. When I’m looking at an individual stock, everything I consider about the business goes through the lens of its impact on the dividend. Is it safe? Will it grow? What kind of total return can I expect based on the dividend yield that the stock is priced for and the subsequent growth rate of the dividend that I’m expecting? Anything else that you consider about the business— the quality of management, capital allocation practices, financial leverage, operating leverage, cyclicality of revenue— all of those things get organized into these three questions. That’s the way I present the analysis in the newsletter, because that’s the way I actually go about looking at these businesses. It provides a really good tool for connecting A to B, and organizing all this information about an individual stock and helping me pick even the stocks that I want to look at and then organizing the information about them. I’m just going to bypass the whole circus of the stock market and everything on TV every day, and go right to, “How does this affect my income stream and my portfolio? Does this play a positive role or not?”
Rob: Well, let me ask a specific question. One of the metrics you mentioned was financial leverage. I know that’s one of the metrics you talk about in your book. So I’m looking at stock that I own that does not pay a 3 percent yield. I own shares of Deere & Company. Their financial leverage at the end of their last fiscal year was 6.77. What does that mean? And how should one go about evaluating that?
Josh: That’s a good point. One of the problems that you run into when you’re trying to do what I do a lot— which is is trying to help people help themselves by educating them and not just telling them to buy such and such stock. Here’s how to think about it and how to evaluate it. There are lots of non-obvious ways those statistics might be less meaningful. And Deere is a good example because most of the leverage at Deere is its financing subsidiary where they lend money to dealerships for inventory and they lend money to farmers to buy their equipment.
Josh: And that type of a business is basically a bank. They’re borrowing money on Wall Street as opposed to taking deposits. Then they’re lending it to another group of people at a higher interest rate. You have to pull that out of the balance sheet basically and look at that banking business and financing on a stand-alone basis and then look at the rest of the balance sheet. When I looked at Deere that way, as I did a few months ago— I was giving the stock a look and it was down around $80. And I thought, “Well, the yields coming up here. Let me think about this.” I felt like they were continuing (as they have done historically) to manage their balance sheet conservatively. Because it’s a very deeply cyclical industry. The cycle right now is heading south on them. I live in central Illinois and it’s very easy when you live in farm country to be aware of the fact that crop prices are falling. And with it, farm incomes and the wherewithal to buy brand new tractors and combines and other equipment. So I got the sense that they’re not going to have to cut the dividend, even though earnings are going to come down. The balance sheet is strong for a reason- so that they can continue to maintain that commitment to shareholders even during the downturn. But it’s not likely that there’s going to be much for dividend growth while earnings are dropping. And it’s a cyclical down turn that could last for awhile so I said, “Yeah, Deere is a high quality business. It’s what we look at as a wide-moat business and very strong competitor in agricultural equipment. The trouble being, it’s going to trade up and down based on those cycles and I just didn’t feel like it was cheap enough to buy at this point. But the question on financial leverage, sometimes the best shortcut is just what’s the company’s credit rating. And Deere I think has an A or A minus credit rating. Don’t quote me on it. But that’s a pretty solid number because the credit rating agencies are aware of the cyclicality of the business as well as management’s history of dealing with that cyclicality. That expresses that the company has a reasonably strong balance sheet. And then you have to compare the dividend to how far could earnings drop. Well, Deere could conceivably lose money at the bottom of a really deep cycle. If you go back to the 80’s when things were really, really, bad, they actually cut their dividend several times. But the last couple of downturns in the industry over the last few decades, they haven’t had to resort to a dividend cut. So I think that’s a more positive sign that they can maneuver through this next down cycle without having to cut the dividend. You just have to be aware that the cycle could last awhile and it could be awhile before the stock really makes an upside move. It could be awhile before the dividend grows again. And if it gets bad enough, it’s not outside the realm of possibility that they could have to cut the dividend. So you have to be true to yourself going in, “Is this something where if the stock price falls by half and maybe the dividend is even going to be cut, could I still buy more so that I could come out of this with a good total return at the end?” You’re not just going to go bust. If they cut the dividend, they’ll bring it back. But that’s not necessarily the risk profile that most dividend investors are looking for.
Rob: Right. Well you know it’s interesting to listen to you, because as I thought about what you were saying it really describes exactly (for me) the kind of company I want to invest in which is one where I don’t really have any reason to believe the company is in peril at all, but it’s got a lot of head-winds right now. I mean, commodity prices are down and as you said, people don’t buy tractors. There will be some pent-up demand and eventually it will spring back, but you don’t know when. Right?
Josh: Yeah. My complaint is much more about valuation in that you’re looking at a pretty significant downturn in US farms income and that’s the bulk of Deere’s operating income— from making tractors for American farmers. Then you pull up a stock price chart and the stock hasn’t really made any forward progress here in about 4 years since early 2011. I just pulled up the chart here on my computer. It got up close to $100 and today it’s at around $90. Now the rest of the market has done very well, so Deere has certainly under-performed relative to the market. But the stock is still up pretty close to it’s all time high range, even though earnings are going into the tank. At a point, you want to be able to say, “Hmm, am I really paying a price that is going to give me the old Graham and Dodd margin of safety for this cycle lasting longer or taking the company down further than people currently expect?” There’s a fair amount of optimism or at least a happy-go-lucky attitude I think in the stock price up here. Now it’s not to say it’s hugely over-valued. I think our analyst has a fair value estimate on Deere that’s in the neighborhood of where it’s trading now. But if you want to be a buyer of a cyclical business like this, I think you want to pay a pretty good discount. Then, if on top of that you are interested primarily in income, you have to ask yourself if it meets your need to maintain and grow a stream of income or is it something that may be better for other types of strategies. It’s kind of the Apple story again in that a stock can have a yield of 3 percent or maybe even more. An above average yield. But that doesn’t mean it has the risk characteristics— the predictability that leads to the confidence to expect a good results. That one is tough. If I’m going to buy a cyclical, I typically want it pretty cheap and I don’t think of Deere as being cheap at all.
Rob: Interesting, interesting. What about return on equity? How important is that to your investment decisions?
Josh: Well, there’s another statistic that can be so messed up. [Laughs]. Obviously, I like it to be higher as opposed to lower but you really have to acquaint yourself with a balance sheet of an individual business. Clorox, for example. At some points over the last couple of years, their shareholder equity has actually been negative. You get people saying, “Wow, they have no equity? The company is going to go bankrupt. They have all this debt and no equity. This is terrible!” Well, that’s really a function of the company’s assets not showing up on the balance sheet. Their main asset is their ability to sell Clorox for more than the store brand because it’s a better product. They’re more efficient manufacturers. They’re more profitable because that brand name has been established over the past 100 years… Those are very important assets, tangible assets. But they don’t show up on the balance sheet in this case. You see it in the cash flow. If you look at the debt relative to the cash flow, it’s very reasonable, I think it’s in the low 2 times Eva Doss range for debt. Again, that is where sometimes it helps to look at a credit rating or something like that. More than the balance sheet. But the same thing that distorts their debt-to-capital ratio, distorts their return on equity. It looks like it’s infinite. Instead, I think it’s better to consider how much does this company have to reinvest in order to grow? Clorox, in this case, is kind of an interesting example because they typically convert all of their income, on average, to free cash flow, which means what you see is what is available to distribute to shareholders, yet they still have the ability to grow a little bit without having to plow money back into the business in that classic sense. You compare that to a utility. A regulated utility might have an allowed rate of return of 9 or 10 percent and it’s actually very expensive to grow the business because at a low return, that means you have to put a lot more dollars to work in order to get a dollar of earning growth. Now your 10 percent is still a good number for a utility but it’s very situational. I wish there were better rules of thumb on how to think about these things but you do have to get in there a little bit and understand how an industry works and the relationship between things like capital spending and growth over time, and understand what the statistics mean opposed to what they are.
Rob: Well, let’s talk more strategically in a way. If someone wants to invest in dividend paying stocks, how many companies should they be looking to buy into to have a somewhat diversified portfolio of investments?
Josh: Part of that would depend on how much money you’re dealing with. If you’re just getting started and maybe you’ve got a couple thousand dollars that you’re working with, I don’t think you have to own 25 different stocks and have the burden of dealing with lots of little trades and expenses associated with that. If you’ve got half a million dollar or a million dollar portfolio, then maybe the number is more 20 plus or minus. My target for the model portfolio I manage is 22 to 28 stocks. I recognize that not all subscribers are going to buy all the stocks so I want to at least have a subset of those that are buys most of the time and that people can put capital to work relatively quickly. There’s a tradeoff. Most people over diversify and forget that the more diversification you add, limits your risk in certain ways. But it increases the risk that you don’t really understand what you’re doing. For an individual investor to own, say, 50 stocks, you can’t know that many well enough to make very good decisions about any of them. I do this all day, every day and I wonder if you can even know 25 companies well enough. Now, I have the benefit of 100 analysts that work for Morningstar to shepherd me through the weeds and make my thinking more productive. The tradeoff is you don’t want to have all of your money in just one or two stocks because if one of them goes bust, then you’re in really, really, tough shape. But there’s not much merit in having so many companies that you wind up with companies going bust and you didn’t even know why because you didn’t have time to pay attention to it. I think 15 to 20— for a sizable portfolio, probably strikes the best balance between knowing what you’re doing and not being over-concentrated.
Rob: For those who also own mutual funds or ETFs, how do you work your asset allocation between the individual stocks that you own and all of the mutual funds or ETFs that you own?
Josh: Yeah. You’d have to put them all on the drawing board and see. If you own a lot of top blue chips that pay good yield, like General Electric, Johnson and Johnson and American Electric Power and things like that, you might look into a dividend fund that you own and realize that the dividend owns all of those too. Are you really getting a benefit for diversification in exchange for owning that fund? You may not be getting that much of a benefit, but you’re certainly paying for it. That’s something that makes it kind of tough for funds to really focus on dividend income. I recognize that I’m getting into a bit of a tangent here, but if you’re running a mutual fund, a typical 100 basis point expense ratio, and you have a portfolio that yields 3 percent after expenses, the dividends that are paid out to the fund’s shareholders is only 2 percent. A lot of the income just gets sucked up by the fees. So the opportunity to own the individual stocks directly, especially among some of the bigger blue chips that are relatively easier to understand and should be financially stronger than smaller companies or foreign companies are where I think active funds can add more value. You can save yourself maybe 1 percent of your assets, but maybe it’s a third or a quarter of your total income. So yeah, loop everything in when you’re considering your asset allocation. I’m not in a real good position to tell people what they should have in bonds or annuities or other types of equity strategies, but I would say this, if you’re moving into portfolio withdrawal mode, you may still want to have some fixed income exposure. But again, you’d have to question how many other types of equity strategies are really going to help you reach your financial objective. High quality, conservative, dividend paying strategies can carry most or even all of the load for a lot of retired investors. It could be their whole equity allocation. They don’t need a tech sector fund or a gold fund or an emerging market fund in order to be properly diversified.
Rob: Right, right. So I know for your dividend investor newsletter (which I’m holding the latest copy now) obviously, they’re all dividend paying stocks. But, would you ever consider maybe for your own portfolio, a non-dividend paying stock? Or are those just totally out of the question for you?
Josh: They’re not totally out of the question but so much of it comes back to what am I trying to accomplish? I expect, like most investors, that I’ve got to build this portfolio up to where eventually I can live off of it. What’s the clearest and most reliable path to get there? It’s going to be dividend-paying stocks. The other thing that I have a passion for, honestly, is small and microcap stocks. Those typically pay lower yields, or more frequently, just don’t pay anything at all. If I can find something that’s really cheap, and I’m making more of an entrepreneurial or enterprising investment, then maybe dividend isn’t immediately part of the situation. I’m interested in capital gain, if I think I have a clear line of sight to get something. But it’s been awhile since I owned any stocks that didn’t pay a dividend, because both professionally and personally, I see again and again that having that dividend income is an advantage to your total return. And just the signal that it sends, about the kind of business you’re dealing with, the kind of management team you’re dealing with— that’s really valuable as well. So even though I own a couple of stocks— Right now I own 3 stocks that Morningstar doesn’t cover. They’re small caps. I own some shares in my personal account too and all 3 of those stocks pay dividends, too. That’s just kind of the way I like it.
Josh: In the best of worlds, you can do both. You can have a good dividend and you can find a stock that is cheap enough that you should be able to get a really nice capital gain out of it. That doesn’t happen very often, but when it does happen take advantage of it if you think it’s something that’s worth trying to accomplish. But I’ll go back and harp on this one more time about knowing what you’re doing. In The Intelligent Investor, Ben Graham’s work for ordinary investors (as opposed to security analysis which is a really heavy textbook, type tone) he, very early on, separated between the defensive/passive investor, for which he gave one set of prescriptions on how they should deal with their money and the enterprising/entrepreneurial investor, for whom he had other recommendations. You really have to decide very clearly which you are. Perhaps you’re doing some of both. But then you want two different accounts. And you want to think about them and operate with them separately. You need that strategic clarity so that you just don’t start wandering all over the map. I think it’s very valuable to know what it is that you’re trying to do, before you go ahead and try to do it. [Laughs].
Rob: Right, right. Let me take kind of a left turn with this next question. I know you focus a lot on rates. Obviously they can have high yields. But today, are REITs or at least US REITs over-valued?
Josh: In general, I think so. That’s a bit of a problem for me. I get questions about interest rates and sometimes it’s kind of frustrating because I think sometimes people treat me like I’m a bond manager or something like that. I assume that interest rates are going to go up longer term. I think that’s an important planning assumption when you’re looking at valuations. Most of the REITs that are out there right now are not priced in a fashion that they will be able to sustain their valuation levels if the 10 year treasury goes to 3 or 4 percent. They’re going to come down in price. There are a couple, actually right now I just recently bought some shares of 1 REIT, called Ventas, in the healthcare area that I think their growth values are under-valued. Relative to other REITs, it looks pretty cheap and I expect it to do well even as interest rates eventually rise. But across the board, I would like interest rates to kind of get on with it. Let’s have interest rates go up because I really am much less interested in the quoted value of these stocks in the short term than I am in having the opportunity to reinvest dividend income and put new money to work at higher yields. Those higher yields are going to correlate to higher total returns over the long run. It’s a difficult mentality to adapt yourself to which is, “I’m not going to look at the statement value. I’m only going to look at the income.” I’m covering my eyes here while I’m even talking. I’m not going to look at the statement value. I’m going to let the market do what it’s going to do from month to month. Over a series of years, definitely you want and should expect capital appreciation. But in the short term, when things are bouncing around, you have lots of stuff going on that you can’t predict, your best defense is to focus on the income. And pay enough attention to valuations so that you don’t buy a stock that simply can’t sustain its current price if interest rates to the 10 year treasury goes to 4 percent. Someday I’m sure it’s going to. I may not know when, but REITs, as well as utilities have gotten to a point maybe a month or 6 weeks ago, they were so over-priced that I couldn’t find anything to buy.
Josh: Now the momentum is broken. Interest rates have come up a little bit. But the share prices have really reacted quite strongly to the downside and now I’m happy about it. Now I get the opportunity to put some more money to work and it’s not my entire portfolio— there are other parts of the portfolio that have done well to offset that affect. There’s lots of moving pieces. With REITs, I think you need to apply the same kind of quality standards to them that you would apply to any other sort of operating business. But over the long run, I think you want those to play a valuable role in an income strategy. And higher interest rates, higher dividend yields… Even at the expense of lower stock prices— that’s going to help and not hurt your ability to compound your future income.
Rob: Right. A question about the tools that you use to track your portfolio/ I use (among other tools) Morningstar’s Portfolio Manager. Is that what you use to track the dividend investor portfolio that you manage? Or do you guys have proprietary tools? How do you track all of the dividends and returns, the dividend reinvestments?
Josh: I built my own spreadsheet from scratch to do that. Maybe that’s a little bit of my OCD showing up or something [laughter]. But there were proprietary statistics that I wanted to track that, unfortunately, aren’t even available in our portfolio manager on Morningstar.com. I use all of our ratings information. And that information is available on portfolio manager and feeds right through to the dividend investor website. But there’s one statistic in particular that I wanted to calculate, and that was dividend growth for my portfolio which is very important. I always come back to balance— I want the high yield but I also want the growth. I’m going to insist on both every time, every stock. If I’m not getting a growing dividend, maybe the next thing that’s going to happen is it’s going to get cut. In order to track that, I think in terms of starting the year— let’s say, a hypothetical $100,000 account. I’ve got a $4,000 income stream off of that. That’s a 4 percent yield. After a year I wanted a way to see how much my income has grown and how? If I’m re-investing my dividend income, then that’s going to buy more shares and increase my income, but I also want to specifically look at what are the companies doing for me. If after a year, let’s say all else being equal, that $4,000 has gone to $4,300 then now I know that was a 7.5 percent growth in my income just from the company. I didn’t have to do anything to get it, it was just a matter of the companies that are out there working hard, using my capital as a shareholder, growing their businesses and, in turn, paying me more and sharing that prosperity with me. That I think is a better reflection of how your portfolio is doing in a year than whether or not the market value went up 30 percent or down 20 percent. I would much rather have that underlying income because it’s going to converge with your market value over time.
Rob: It’s interesting you mention that statistic. Last night I was doing my own spreadsheets of a number of companies and I was tracking growth of dividends, revenue, net income and I noticed that dividend growth was significantly higher than earnings per share, among other statistics. I’m thinking of IBM in particular. Then I went to the payout ratio and it hadn’t changed much. They were buying back a lot of shares so the number of shares outstanding have gone down. You talk about this in your book, but I’m curious as to your sense. Are share buybacks good for investors?
Josh: Mostly not. [Laughs]. I don’t mind share buybacks playing a supplementary, secondary role in returning cash to shareholders but they simply aren’t a substitute for dividends. All you have to do is ask, “Where does the cash go?” IBM is a good example, where they have spent tens of billions of dollars on share repurchases. Lots of those shares were bought back at higher prices than the stock trades for now. If they had paid the same sum out as dividends over the years, then shareholders would just be richer to exactly that amount. Instead, by keeping control of that cash and essentially forcing their shareholders to reinvest what could otherwise have been cash dividends back into IBM shares—because that’s kind of what a share buyback is. It’s a mandatory dividend reinvestment program that has not worked out real well. Even if the stock had gone up, they still say they’re going to return 20 billion dollars to shareholders, But if only 4 billion of that is dividends and 16 billion is share buybacks, well how much are they actually paying? And to whom? Well, 4 billion goes to the people who actually still own the stock and 16 billion went to the people who used to own it, the people who sold it— the least loyal shareholders. That’s not my idea of how you really want to share the prosperity of a business— by paying people to go away. I can’t remember. That’s a brilliant quote and it’s not mine— I can’t remember quite who used that. It was a mutual fund manager who used that phrase to describe share buybacks and didn’t like companies, who pay people to go away. But there’s a real element of truth there. Share buybacks statistically, for the market overall, are still much more popular among companies than dividends and it’s because they don’t instill the same level of discipline. Companies can turn the buyback spigot on and they can shut it off to divert the cash elsewhere, make a big acquisition, expand the empire… CEO gets a big pay rise out of it. Maybe shareholders benefit but more than likely they don’t. Or you’ve got managers who are paid on the basis of earning for share growth as opposed to absolute earnings growth. Share buybacks help with that and dividends don’t even though the dividends provide the shareholder with a more certain return, something that they can actually put in their pocket. So where share buybacks come in, I think, is when the company has excess cash, they already pay a good dividend but don’t want to raise it to a point where they might have to cut it or that it would create financial pressure in a future downturn. To use buybacks as a way of returning a little bit of additional cash after a big dividend has already been paid. I typically don’t complain about that too much, but even in those cases, when do companies buyback the most stock? When they’re the most profitable and generating the most cash. Well, where do you think their stock prices are when that’s happening? They’re at the peak. And some of those shares get reissued at much, much, much, much lower prices in the next downturn. That’s what we saw with the banks that were buying back tens of billions of dollars worth of shares then reissuing them just a year or two later in the heat of financial crisis. Dividends don’t hurt anybody. I suppose there’s a very rare case where maybe a company paid out too much in a dividend and they didn’t reinvest in the business or they stressed out their balance sheet perhaps a more conservative approach would have served everyone better in the long run. But for every instance like that, there’s probably 100 or 500 instances where the company isn’t paying out enough of a dividend and shareholders on balance are going to suffer as a result.
Rob: Right, right. I’m curious. Your book came out I think in 2005. Is there another book in your future?
Josh: It was actually early 2008. I was writing that through the peak of the last bull market in the 2007.
Rob: You talked about low 5 percent interest rates in the book, which I found kind of funny given our environment today.
Josh: Yeah. When I look at my own spreadsheet I’ve got an interest rate series in there and I’m like, “Wow, it was 5 percent back just a couple of years ago?” Now that would seem just like money falling from the sky.
Rob: So is there going to be another book, or are you done writing?
Josh: Well, I don’t often tell this story, but I’m going to tell it because it provides the best backdrop for why I say, no. When I was writing the book, I got to find out just how good the service is in an emergency room when you walk in and announce that you have chest pains which is what I did 3 weeks before my deadline. I felt like everything was just in total chaos and disarray and I was just going to blow my deadline and then, of course, the world would come to an end. Well they put you in a room right away. They call in the doctors and the nurses. They strapped all this equipment onto me and they started snickering (I could see around the corner). Then they disconnected it all, gave me a bottle of Xanax and sent me home. So no, I’m not so interested in writing another book. [Laughs].But what the book accomplished was to have this long form, open-ended discussion where I could get into a lot more of the details of how to analyze a business, how to analyze dividend safety, how to analyze dividend growth like some of the things we talked about earlier, like Clorox not having any shareholders equity and what that means for their financial condition. Those kind of things I could cover in the book, whereas it’s very hard to cover that in the newsletter. The newsletter is more oriented around what is going on and what the best ideas are now, But the newsletter is basically an extension of the book. It’s a piece of the conversation that gets added to each month. Then there’s my online comments and whenever I make some trades that goes out by email. So that all is continuing to develop the conversation that started with the first issue of the newsletter back in January 2005. Then there was the book release in early 2008. The book has lots of examples that are dated and some that are frankly wrong. I mean, if you write a book like that, you know, 300 and some pages, and you look back and say, “I said some really stupid things.” I think I pointed out that there had been more utilities that had cut their dividends in the previous 10 years than banks… Wow that was dumb! [Laughs]. It was accurate because the utility industry had gone through the Enron period, the implosion of energy trading and merging generation and there had been quite a few dividend cuts and banks hadn’t had a serious downturn going back to the S&L crisis. So it was a true statement but it really underestimated the risk profile of the banking industry. There’s a lot more examples in there about banks than I would have today if I was writing a book. But that’s the nature of how things evolve. What I’ve found is that the core principles that I’ve really had since the first year– Is it safe? Will it grow? What’s the return? What’s the framework for evaluating a stock? Looking at the dividend income and the growth of that income over the course of a year is an indication of how I’m really doing and not really messing around with these head to head comparisons with the S&P. Those types of principles that I laid out early on in the newsletter and then amplified with the book, those have really stood the test of time very well. I’ve made mistakes. I mean, believe me, I’ve made plenty. It’s been in execution. It’s been in buying stocks that didn’t turn out to actually meet the standards that the strategy should have demanded from them. I’ve owned lots of banks going into the crash and I learned some painful lessons. If there’s a lot of leverage, however, that’s defined, that is your enemy as a shareholder who’s looking for a dividend, because those creditors are always going to get paid first. So that, again, is where the newsletter comes in real handy. I like that the book is out there and that I don’t ever have to write another one or rewrite that one. But the lessons that are in there still apply. And I’m still using that same framework every day in managing our portfolio and writing about the strategy.
Rob: Well that’s great. And I really appreciate your time. I’ve kept you a long time. Let me ask you one last question. For folks that want to learn more about investing in dividend stocks, obviously they’ve got your book, The Ultimate Dividend Playbook, and I’ll link to it in the show notes that go with this podcast. Are there other books, resources, websites, blogs that you think are good that have influenced your thinking on dividend investing?
Josh: Not really. [Laughs]. I hate to say that, but there aren’t a whole lot of people that are out there, especially in the Wall Street institutional universe, who really prioritize dividend yields the way my strategy has come to do. I’ve got some friends in the business who run some similar strategies, but it’s hard to find. Maybe this is just a function of the way I think, or maybe I’m just being conceited or something like that, but when I see other people talking about dividends, I see people glob onto one end of the spectrum or the other. They’re either very excited about dividend growth. Dividends growing 15, 20, 25 percent a year. Then I look at the stock and the yield is only 1 percent. That kind of growth rate can’t be kept up forever and most of the growth is an expanding payout ratio, it’s not growth and earnings. So I can kind of pick it apart and say, “Yeah, that wouldn’t work for me.” Or much worse, people tend to glob onto the mortgage REITs and the BDCs and they’re buying these black-block financial creations that really are very hard to understand and have loads of risk that can blow people’s portfolios off. But there’s a lot of attraction in the idea of a double-digit dividend yield. If they really existed and were safe, sound, reliable and could still grow that would be great. But that’s just not the case. So I tend to have a high yield relative to most of the strategies that are offered by mutual funds and even ETFs, but I’m still insisting on a lot of quality. I’m still insisting on dividend growth from all my holdings. And, off the top of my head, I only know of 1 mutual fund manager of the Federated Strategic Value Dividend Fund who runs a strategy very similar to mine. We talk on the phone every so often. We just happen to own a lot of the same stocks because there are only so many to pick from and we do think alike. But, I think what’s more important than finding lots of different voices from people who are talking about dividends, is to remember something that I said earlier, which is that a good dividend doesn’t turn a bad business into a good investment. The best resources, for me, are the ones that make sure that I’m buying good businesses and Morningstar’s own research provides a lot of that. The kind of books that I’ve read in the course of developing my strategy has been reading Graham & Dodd. It’s been reading Warren Buffett. The first book I read on investing when I got interested in the stock market when I was 13 years old was, One Up On Wall Street. I’m a big Peter Lynch fan. You know, these were not people who necessarily prioritized dividends but they are keenly interested in how the businesses were operating and what the numbers mean and how does this turn into a good investment versus a bad investment. To have that sort of dividend overlay where I say, “I want a good business at a fair price but I also want this dividend,” what it does is narrow down your investment universe, makes it more manageable. And frankly, it gives you a better class of companies to use these timeless principles to pick through, evaluate, and try to get the best one.
Rob: Well that’s great. I appreciate it. I haven’t finished reading it, but I’ve taken a peek at Buffett’s shareholder letter that went out last week and I think if you’re still doing your Dividend Investor Newsletter in 20 years you might be able to add Berkshire Hathaway to your portfolio. They might just be paying a dividend then. But not now.
Josh: Yeah, maybe 2 or 3 years ago he had taken on this question about a dividend from Berkshire in 2012 and I wrote a cover story for Dividend Investors the following month. It was titled, In Buffett We Trust, All Others Pay Cash. I thought it was kind of clever, but it also hit the nail right on the head in terms of how I felt on that. He’s the exception that proves the rule. He’s been able to invest in basically any kind of industry, whether it was listed securities or privately issued securities or swallowing whole businesses and has been able to generate very high returns on capital, for a very long time. He can go anywhere and do anything. Can General Mills do that? I love General Mills, but if General Mills decided that they were going to buy a machine tools manufacture in Israel like Buffett did, I don’t expect General Mills to be able to do something like that and pull it off. And I don’t want them to. When General Mills pays me a dividend, they’re giving me the opportunity to do with those profits whatever I want. And high on that list is to allocate it to other businesses that I get to select. I get to make those decisions as opposed to the executives and the board at General Mills making those decisions. Buffett can go anywhere and he’s created a cliental and class of shareholders who accept that deal and aren’t looking for dividends. But from other types of companies, I want General Mills to be the best cereal manufacturer and the best yogurt manufacturer. And they work very hard at that. The profits that are left over after they’ve reinvested what they can in a business that doesn’t grow very fast— It’s not Apple or anything like that but does fairly well, the rest of the profits can come back to shareholders so that shareholders can reallocate the capital. That’s not just good for General Mills as a business, by keeping them focused on the food business. It’s not just good for me as a shareholder because I’m getting the opportunity to control what’s happening with the capital instead of having all the control remain with the companies themselves, it’s good for capital to get out there, be recycled and circulate so that mature businesses that don’t need all the cash they generate can provide that money back to the market. And the market can reallocate it. Individual investors can reallocate it instead of it being siloed. Google is kind of the example there. A great business, an online search. But does this really translate into them being the ones who will invent the self-driving car? Maybe they can pull it off. But the odds of having back-to-back, once in a century type innovations is pretty low. I think Google would be an interesting investment. I think it’s a good business. But, it doesn’t have a dividend at all. If there was a good dividend policy in place as part of a good capital allocation strategy, then I would be interested in owning that.
Rob: No, I agree completely. Particularly on Google. It would add some discipline to how they’re allocating their capital. And right now they make so much money and they don’t pay a dividend so they don’t have to have discipline. They can spend it however they want. And they’ve spent more money on projects that they then just shut down. Anyway, that could be a whole other podcast. Well, I promised that would be my last question, but this is a quick one though. In your Dividend Investor, do you automatically reinvest the dividends into the companies that paid them? Or do they go to cash and then you decide where to invest the money?
Josh: The latter. I call that ‘active dividend reinvestment’ as opposed to passive or automatic. The automatic plans are nice, especially if you’re dealing with a small portfolio and you can have those dividends reinvested for free. That’s just more efficient. But if you’re collecting a couple thousand dollars a year worth of dividends or more, then pick the best stock at the time to put that capital into. I think that adds a little bit of value relative to just having every dividend go back into the company that paid it.
Rob: You know, one problem I’ve had— and this has absolutely nothing to do with really active dividend investing, but it’s with the Morningstar Portfolio Manager. It’s easy to click a button and have it automatically show the reinvestment of your dividend. But, if you don’t want to do that, it’s not as easy to use the portfolio manager if you want to do active dividend investment.
Josh: Yeah, well it turns into individual trades. Then you’ve got cash balance to contend to in the meantime. The accounting gets a little bit more difficult, but all of these things always take place in the context of tradeoffs, “Am I adding enough value to my portfolio over the long run to have it be worth the work or is the automatic strategy passive strategy the way to go?” Thus far I’ve been satisfied that I’m getting enough value from the active approach to continue doing it, but different people are going to have different looks at that.
Rob: Well, Josh listen, I really appreciate your time. I’m a big fan of your work. I love your book. And again, thank you for being on the show.
Josh: Wonderful questions. Wonderful conversations. I was very happy to join you here today.
Rob: Great. Thank you so much.
Josh: Thank you.