Vol. 9 11 DividendInvestor - rebel Financialrebelfinancial.com/wp-content/uploads/MS-Dividend... · The Dividend Drill 17 Boardwalk Pipeline Partners Vornado Realty Trust Josh Peters,

It still doesn’t feel like mass prosperity—perhaps because it isn’t—but 2013 is shaping up to be the best year for the U.S. stock market in the nine-year run of DividendInvestor to date. As of this writing Nov. 13, the S&P 500 Index stood at yet another all-time high—the 33rd new high since topping the 2007 peak in April. Investors have enjoyed a 27.3% year-to-date total return. If we finish the year at this level, 2013 will be the highest-returning year since 2003, and the best year since 1998 that didn’t follow an annual decline. (In the case of 2003, its 28.7% return followed three straight years of negative returns.)

A year like this one can’t help but inspire some strong emotions. Certainly the updraft in stock prices reflects that cash is moving into the market, perhaps by selling bonds that have lost their luster. I also detect plenty of nervousness, particularly in emails from DividendInvestor subscribers and media stories describing a “melt-up” in prices. In the past 14 years, two romping bull markets were followed by plunges exceeding 50%. Economist John Kenneth Galbraith, a historian of euphoria and panic in markets, once wrote of the “extreme brevity of the financial memory … There can be few fields of human endeavor in which history counts for so little as in the world of finance.” Perhaps our collective memories aren’t quite as short as they used to be. These days, it seems there’s a bubble around every corner.

Fear of loss is a valuable trait for investors to have. No amount of upside is worth considering before

you’ve contemplated the possible risks and losses. Still, I think it’s important to separate the trend in stock prices from their value, as the latter holds much more sway over our long-run fate. Just because the S&P is up more than 40% since the end of 2011 doesn’t mean that stocks have become absurdly overpriced. I think it’s more accurate to say that stocks were absurdly cheap in 2011 (a conclusion that I, like a lot of investors, missed at the time) and are now in the ballpark of fair value.

I say this with the following context in mind: Stocks are no longer cheap, they will not go on rising forever on the 20%-plus annual track they’ve been on, and a downturn could strike at any time. But for long- term investors, I don’t believe this is a time to bail on stocks. Instead, it’s yet another opportunity to focus on strategy and controlling the variables we can.

Know Your P/E HistoryPrice/earnings ratios, often referred to as simply multiples, are hardly the ultimate yardstick for value. Some companies, industries, or periods of economic history merit high multiples; others deserve low ones. Still, this statistic has some value in appraising value, particularly for the stock market as a whole.

Builder Portfolio 4Still more dividend hikes and fair value increases in a strong 2013

Builder Focus 7Procter & Gamble: We believe a slow and steady revival is underway

Harvest Portfolio 8Record number of dividend and distribution hikes last month; details on recent trades

Harvest Focus 11Altria Group: Overpriced if profits eventually decline, but that’s a ways off yet

Income Bellwethers 12What will Chairwoman Yellen mean for interest rates?

The Dividend Drill 17 Boardwalk Pipeline PartnersVornado Realty Trust

Josh Peters, CFA Director of Equity-Income Strategy and Editor

Continued on Page 2

Seems Reasonable, So Let’s Carry On

DividendInvestorDecember 2013 Vol. 9 No. 11

Quality recommendations for current income and income growth from stocks

SM

p Trailing P/E p Median

Data from Q1/1989 through Q3/2013. Source: Standard & Poor’s.

S&P 500: Operating P/E Since 1989

89 91 93 95 97 99 01 03 05 07 09 11 13

30

26

22

18

14

2

The preceding chart uses trailing operating earnings per share for the S&P 500 to determine the market’s P/E, and it goes a long way toward explaining recent gains. Since the end of 2011, earnings for the S&P are up only 6%, but the price level of the index has surged nearly 42%. The P/E turns out to be the swing factor, moving from 13.0 then to 17.4 today.

The lack of earnings growth raises the notion that this has been a low-quality rally. However, looking at the history of the market’s P/E, it’s hard to say that the stock prices are way ahead of earnings: The median P/E since 1989 (17.8) is actually a bit higher that the current level. It’s far easier to conclude that stocks were cheap in 2011: The S&P’s P/E of 13.0 at year-end was the second lowest since 1990, following only the third-quarter 2011 P/E of 12.0. The most obvious explanation for the recent rally isn’t monetary stimulus or the rapid formation of bubbles; it’s that the market’s P/E simply went back to normal.

Reaching further back into market history, one can draw a slightly different conclusion. S&P only has quarterly operating EPS data from 1988 onward; before that, I blend in results under generally accepted accounting principles on the premise that unusual items were indeed more unusual back then. On this basis, the median P/E since 1946 is 15.8, and here we stand at 17.4. If this comparison suggests that stocks are 10% overpriced, it’s important to recall that long stretches of low P/Es are usually associated with periods of high inflation (1946–1948, 1951, 1968–1982). Given how low Consumer Price Index inflation is right now—about 1.3%—a P/E ratio slightly above the long-run median makes sense.

Evaluating the ‘E’The price in P/E ratios is easy. The earnings, however, are wide open for interpretation. Lots of technical details muddy the waters. Should we use trailing earnings or forward-looking forecasts? (For macro purposes, I prefer trailing—in addition to a timing mismatch, Wall Street consensus earnings estimates tend to be too high.) How about operating earnings versus GAAP? (Operating results that exclude unusual gains and losses is the market’s convention, so that’s what I used above, but it is fairly noted that nonrecur-

ring losses have a habit of recurring and do reflect a loss of shareholder value. Since 1989, profits under GAAP have typically been 10% lower than the oper-ating figures provided by companies.)

Cyclical conditions have a significant effect on P/E ratios too (especially under GAAP, since unusual write-offs have surged during recent recessions). Yale professor Robert Shiller, author of Irrational Exuber-ance and, as of this year, a Nobel laureate, believes earnings should be smoothed over longer periods to properly account for cyclical factors. He calculated a cyclically adjusted P/E (or CAPE) by averaging S&P earnings over trailing 10-year periods with an adjustment for inflation. This version of the CAPE now stands at 24.6, compared with a median of 15.9 going back to 1871. That suggests wild overvalu-ation—not dot-com wild, but dangerous nevertheless.

Here’s where the discussion gets interesting: What’s the right CAPE? Except during the recession of 1990 and the darkest days of the 2008–09 crash, the CAPE hasn’t been below its since-1871 median since 1989; 24.6 sounds like a big number, but it’s only 5% above the 23.4 median since 1989.

My sense is that the mean to which the market’s P/E reverts has shifted because corporations have become a lot more profitable. The S&P 500 is earning about a 15% return on equity right now; 15% is also the average for the index since 2000. I don’t have ROE data for the S&P before 2000, but records for the Dow Jones Industrial Average show a median ROE of 12% between 1945 and 1990. With higher returns on equity, a company generates more free cash flow that it can use to reward shareholders, even if the rate of earnings growth doesn’t change. And while a move from 12% to 15% ROEs (admittedly using different sets of data) is a material step up on its own, I suspect the improvement is greatly understated. Goodwill and other intangibles—mostly arising from mergers and acquisitions—now make up half of shareholders’ equity for the S&P 500. The ROE associ-ated with internal growth for the S&P 500 as a whole is probably much higher than 15%, reflecting both historically high profit margins in the ROE numerator and lower capital investment in the denominator.

Seems Reasonable, So Let’s Carry On Continued From Cover

3Morningstar DividendInvestor December 2013

Now for the biggest question of all: Can today’s level of profitability be sustained? The reduction in capital intensity strikes me as permanent; American industry is now dominated by knowledge- and service-based fields that don’t require hard assets (factories, machinery, inventories, and so on) that weighed on returns for the corporate giants of the past.

As for profit margins, one macroeconomic statistic—corporate profits as a share of U.S. gross domestic product—is clearly above its long-run median.

Some smart fellows argue forcefully that today’s levels can’t be maintained indefinitely—including the strategists at Jeremy Grantham’s firm of Grantham, Mayo, Van Otterloo. They expect that corporate profit-

ability will revert to the long-term mean, which for many economic relationships is a sound assumption. Yet mean reversion, especially of this particular type, doesn’t take place in a vacuum. Some combination of forces would need to push profit margins lower, and I can’t see any obvious problems on this front.

For example, corporate income taxes could go up, reducing aftertax profits. There is a broad, centrist mandate for reform—cutting out loopholes—but this is usually joined with a call for lower tax rates. Or interest costs could rise; corporations have certainly benefited from the low-rate environment. However, higher rates would benefit some financial institutions, and few publicly traded nonfinancial firms are heavily indebted right now. The biggest likely swing factor is labor costs, but outside of CEO pay, there isn’t much upward pressure. Benefit and retirement costs are going up, but the burden is steadily shifting from companies to workers. Persistent underemployment limits the potential for wage growth, and organized labor has little clout—especially in the private sector.

The final question is: What happens to the earnings? Will they benefit shareholders? For years, I’ve harped about the low dividend payout ratios for the S&P as a whole. Between 1946 and 1994, the median payout

DividendInvestor Portfolios: Combined Performance

DateBuilder

PortfolioPeriod

Return (%)Harvest

PortfolioPeriod

Return (%) MDI Portfolios

CombinedPeriod

Return (%)Compound

Value of $100kS&P 500

Return (%)MDI B/(W)

than S&PM* Div LdrReturn (%)

MDI B/(W) than MDL

01/07/2005 1 100,000.00 100,000.00 100,000.00

12/30/2005 102,324.82 +2.3 102,324.82 +2.3 102,324.82 +7.1 -4.8 +5.2 -2.9

12/29/2006 2 124,722.19 +21.9 100,000.00 224,722.19 +21.9 124,722.19 +15.8 +6.1 +25.5 -3.6

12/31/2007 121,180.73 -2.8 101,776.82 +1.8 222,957.55 -0.8 123,742.80 +5.5 -6.3 -10.2 +9.5

12/31/2008 99,046.55 -18.3 70,128.71 -31.1 169,175.26 -24.1 93,893.30 -37.0 +12.9 -31.4 +7.2

12/31/2009 105,161.54 +6.2 94,045.47 +34.1 199,207.01 +17.8 110,561.11 +26.5 -8.7 +14.8 +2.9

12/31/2010 120,339.85 +14.4 120,346.67 +28.0 240,686.52 +20.8 133,582.49 +15.1 +5.8 +16.7 +4.2

12/31/2011 134,138.79 +11.5 141,647.14 +17.7 275,785.93 +14.6 153,062.88 +2.1 +12.5 +15.0 -0.4

12/31/2012 154,064.74 +14.9 159,410.81 +12.5 313,475.55 +13.7 173,980.85 +16.0 -2.3 +9.8 +3.9

Year-to-Date 2013 191,873.19 +24.5 193,162.48 +21.2 385,035.67 +22.8 213,697.15 +27.3 -4.5 +21.4 +1.4

Totals (since inception) 191,873.19 +91.9 193,162.48 +93.2 385,035.67 +113.7 213,697.15 +80.9 +32.8 +67.1 +46.6

Annualized (since inception) +7.6 +10.1 +9.0 +6.9 +2.0 +6.0 +3.0

Data through Nov. 13, 2013. “M* Div Ldr” Morningstar Dividend Leaders index of high-yielding stocks. 1 Inception of Builder. 2 Inception of Harvest. 3 Annualized return for the Harvest covers a shorter time period. Cumulative returns for the combination of our two portfolios are calculated on a time-weighted basis according to guidelines published by the CFA Institute and reflect different inception dates for the two accounts. The cumulative value of a single $100,000 investment earning returns across our strategy since Jan. 7, 2005 is shown in the column labeled “Compound Value of $100k”.

3

Continued on Page 19

p Corporate Profits/GDP (%) p Median

Data from Q1/1947 through Q2/2013. Source: St. Louis Federal Reserve Bank

Corporate Profits’ Share of U.S. GDP

1947 1957 1967 1977 1987 1997 2007

12

10

8

6

4

2

4

It’s tough for a generally conservative portfolio to keep up with the market when the S&P 500 Index returns a whopping 27.3% year to date. Still, our Builder Port-folio is doing an admirable job, with a total return of 24.5% thus far in 2013. Between Oct. 11 and Nov. 13, the Builder actually beat the S&P by a small margin, as low-double-digit returns from two of our more cyclical holdings (General Electric GE and United Parcel Service UPS) offset the drag of our currently out-of-favor energy holdings (Chevron CVX, Kinder Morgan, Inc. KMI, and Spectra Energy SE).

We also received a pair of dividend increases last month, bringing the Builder’s full-year count to 17 for a cumulative income increase of 8.4%. Kinder Morgan has now raised its dividend each quarter since we bought the stock two years ago; the most recent dole of $0.41 a share represents a 2.5% increase from the previous quarter and 13.9% growth from a year ago.

Emerson Electric EMR provided the Builder’s other dividend hike this month, a 4.9% increase to $0.43 a share on a quarterly basis. This marked a second year of below-trend dividend growth; my long-term fore-cast calls for annual hikes of 7%–8%, consistent with the past 30 years. But it’s not hard to see what’s holding Emerson back: Global spending on capital equipment remains weak. In the fiscal year ended September, operating earnings per share rose only 4% on a scant 1% gain in revenue. Management’s initial outlook for fiscal 2014 is modest as well, calling for EPS growth of 4%–7%.

We think Emerson remains on a solid track for the long term, and we raised our fair value estimate $3 a share to $61 after reviewing the year’s results. We’ve done very well with the stock thus far, earning a total return near 40% in just 13 months as the market (apparently) anticipates faster economic growth in the years ahead. However, the stock trades at a 10%

premium to our updated valuation, and while the current dividend yield of 2.6% is only slightly below the stock’s long-term average, it’s not what I would call attractive. Given the lack of ready alternatives, I have no immediate plans to sell, but I would describe our position as “lightly held” at this point.

With these two dividend increases in the books, the Builder’s annualized income has grown 8.4% thus far in 2013 before the effect of trades and reinvested income. I see only one more likely dividend increase on the horizon—GE, from which I expect a 10.5% boost to $0.84 annualized. Assuming I’m correct, our income growth should reach 9.0% for the full year and hit the top end of our long-run target even though I haven’t included the 9.8% boost Spectra Energy has already planned for 2014. (I have no doubt that Spectra will make good on its promise, but I’m not sure it will continue to announce annual dividend increases in the final months of the preceding year.)

In addition to the fair value estimate boost for Emerson, I can report several other positive updates from our research staff.

We now value Chevron at $130 a share, up $5 from our previous appraisal. Part of this change reflects an 8% cost of equity assumption versus our prior 10%. All else being equal, this change increases the present value of cash flows we’ve forecast for the future, though it does not alter the actual total returns we expect shareholders to earn—it simply indicates that, due to a favorable risk profile, we think a higher price is justifiable. We also believe Chevron will soon generate a torrent of free cash flow. Its $37 billion of capital spending has slightly exceeded that of ExxonMobil XOM in the past 12 months, even though ExxonMobil’s revenue is nearly twice as large. We believe Chevron’s investments will pay off with a surge in operating cash flow as big new projects start producing between 2014 and 2016. As capital spending tails off after 2015, the company will be in a position to return even more cash to investors. Despite the stock’s sluggish relative performance this year (up 13.7% including dividends), Chevron remains a core Builder holding and my top pick in the oil patch.

The Dividend Builder Portfolio Morningstar Stock Portfolios | Josh Peters, CFA

What is the goal of the Builder Portfolio? To earn annual returns of 10%–12% over any three- to five-year rolling time horizon.

For our portfolio as a whole, this goal is composed of:

3%–4% current yield6%–9% annual income growth

Continued on Page 6

Income Update

Dividends Received 254.15Interest Income 0.00Total Income 254.15

Performance Update

Yield on Original Cost 4.2Yield on Current Value 3.2

Income Yield, Year Ago 3.6Income Growth (TTM) 9.3

Price/Fair Value–Portfolio 0.97Price/Fair Value–Market 1.04

Reporting Period: Oct. 11, 2013 to Nov. 13, 2013. Yield and Price/Fair Value data exclude cash balances.

Income growth (TTM) measures the impact of dividend increases net of dividend cuts, excluding the effect of portfolio transactions.

Invest in the Dividend Portfolios’ Approach—The Hassle-Free WayDid you know that Morningstar Investment Services now offers a customizable portfolio patterned after the Dividend Builder and Dividend Harvest portfolios? To learn more, call 1-866-765-0663.

Morningstar Investment Services, Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc.


Builder Portfolio Transaction Summary and Performance BreakdownMorningstar Ratings & Fundamentals Portfolio Data

Portfolio HoldingStar Rating

EconomicMoat

Credit Rating

Fair Value

Fair Val Uncert

Current Price

Price/Fair Value

Div Rate

Yield (%)

First Purchase

# of Shares

Cost Per Share

Current Value

% of Acct

Total Rtn (%)

Annual Income

Stocks to Consider Buying

Philip Morris Int’l PM QQQ Wide A- 95.00 Med 90.62 0.95 3.76 4.1 05-21-10 140 44.30 12,686.80 6.6 128.4 526.40

Chevron CVX QQQQ Narrow AA 130.00 Low 120.09 0.92 4.00 3.3 10-05-11 100 97.62 12,009.00 6.3 29.5 400.00

Kinder Morgan Inc. KMI QQQQ Wide — 41.00 Med 34.53 0.84 1.64 4.7 11-17-11 315 28.60 10,876.95 5.7 30.3 516.60

Spectra Energy SE QQQQ Wide A- 39.00 Low 34.10 0.87 1.22 3.6 09-14-10 310 22.99 10,571.00 5.5 62.4 378.20

Clorox CLX QQQ Wide A- 95.00 Low 92.42 0.97 2.84 3.1 10-22-09 110 58.43 10,166.20 5.3 75.4 312.40

U.S. Bancorp USB QQQQ Narrow A+ 43.00 Med 38.02 0.88 0.92 2.4 11-18-05 250 31.38 9,505.00 5.0 34.5 230.00

McDonald’s MCD QQQQ Wide AA- 105.00 Low 98.11 0.93 3.24 3.3 10-22-12 95 87.56 9,320.45 4.9 15.6 307.80

Intel INTC QQQ Wide AA 25.00 Med 24.60 0.98 0.90 3.7 10-11-12 375 21.54 9,225.00 4.8 19.3 337.50

Wells Fargo WFC QQQ Narrow A+ 46.00 Med 42.76 0.93 1.20 2.8 11-01-05 200 30.00 8,552.00 4.5 65.9 240.00

Procter & Gamble PG QQQQ Wide AA 87.00 Low 83.50 0.96 2.41 2.9 04-12-11 100 63.02 8,350.00 4.4 42.3 240.60

F Unilever PLC ADR UL QQQQ Wide A+ 45.00 Med 39.82 0.88 1.45 3.6 07-30-13 165 40.65 6,570.30 3.4 -0.3 238.56

F Rogers Communications RCI QQQQ Narrow A- 60.00 Med 44.78 0.75 1.66 3.7 05-31-13 140 45.32 6,269.20 3.3 0.0 232.15

Stocks to Hold

Johnson & Johnson JNJ QQQ Wide AAA 90.00 Low 93.34 1.04 2.64 2.8 01-10-05 165 65.13 15,401.10 8.0 65.3 435.60

General Mills GIS QQ Narrow A 48.00 Low 50.88 1.06 1.52 3.0 06-22-12 285 38.15 14,500.80 7.6 38.8 433.20

Paychex PAYX QQ Wide — 38.00 Med 42.77 1.13 1.40 3.3 03-11-08 300 30.19 12,831.00 6.7 55.9 420.00

General Electric GE QQQ Wide AA- 27.00 Med 27.15 1.01 0.76 2.8 04-17-08 465 23.95 12,624.75 6.6 24.9 353.40

United Parcel Service UPS QQQ Wide A+ 92.00 Med 101.04 1.10 2.48 2.5 01-03-07 120 74.48 12,124.80 6.3 51.1 297.60

Emerson Electric EMR QQQ Narrow A 61.00 Med 66.85 1.10 1.72 2.6 10-11-12 135 49.07 9,024.75 4.7 40.4 232.20

Cash Holdings 0.0 534.02 0.3 0.00

Dividends Receivable (CLX, EMR, INTC, KMI, PAYX, PG, SE, UL, WFC) — 730.07 0.4

Builder Portfolio Total 3.2 191,873.19 100.0 6,132.21

Trailing Return (%) Index Level This Month 12 MonthAnnualized

Since Inception

Builder Portfolio 4.9 28.1 7.6

S&P 500 Index 1,782 4.8 32.5 6.9

M* Dividend Leaders 4,627 3.5 23.4 6.0

Top Sectors (%) Style Breakdown (%)

s Consumer Defensive 27.2

p Industrials 24.3

o Energy 17.4

y Financial 9.4

d Healthcare 8.0

Value Core Grwth

Lrg

Med

Sm

p 51 – 100

p 26 – 50

p 11 – 25

p 0 – 10

38 41 16

0 5 0

0 0 0

Footnotes:Morningstar ratings and fundamentalsdata as of Nov. 13, 2013. Builder Portfolio inception: Jan. 7, 2005.

Total returns for individual holdings include dividends and realized capital gains and losses, if any.

Cost basis for individual holdings, as well as all portfolio returns, include commissions we have paid.

“Stocks to Consider Buying” are those holdings trading below our their current fair value estimates.

Other definitions may be found in the DividendInvestor Subscriber’s Manual.

Taxing the Builder:All of the stocks currently held in the Builder Portfolio are eligible for “qualified” dividend tax rates, but RCI may have foreign dividend taxes withheld. Please contact your broker for more information.

p Builder Portfolio p S&P 500 Index p Morningstar Dividend Leaders Index

Cumulative Total Return Comparison (%)

105

70

35

0

-35

2005 2006 2007 2008 2009 2010 2011 2012 2013

Legend: Shares added Shares sold New holdingUR Under Review

Å

Í

C

6

Second, we raised our fair value estimate for United Parcel Service by $5 a share to $92. This reflects numerous small changes as well as the time value of money effect in discounted cash flow analyses. (If a business performs in line with our expectations, our fair value estimate naturally tends to rise as the cash flows we forecast are realized.) With its wide economic moat, abundant cash generation, and solid long-term growth prospects offsetting its cyclicality, I have considered UPS a core holding for years, and our patience has paid off with a year-to-date total return of 39.6%, the second strongest of any Builder holding this year. I’m no longer enthusiastic about the price, as the yield has slumped to 2.5%, and the stock still looks 10% overvalued relative to our new fair value estimate. But I still have no plans to sell—nothing of comparable quality from a fundamental perspective strikes me as more attractively priced.

Finally, though our fair value estimate remained unchanged at $95 a share, we raised our moat rating for Clorox CLX to wide from narrow. This reflects our confidence in the company’s ability to sustain high

returns on invested capital (23% on average over the past five years) for at least the next 20 years.

Though Clorox doesn’t have the massive scale or global scope of Procter & Gamble PG or Unilever UL, it generally doesn’t compete head-to-head with these giants in its categories. Instead, it dominates smaller niches like bleach, water filters (Brita), charcoal (Kingsford), and ranch dressing (Hidden Valley). Nearly 90% of its brands hold either the number-one or number-two share in its category, allowing it to maintain premium prices and push through price increases (64 of 66 of which have stuck since 2005) that offset rising commodity costs. We also regard Clorox as a highly efficient manufacturer, and management does an excellent job allocating capital. Yielding 3.1% at present, I think the stock is a buy. œ

© 2013 Morningstar, Inc. All rights reserved. Any opinions, recommendations, or information contained herein: (i) are for educational purposes only; (ii) are not guaranteed to be accurate, complete, or timely; (iii) have not been tailored to suit any particular person’s portfolio or holdings; and (iv) should not be construed as investment advice of any kind. Neither Morningstar nor any of its agents shall have any liability with respect to such opinions, recommendations, or information. Morningstar has not given its consent to be deemed an “expert” under the federal Securities Act of 1933. Past performance is no guarantee of future results. Before making any investment, consult with your financial advisor. Morn-ingstar employees may have holdings in the stocks recommended.

Builder Portfolio Continued From Page 4

Builder Portfolio Payment Schedule

Company NamePayment Cycle

Expected Payment

Ex Date Pay DateAnticipated Amount ($) Our most recent thoughts

Dividend Growth

Past 5 Yrs 5-Yr Forecast

Johnson & Johnson JNJ 3, 6, 9, 12 11-22-13 12-10-13 0.66 Top pick in healthcare sector as new drugs, R&D pipeline revive L-T EPS/div growth 8.2 7.0

McDonald’s MCD 3, 6, 9, 12 11-28-13 12-16-13 0.81 Smallest div hike since 2002 amid N-T headwinds, still expect faster growth L-T 13.9 8.0

Rogers Communications RCI 1, 4, 7, 10 12-11-13 01-02-14 0.42 2 Verizon declines to enter Canada, reduces risk & underscores resiliency of oligopoly 31.2 8.0

Philip Morris Int’l PM 1, 4, 7, 10 late Dec mid Jan 0.94 Ethical concerns aside, top L-T total return profile (high yield and growth) in our field — 9.0

US Bancorp USB 1, 4, 7, 10 late Dec mid Jan 0.23 High quality and highly profitable, but low payout ratio/yield limits appeal for income Cut 8.0

General Electric GE 1, 4, 7, 10 late Dec late Jan 0.21 1 Looking for 10.5% div hike in December as profit recovery continues, GECS shrinks Cut 8.0

General Mills GIS 2, 5, 8, 11 early Jan early Feb 0.38 Core Builder holding drives div growth with innovation, efficiency, financial strength 11.0 7.5

Clorox CLX 2, 5, 8, 11 mid Jan mid Feb 0.71 New wide-moat rating reflects brand dominance of niche products, efficient mfg 9.9 7.0

Procter & Gamble PG 2, 5, 8, 11 mid Jan mid Feb 0.6015 Revival slow in N-T, clawing back mkt share with promotions, decent L-T prospects 9.6 7.5

Kinder Morgan Inc. KMI 2, 5, 8, 11 late Jan mid Feb 0.42 1 Otherwise strong appeal dimmed a bit by KMP’s oil biz, L-T challenge surmountable — 9.5

Paychex PAYX 2, 5, 8, 11 late Jan mid Feb 0.35 Despite premium price, still view as core holding for wide moat, attractive div policy 2.1 7.0

Intel INTC 3, 6, 9, 12 early Feb early March 0.225 Disappointed by flat div in 2013, plan to give firm a chance to revive div hikes in ‘14 14.1 6.5

Wells Fargo WFC 3, 6, 9, 12 early Feb early March 0.30 Mortgage profits fall before higher rates benefit interest income, still a solid L-T buy Cut 8.5

Unilever PLC ADR UL 3, 6, 9, 12 early Feb mid March 0.37 2 Weakness in emerging mkts a N-T challenge, still a big benefit for UL over long haul 6.0 8.0

United Parcel Service UPS 3, 6, 9, 12 early Feb mid March 0.67 1 Surges past $100 on economic optimism, yield falls and now overvalued, still a hold 6.3 8.0

Chevron CVX 3, 6, 9, 12 mid Feb mid March 1.00 Top Big Oil pick: Output growth accelerates in next few yrs, free cash flow to surge 9.2 8.5

Emerson Electric EMR 3, 6, 9, 12 mid Feb mid March 0.43 4.9% div hike extends long streak but doesn’t do much for yield, which remains low 8.8 7.5

Spectra Energy SE 3, 6, 9, 12 mid Feb mid March 0.335 1 Div hike delayed until Q1/2014, planned 9.8% increase gives forward yield of 3.9% 5.4 8.5

Data through Nov. 13, 2013. 1Denotes an increase we expect, but which has not yet been announced. 2 Dividend to be paid in foreign currency; subject to exchange fluctuations.


Morningstar’s TakeProcter & Gamble PG is the leading consumer product manufacturer in the world, with more than $80 billion in annual sales. Its wide moat derives from the economies of scale that result from its portfolio of leading brands, 25 of which generate more than $1 billion in revenue per year. Given its dominant market positions (35% of baby care, 70% of blades and razors, 30% of feminine protection, and 25% of fabric care), retailers rely on P&G’s products to drive traffic in their stores. Further, the size and scale P&G has amassed over many years enable it to realize a lower unit cost than its smaller peers. P&G supports its advantages by investing in research and development (2.5% of sales) and marketing (11.5% of sales) for core brands.

However, P&G has stumbled over the past several years, indicating its wide moat may be eroding. We think the firm entered too many new markets too quickly, especially in emerging economies where it was late to the game relative to key global competi-tors. In addition, its products missed the mark with value-conscious consumers, and volume and market share retreated. These miscues led to the early retirement of Bob McDonald, who had held the CEO job only four years, and the return of his well-regarded predecessor, A.G. Lafley. Lafley left in place

a $10 billion cost-saving initiative designed to lower costs (via reduced overhead, lower material costs from product design and formulation efficiencies, and increased manufacturing and marketing productivity). However, most savings are likely to be reinvested in operations, and we expect Lafley to focus on stabi-lizing market share and driving product innovation.

Though progress will probably be slow in the near term, we’re encouraged that results in the most recent fiscal quarter were in line with management’s full-year expectations (3%–4% revenue growth, 5%–7% operating earnings per share growth). However, the degree to which recent revenue growth is bene- fiting from price cuts is still a concern following recent comments from two of P&G’s chief global competi- tors (Colgate CL and Unilever UL), which both cited stepped-up promotional activity in the U.S. In our opinion, promotional spending isn’t a sustainable long-run growth strategy.

The Dividend: What’s New?In April, P&G raised its dividend for the 57th year in a row with an increase of 7.0%, identical to the previous year. Growth in operating earnings per share has been sluggish for some time—just 3.4% a year on average since fiscal 2008, compared with 10.9% in the five years from 2003 to 2008. With dividends rising faster than EPS, P&G’s payout ratio rose from 42% to 56% in fiscal 2013 (ended June). Given the size and stability of free cash flows, P&G can easily afford this higher payout level, if not more. However, we think P&G needs more earnings growth to provide high-single-digit dividend growth in the years ahead.

We expect sales growth to average 4% annually over the longer term—slightly faster than the 3% growth rate of the firm’s product markets. We also expect operating margins (19.3% in our 2014 forecast) to reach 22% in 2018. Using free cash flow in excess of the dividend, we expect P&G to retire about 2% of its shares each year. These factors result in the potential for average annual EPS growth of 8%–9% through 2018. As we suspect faster EPS growth may lead P&G to trim its payout ratio a bit, we see dividend growth of 7%–8% a year. In the context of a 2.9% yield, we believe P&G offers attractive long-run total returns. œ

Procter & Gamble PG Builder Focus | Josh Peters, CFA, and Erin Lash, CFA

p Stock Price p Dividend Rate

Procter & Gamble: Stock Price and Dividend Rate ($)

Data through Nov. 13, 2013.

80

60

40

20

2.20

1.65

1.10

0.55

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Procter & Gamble PG

Star Rating QQQQEconomic Moat Wide

Uncertainty Rating Low

Fair Value ($) 87.00

Current Price ($) 83.50

Price/Fair Value 0.96

Dividend ($) 2.41

Yield (%) 2.9

Payout (%) 56

5-Yr Growth (%) 9.6

Credit Rating AA

8

While the Harvest’s year-to-date total return now stands at 21.2%, our high-yield portfolio slipped a little further behind the rollicking S&P 500 in the past month. Nevertheless, I’m pleased to report that the Harvest received eight dividend increases between Oct. 11 and Nov. 13, our highest one-month total ever. Four of the hikes came from master limited partner-ships, and three of these met my forecasts: Kinder Morgan Energy Partners KMP (up 2.3% from last quarter and 7.1% from a year ago), Magellan Midstream Partners MMP (4.7% and 14.9%), and Spectra Energy Partners SEP (1.5% and 5.4%).

Energy Transfer Equity ETE was the outlier: Its quarterly dole rose 1.75 cents a unit (2.7% and 7.6%) rather than the penny I was looking for. This accelera-tion in growth reflects continued expansion for its subsidiary MLPs as well as recent transactions meant to simplify an overly complex organizational structure. But the units now trade above our fair value estimate; I wouldn’t buy more here.

The four other hikes were gratifying as well. The 2.0% boost from American Electric Power AEP on Oct. 22 came as a surprise, as AEP had already raised its dividend 4.3% on April 23. Between the two increases, shareholders’ pay is up 6.4% this year, and we expect the dividend to continue rising at the upper end of management’s 4%–6% target for annual earn-ings per share growth. We also raised our fair value estimate by $2 to $50. AEP remains my top utility pick.

On Oct. 23, we got our first dividend increase from GlaxoSmithKline GSK, which I added to the Harvest at the end of May. The interim quarterly dividend rose 5.6% to GBX 19 for the firm’s ordinary shares in London; this translates to $0.6161 per American depositary share. Also, in our recent review of devel-opment pipelines for large global drugmakers, Glaxo-

SmithKline notched the best ranking, which suggests the potential for faster earnings growth in the years ahead. I still like the stock here, and it’s one of my two best ideas for new money right now.

My other top idea right now is Health Care REIT HCN, which on Nov. 5 announced that its board has approved a quarterly dividend rate of $0.795 a share for 2014, up 3.9% from this year’s payments. Thanks to higher interest rates, the stock is 25% off the all-time high it reached in May and 16% below our $71 fair value estimate. In this context, I think the Harvest’s current weighting of 4.3% is too low, given the likelihood of 3%–4% annual dividend growth going forward.

Finally, Vodafone VOD raised its interim dividend 8% to what I estimate will be $0.55 an ADR at current exchange rates. Until lately I’ve been inclined to sell the Harvest’s stake before Vodafone makes special distributions of cash and Verizon VZ stock in the first quarter of 2014. In addition to some unfriendly tax aspects of these distributions for taxable accounts, the ADRs have been trading above our $35 fair value estimate (recently raised from $33 on the rebound of the British pound relative to the dollar). But I haven’t been able to identify a suitably attractive replacement for Vodafone thus far. I’m not yet convinced that Bell Canada BCE is a better option, in part because Canada (unlike the United Kingdom) levies a 15% withholding tax on U.S. shareholders that seems to be very difficult to recover in tax-deferred accounts. I plan to continue holding Vodafone for now.

All told, these eight increases added $159 (1.8%) to the Harvest’s annualized income, bringing our full-year income growth from dividend hikes to 7.0%—trouncing our long-term target of 4%–5%. I’ll have a full review of our progress, as well as dividend fore-casts for 2014, in next month’s issue.

Transaction UpdateI made two trades in the Harvest on Oct. 14, just after our data cutoff date but just before the November issue went to press, which allowed me to mention them only briefly. Now I can relate the full story.

The Dividend Harvest Portfolio Morningstar Stock Portfolios | Josh Peters, CFA

What is the goal of the Harvest Portfolio? To earn annual returns of 9%–10% over any three- to five-year rolling time horizon.

For our portfolio as a whole, this goal is composed of:

4%–6% current yield4%–5% annual income growth

Continued on Page 10

Income Update

Dividends Received 245.42Interest Income 0.01Total Income 245.42

Performance Update

Yield on Original Cost 6.9Yield on Current Value 4.9

Income Yield, Year Ago 5.5Income Growth (TTM) 7.4

Price/Fair Value–Portfolio 0.98Price/Fair Value–Market 1.04

Reporting Period: Oct. 11, 2013 to Nov. 13, 2013. Yield and Price/Fair Value data exclude cash balances.

Income growth (TTM) measures the impact of dividend increases net of dividend cuts, excluding the effect of portfolio transactions.

Invest in the Dividend Portfolios’ Approach—The Hassle-Free WayDid you know that Morningstar Investment Services now offers a customizable portfolio patterned after the Dividend Builder and Dividend Harvest portfolios? To learn more, call 1-866-765-0663.

Morningstar Investment Services, Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc.


Harvest Portfolio Transaction Summary and Performance BreakdownMorningstar Ratings & Fundamentals Portfolio Data

Portfolio HoldingStar Rating

EconomicMoat

Credit Rating

Fair Value

Fair Val Uncert

Current Price

Price/Fair Value

Div Rate

Yield (%)

First Purchase

# of Shares

Cost Per Share

Current Value

% of Acct

Total Rtn (%)

Annual Income

Stocks to Consider Buying

R Realty Income O QQQ Narrow — 44.00 Med 40.10 0.91 2.18 5.4 12-29-06 335 27.49 13,433.50 7.0 72.8 731.05

P Spectra Energy Partners SEP QQQQ Wide — 46.00 Low 43.45 0.94 2.07 4.8 11-19-12 275 27.99 11,948.75 6.2 62.5 567.88

P Kinder Morgan Energy KMP QQQQ Wide BBB+ 98.00 Med 80.67 0.82 5.40 6.7 12-29-06 140 47.81 11,293.80 5.8 102.8 756.00

P AmeriGas Partners APU QQQ Narrow BB+ 46.00 Med 43.04 0.94 3.36 7.8 12-29-06 260 34.80 11,190.40 5.8 49.0 873.60

Kraft Foods Group KRFT QQQ Narrow BBB+ 53.00 Med 52.52 0.99 2.10 4.0 10-10-12 210 46.59 11,029.20 5.7 17.1 441.00

American Electric Power AEP QQQQ Narrow BBB+ 50.00 Low 47.32 0.95 2.00 4.2 04-12-11 230 35.69 10,883.60 5.6 45.5 460.00

F Royal Dutch Shell B ADR RDS.B QQQ Narrow AA- 71.00 Low 68.26 0.96 3.60 5.3 10-05-11 155 65.23 10,580.30 5.5 14.6 558.00

Philip Morris Int’l PM QQQ Wide A- 95.00 Med 90.62 0.95 3.76 4.1 10-14-13 110 84.89 9,968.20 5.2 6.7 413.60

Public Service Enterprise PEG QQQ Narrow BBB+ 35.00 Med 33.57 0.96 1.44 4.3 07-10-12 275 32.00 9,231.75 4.8 10.1 396.00

R Health Care REIT HCN QQQQ Narrow — 71.00 Med 59.99 0.84 3.18 5.3 02-13-09 140 37.83 8,398.60 4.3 89.7 445.20

F GlaxoSmithKline ADR GSK QQQ Wide A+ 56.00 Med 51.94 0.93 2.55 4.9 05-31-13 145 52.15 7,531.30 3.9 1.8 369.53

Southern Company SO QQQQ Narrow A- 45.00 Low 41.74 0.93 2.03 4.9 05-31-13 175 44.40 7,304.50 3.8 -3.7 355.25

Stocks to Hold

PMagellan Midstream MMP QQ Wide BBB+ 54.00 Low 60.69 1.12 2.23 3.7 12-05-08 380 17.27 23,062.20 11.9 232.0 847.40

F Vodafone Group ADR VOD QQQ Narrow BBB+ 35.00 Med 37.05 1.06 1.63 4.4 06-22-12 305 27.31 11,300.25 5.9 41.4 498.52

Altria Group MO QQ Wide BBB 32.00 Med 37.58 1.17 1.92 5.1 09-11-09 300 19.01 11,274.00 5.8 122.9 576.00

FNational Grid PLC ADR NGG QQQ Narrow BBB+ 60.00 Low 62.43 1.04 3.22 5.2 07-09-09 165 43.29 10,300.95 5.3 72.2 531.84

P Energy Transfer Equity ETE QQQ Wide — 65.00 Med 69.21 1.06 2.69 3.9 03-16-11 100 39.73 6,921.00 3.6 91.6 269.00

AT&T T QQ Narrow A- 32.00 Med 35.07 1.10 1.80 5.1 03-16-11 165 27.51 5,786.55 3.0 45.1 297.00

Cash Holdings 0.0 294.50 0.2 0.00

Dividends Receivable (AEP, APU, ETE, GSK, HCN, KMP, MMP, O, RDS.B, SEP, SO) — 1,429.13 0.7

Harvest Portfolio Total 4.9 193,162.48 100.0 9,386.88

Trailing Return (%) Index Level This Month 12 MonthAnnualized

Since Inception

Harvest Portfolio 3.0 25.3 10.1

S&P 500 Index 1,782 4.8 32.5 5.6

M* Dividend Leaders 4,627 3.5 23.4 3.5

Top Sectors (%) Style Breakdown (%)

Value Core Grwth

Lrg

Med

Sm

p 51 – 100

p 26 – 50

p 11 – 25

p 0 – 10

o Energy 33.0

f Utilities 25.3

s Consumer Defensive 16.7

u Real Estate 11.3

i Communication Svcs 8.8

49 16 4

6 25 0

0 0 0

Legend: Shares added Shares sold New holdingUR Under Review UR+ Under Review, positive outlook

Å

Í

C

Taxing the HarvestP Master limited partnerships. Income is taxed at ordinary rates, though a

portion of cash distributions may not be taxable until units are sold. Not suitable for tax-deferred accounts including IRAs, Roth IRAs, and 401(k) plans.R Real estate investment trusts; mostly taxed at ordinary rates.F Foreign stock, income treated as qualified dividends.

Footnotes:Data as of Nov. 13, 2013. Harvest Portfolio inception: Dec. 29, 2006. Please refer to Page 5 or the DividendInvestor Subscriber’s Manual for other definitions.

120

80

40

0

-40

pHarvest Portfolio p S&P 500 Index p Morningstar Dividend Leaders Index

Cumulative Total Return Comparison (%)

2007 2008 2009 2010 2011 2012 2013

10

p Sold 595 shares of People’s United Financial PBCT at $14.74 each. When I bought this regional bank in July 2012, I recognized that dividend growth—just 1.6% a year on average over the past five years—would remain modest until 1. People’s deployed the rest of the excess capital stemming from its full demu-tualization in 2007 and 2. short-term interest rates rebounded, relieving the downward pressure on net interest margins. At the outset, I felt fairly compen-sated by a 10% discount to our original $13 fair value estimate and a hefty 5.4% yield. Then, as the stock price rose much faster than our fair value estimate (now $14) or the dividend, People’s yield dropped to 4.4% and became somewhat overvalued. I was also concerned about a downgrade in our Stewardship Rating to Poor, reflecting a failure to efficiently inte-grate past acquisitions. The stock provided us with a market-beating total return of 32.3%, but with faster dividend growth still several years away and an attractive replacement at hand, it was time to sell.

p Bought 110 shares of Philip Morris International PM at $84.89. Philip Morris is no stranger to the

pages or portfolios of DividendInvestor ; it’s been part of the Builder Portfolio since May 2010. The stock has performed exceedingly well since then, yet it still struck me as attractively priced in mid-October. By swapping People’s for Philip Morris, we got the same current yield, but replaced a narrow-moat stock with a wide-moat one, a stock that was 5% over-valued relative to our fair value estimate with one that was 11% undervalued, and gained a management team whose stewardship we rate as Exemplary rather than Poor. Best of all, the swap brings dramatically improved prospects for dividend growth. Rather than roughly 1.5% annual increases from People’s that could eventually improve to 5.0%, I expect Philip Morris to deliver 8%–10% annual dividend growth for many years to come. As Peter Lynch has said, “The best stock to buy may be the one you already own.”

In Other NewsOnly one other development last month bears mention. We raised our fair value estimate for Altria Group MO by $1 a share to $32. Though the stock still looks overvalued, I plan to continue holding. œ

Harvest Portfolio Continued From Page 8

Questions? Comments?

You can contact me via email

at [email protected].

I can’t promise a reply to every

message, but I do read them all,

and when a topic shows up

repeatedly I will address it for all

subscribers in DividendInvestor or our weekly email update.

Josh Peters, CFA, owns these

stocks in his personal portfolio:

AEP, APU, CLX, CVX, EMR, ETE,

GE, GIS, GSK, HCN, INTC, JNJ,

KMI, KMR, KRFT, MCD, MMP,

NGG, O, PAYX, PEG, PG, PM, RCI,

RDS.B, SE, SEP, SO, UL, UPS, USB,

VOD, WFC.

Harvest Portfolio Payment Schedule

Company NamePayment Cycle

Expected Payment

Ex Date Pay DateAnticipated Amount ($) Our most recent thoughts

Dividend Growth

Past 5 Yrs 5-Yr Forecast

Vodafone Group VOD 2, 8 11-20-13 02-05-14 0.55 2 No replacement buys on the horizon so inclined to hold, even through VZW payouts 6.7 4.0

Realty Income O Monthly 11-27-13 12-16-13 0.181854 Top-rate capital allocation, valuation already consistent with 4%–5% interest rates 4.8 4.0

Public Svc. Enterprise PEG 3, 6, 9, 12 early Dec late Dec 0.36 N-T div growth low amid low wholesale power prices, but both should rebound L-T 4.0 6.0

National Grid NGG 1, 8 early Dec mid Jan 1.15 2 Targets div growth equal to or above UK inflation driven by infrastructure spending 6.4 4.0

Altria Group MO 1, 4, 7, 10 late Dec early Jan 0.48 Likelihood of slowing growth crimps our valuation, but total return prospects still OK — 6.0

Kraft Foods Group KRFT 1, 4, 7, 10 late Dec mid Jan 0.525 Raised div 5% on Oct. 1, look for 5%–7% hikes L-T as mgmt revitalizes operations — 6.0

Philip Morris Int’l PM 1, 4, 7, 10 late Dec mid Jan 0.94 Builder holding joins Harvest as well, provides excellent div growth for yield of 4%+ — 9.0

AT&T T 2, 5, 8, 11 early Jan early Feb 0.46 1 Rumored to pursue VOD after VZW sale complete, hurts prospect of faster div hikes 3.9 4.5

Kinder Morgan KMP 2, 5, 8, 11 late Jan mid Feb 1.36 1 Oil biz, IDRs hurt L-T growth, but expansion elsewhere should overcome headwind 7.4 5.5

AmeriGas Partners APU 2, 5, 8, 11 early Feb mid Feb 0.84 Weather creates S-T volatility in results, but L-T outlook holds steady distr. hikes 5.6 5.0

Energy Transfer Equity ETE 2, 5, 8, 11 early Feb mid Feb 0.69 1 Steps up distr. hikes from 1c to 1.75c as key subsidiary ETP returns to growth itself 8.3 15.0

Magellan Midstream MMP 2, 5, 8, 11 early Feb mid Feb 0.5825 1 Willing to hold top position despite premium valuation for double-digit distr. growth 7.4 12.0

Spectra Energy Partners SEP 2, 5, 8, 11 early Feb mid Feb 0.52625 1 Becomes a core holding thanks to SE’s dropdowns, broad opportunity for expansion 9.1 6.5

Health Care REIT HCN 2, 5, 8, 11 early Feb late Feb 0.795 1 Announces 3.9% div hike for 2014, high payout ratio but strong finances, cash flow 2.5 3.5

American Electric Power AEP 3, 6, 9, 12 early Feb early March 0.50 Surprises with 2nd div hike in ‘13, which signals growth outlook for regulated units 3.5 6.0

Southern Company SO 3, 6, 9, 12 early Feb early March 0.5075 Cost overruns make AEP a bit more attractive, but SO still a good pick in utilities 4.0 4.0

GlaxoSmithKline ADR GSK 1, 4, 7, 10 late Feb mid April 0.74 1 Got top slot in our annual ranking of Big Pharma R&D pipelines, may boost growth 7.5 4.0

Royal Dutch Shell B RDS.B 3, 6, 9, 12 mid Feb late March 0.90 Another bad qtr, but cash flow outlook strong, restructuring likely under new CEO 4.0 5.0

Data through Nov. 13, 2013. 1Denotes an increase we expect, but which has not yet been announced. 2 Dividend to be paid in foreign currency; subject to exchange fluctuations.


Morningstar’s TakeThe addictive nature of tobacco products, smokers’ brand loyalty, and significant scale benefits make the tobacco industry conducive to wide moats. As the dominant player in the U.S. market with more than 50% share, Altria MO generates the greatest econo-mies of scale in the industry. Its iconic Marlboro brand has an exceptionally loyal following, with 90% of Marlboro smokers purchasing the brand 100% of the time. The scale that cigarette manufacturers possess gives them immense power over tobacco farmers, suppliers, and distributors.

Altria also holds leading shares in moist smokeless tobacco and machine-made cigars. Its Copenhagen and Skoal brands combined enjoy roughly 50% share in the steadily growing smokeless tobacco market. Unlike its cigarette brands, the company’s smokeless tobacco products enjoy increasing demand in addition to strong pricing power and high profit margins.

We recognize that the U.S. government could take actions that would significantly shrink the industry, but we think this is unlikely due to governments’ depen-dence on tobacco excise tax revenue (more than $36 billion for federal and state governments in 2012). Separately, while litigation threats have been ebbing for more than a decade and Altria retains a very

capable legal team, the risk of further litigation remains an unpredictable threat to our valuation.

Altria is rolling out its MarkTen electronic cigarette brand across select parts of the U.S. Though their impact on industry profitability has been limited to date, e-cigs could be quite disruptive to Big Tobacco, and there is a chance that the 2025 profit pool from cigarettes/e-cigs could be smaller than it is today—particularly as e-cigs have slimmer margins than ciga-rettes. We think that Altria will be slow and delib-erate as it expands MarkTen.

The Dividend: What’s New?Since spinning off Philip Morris International PM in early 2008, Altria has raised its dividend seven times for an average annual growth rate of 8.8%, which includes the 9.1% boost announced Aug. 23. Though dividend growth has benefited from an 80% payout ratio target, up from 75% at the time of the Philip Morris spin-off, adjusted earnings per share have been rising at an 8% annual clip as well. However, top-line growth has been modest since the 2009 acquisition of UST, and the primary driver of profit growth has been cost-cutting—particularly in the selling, general, and administrative expense category.

We expect Americans to decrease their cigarette consumption by 3%–4% per year for the next several years, though we believe the immense pricing power of Altria and its rivals should eclipse volume declines in the decade to come. However, following a six-year period of rapidly improving profit margins for Altria, further cost-reduction opportunities are more limited. We expect margins to slowly trend lower, leading to medium-term per-share earnings and dividend growth of 5%–6% annually (below management’s target of 6%–9%). Also, for years beyond our 10-year explicit forecast horizon, we incorporate in our valuation an assumption that profits will decline 3% annually.

For these reasons, we currently value Altria at $32 a share, pegging the stock as somewhat overvalued. However, as long as Altria provides a reliable yield around 5% or better and annual dividend growth remains in the mid- to upper single digits, the stock can continue generating worthwhile total returns. œ

Altria Group MO Harvest Focus | Josh Peters, CFA, and Thomas Mullarkey, CFA



Altria Group: Stock Price and Dividend Rate ($)

36

27

18

9

2.16

1.62

1.08

0.54

Altria Group MO

Star Rating QQEconomic Moat Wide

Uncertainty Rating Medium




Dividend ($) 1.92

Yield (%) 5.1

Payout (%) 77

5-Yr Growth (%) Cut

Credit Rating BBB

2008 2009 2010 2011 2012 2013

12

President Obama’s nomination of Janet Yellen to become chairwoman of the Federal Reserve was nearly lost on the market in the thick of the recent federal government shutdown, but it’s back in the news. Her credentials for this extraordinarily powerful role are as impeccable as anyone could hope, but there’s also a wide perception that she is a policy

“dove,” more disposed to let inflation rise than tamp down on economic growth.

Though I don’t care to take public stances on political appointments, and I can’t say for sure whether Yellen is a true dove, I do think her public statements reflect a carefully considered position. Inflation is tough to corral once it takes hold, as the country discovered disastrously in the 1970s and early 1980s, but infla-tion isn’t our chief economic problem—that would be persistently weak economic growth and employment. We’ve now had five years of aggressive monetary stimulus, yet the Consumer Price Index is rising at only a low 1% rate. It seems you can’t have inflation without printing a lot more money, but you can print a lot of money without necessarily getting inflation.

If anything, I believe a too-hasty return to tighter monetary policy in the short term could tip us into deflation at a time when consumers and governments are still heavily indebted, and deflation is just as bad or worse of an economic ill as inflation. The Fed’s current toolkit for encouraging faster economic growth may not be ideal for the task, but at least Yellen’s nomination lends continuity to current policy.

I still expect that interest rates will eventually rise, though I don’t have a time frame in mind—this isn’t a forecast. Instead, I use a 10-year Treasury yield of 4%–5% as a planning assumption when evaluating rate-sensitive stocks like American Electric Power AEP and Realty Income O. At this point I believe these and several other high-quality names in our port-

folios are attractively priced even for a normalized interest rate environment. I also know they’ll probably lag the market when rates are moving higher, but that’s a trade-off I’m happy to accept given the reliability and growth of their dividends and their limited downside risk should the economy stall or contract once more.

Lost in TransmissionI recently added ITC Holdings ITC to the Bellwethers, one of only two utilities to garner our wide economic moat rating. Though it wouldn’t be a good fit for the stated income objectives of our Builder Portfolio, a current yield around 2% strikes me as justifiable, given ITC’s outlook for mid-double-digit earnings and dividend growth. But this attractive story now faces some trouble, with implications for other utilities too.

In addition to steady revenue and cash flows, the chief attraction of interstate transmission is the generous (12%–14%) returns on equity allowed by the Federal Energy Regulatory Commission. These returns for transmission are meant to encourage much-needed investment in the nation’s power grid, and new systems often pay for themselves by making genera-tion markets more competitive. But power customers in several parts of the country are now demanding cuts in the rates that ITC and other operators are allowed to charge, since the FERC hasn’t lowered the allowed returns for transmission despite years of low interest rates. While we think any cuts are likely to be modest, it is a point of vulnerability worth watching—not just for ITC, but also other transmis-sion-heavy stories like Northeast Utilities NU. The Harvest’s AEP and Public Service Enterprise Group PEG are also looking to transmission to drive growth, so I’ll be keeping an eye on this story.

Bellwether ChangesPeople’s United Financial PBCT joins the Bell-wethers after I sold it from the Harvest last month, but it isn’t a likely repurchase candidate. Texas Instru-ments TXN also joins with recent dividend increases giving the stock a $1.3 billion annual payout and a 2.8% yield; I’ll be looking to profile the stock in a future issue. Making room for these additions were two of the lowest-yielding issues: Walgreen WAG (2.1%) and Marsh & McLennan MMC (2.2%). œ

Income BellwethersDividend Watchlist | Josh Peters, CFA

Payouts in Peril

BGC Partners BGCP

Entergy ETR

FirstEnergy FE

Frontier Commmunications FTR

Garmin GRMN

GFI Group GFIG

NuStar Energy NS

NuStar GP Holdings NSH

R.R. Donnelly RRD

Windstream WIN

Asset Management MLPs

Energy Production MLPs

Mineral Mining

Mortgage REITs

Ocean Transport

Oil Refiners (MLPs or stocks)

Rural Telecom

Specialty Financials/BDCs

Stocks and industry groups whose dividends may be at risk of being reduced. We would avoid these stocks for income purposes.

About Income BellwethersThis is our coverage list of 100 large, widely held higher-yielding stocks on U.S. exchanges. Our “strategic appeal” ranking reflect our views of the company:

High Potential Builder or Harvest buy if the valuation becomes relatively attractive.

Avg A run-of-the-mill issue from a dividend perspective.

Low Needs dividend policy to improve or risks reduced to attain an “average” rankings.

None Significant concerns regarding dividend safety or fundamental quality.


Data through Nov. 13, 2013. UR Under Review Master Limited Partnership REIT Foreign Stock Cut Div. reduced in past 5 years.

Income Bellwethers

Company NameStar Rating

Fair Value

Last Price

Price/Fair Value

Divi-dend

Yield (%)

5-Yr Div Grth (%)

Strategic Appeal Comments

3M MMM QQ 120.00 128.59 1.07 2.54 2.0 4.2 Avg Keeping 2% yielder as Bellwether on wide moat, 55 years of hikes, poten-tial for faster div growth, but may not offer 3% again until next bear mkt.

AbbVie ABBV QQQ 45.00 47.85 1.06 1.60 3.3 — Avg Raised FVE on optimism for drug pipeline, particularly hepatitis C, but Humira still the main story and its eventual decline leaves huge hole to fill.

AGL Resources GAS QQ 40.00 47.49 1.19 1.88 4.0 1.1 Low Atlanta Gas Light still an attractive utility, but Nicor acquisition (in ute-unfriendly Illinois) and unregulated operations keep overall story mediocre.

Air Products & Chemicals APD QQQ 110.00 108.04 0.98 2.84 2.6 11.1 Avg Activist investor shakes up board, CEO McGlade to retire, but change takes time—seeing only modest growth in 2014. Stay on sidelines for now.

Alliant Energy LNT QQ 47.00 52.64 1.12 1.88 3.6 7.2 High Midwestern utility with solid regulatory relations, healthy finances & good rate base growth. 5%–7% L-T div hikes. Appealing should yield top 4%.

Ameren AEE QQQ 34.00 36.18 1.06 1.60 4.4 Cut Low With wholesale generation plants being sold, decent rate-base growth story emerges, albeit at low returns. Regulation in IL, MO remains tough.

American Water Works AWK QQ 33.00 42.41 1.29 1.12 2.6 — Avg A very steady business, but easily (and apparently) overappreciated: Extreme capital intensity and low allowed returns on equity limit L-T returns.

Apple AAPL QQQ 600.00 520.63 0.87 12.20 2.3 — Low Revenues likely continue growing, but margins almost certainly contract, hindering profit growth. High uncertainty sharply limits appeal of dividend.

Automatic Data Proc. ADP QQ 65.00 76.45 1.18 1.92 2.5 9.1 High Uninterrupted div hikes since 1974 continue with another 10.3% hike. Not owning the stock becoming one of my top regrets, but too pricey here.

Baxter International BAX QQQQ 80.00 66.37 0.83 1.96 3.0 16.9 High Biotech with wide-moat franchises, promising drug pipeline, emerging-mkt growth and solid div policy. Considering carefully now that yield is 3%.

BB&T BBT QQQ 33.00 33.26 1.01 0.92 2.8 Cut Avg Settled with regulators over capital ratio accounting issues, no further dividend hikes in 2013. Div growth likely next year, albeit at modest pace.

F BCE BCE QQQ 43.00 44.04 1.02 2.22 5.0 9.2 High Canada’s version of AT&T T, albeit with a stronger commitment to dividend growth. Wireless, media assets offset declines of legacy voice service.

Bemis Company BMS QQ 35.00 39.23 1.12 1.04 2.7 3.6 Low Restructuring and focuing on higher-end packaging, but recent price more than discounts improvement potential. Slow pace of div growth likely.

Blackrock BLK QQQ 300.00 298.68 1.00 6.72 2.2 17.5 Avg Manages $4 trillion across geographies, asset classes, styles. Results will reflect market fluctuations, but efficiency, dividend policy are appealing.

P Boardwalk Pipeline Ptrs BWP QQQQ 30.00 27.80 0.93 2.13 7.7 4.2 Low Supported by fee-based revs and strong GP, but industry gas glut hurts regional px differentials to result in weak (2%) L-T distr. growth potential.

Bristol-Myers Squibb BMY QQ 41.00 51.86 1.26 1.40 2.7 3.6 Low Despite a solid drug pipeline, major patent expirations still loom in 2014–15. Div growing only about 3% annually, making stock look expensive.

P Buckeye Partners BPL QQQ 68.00 65.45 0.96 4.30 6.6 5.2 Avg Resumed growth in distributions gives px a big lift this year, biggest head-winds subsiding, gas storage biz a drag but lack of IDRs a long-term aid.

Campbell Soup CPB QQQ 43.00 42.18 0.98 1.25 3.0 5.4 Avg First dividend hike since 2010 a sign of progress. Innovation, asset shuf-fling should help, but KRFT offers comparable L-T growth with higher yield.

CenturyLink CTL QQQQ 41.00 31.48 0.77 2.16 6.9 Cut None Buying back shares with both hands after payout cut earlier this year. Reduced dividend more sustainable than WIN or FTR, but no hikes in sight.

Cisco Systems CSCO QQQ 26.00 24.00 0.92 0.68 2.8 — Avg Best viewed as a cyclical—not unlike “old economy” industrials—though capital allocation polices are improving, one of the better tech-sector divs.

Coca-Cola KO QQQQ 45.00 40.12 0.89 1.12 2.8 8.5 High One of the all-time greats, 2013 brought another nice dividend increase (9.8%), 51 straight years of growth. Possible Builder buy if yield tops 3%.

Colgate-Palmolive CL QQ 59.00 65.09 1.10 1.36 2.1 11.8 Avg Wide-moat global franchises furnish high-single-digit EPS & div growth, not much to criticize, but I prefer higher yields (CLX, UL, KRFT) in staples.

Compass Minerals Int’l CMP QQQQ 84.00 73.45 0.87 2.18 3.0 9.1 High Caught in the potash industry’s bizarre drama, but 75% of profits still come from mining salt—a wonderful business despite weather fluctuations.

ConAgra Foods CAG QQQ 30.00 32.81 1.09 1.00 3.0 5.7 Low Second-rate play in staples as weak brand portfolio, above-avg exposure to commodity prices, near constant restructuring minimizes L-T appeal.

ConocoPhillips COP QQQ 69.00 73.34 1.06 2.76 3.8 10.0 Avg Planned production growth, asset portfolio changes are helpful but already discounted in current price. Prefer CVX, even at somewhat lower yield.

14

Income Bellwethers (continued)



Fair Value

Last Price

Price/Fair Value

Divi-dend

Yield (%)

5-Yr Div Grth (%)


Consolidated Edison ED QQQ 54.00 57.13 1.06 2.46 4.3 0.9 Low Reliable payer, but disappointing growth. Another tough rate case in NYC hinders L-T prospects despite big need for infrastructure replacement.

Darden Restaurants DRI QQ 45.00 52.21 1.16 2.20 4.2 22.7 Low Same-store sales and profits still under pressure, lofty payout ratio a risk factor. Activist investor agitating for breakup, better to stay on sidelines.

F Diageo ADR DEO QQQ 125.00 128.74 1.03 3.03 2.4 6.6 High Dividend hikes continuing to accelerate (up 9% most recently), admirable wide-moat brands and distribution, but income appeal hurt by low yield.

Dominion Resources D QQ 58.00 66.33 1.14 2.25 3.4 7.6 High Plans MLP for midstream assets, regulated operations in Virginia remain attractive. Thx to above-avg growth, a Builder candidate if yield tops 4%.

Dr. Pepper Snapple DPS QQQ 46.00 48.14 1.05 1.52 3.2 — Avg Above-avg yield compared to rivals KO, PEP offset by poor internal growth potential, hindered by focus on sugar soda and lack of global presence.

DTE Energy Holding DTE QQ 58.00 68.16 1.18 2.62 3.8 2.6 Avg Decent growth potential driven by regulated investment and unregulated operations, but we remain wary of economic conditions in Michigan.

Duke Energy DUK QQQ 72.00 70.92 0.99 3.12 4.4 3.3 Avg New CEO has work cut out following Progress merger and mgmt turmoil. Recent div hike—just 2%—indicative of medium-term growth potential.

E.I. du Pont de Nemours DD QQQ 57.00 60.94 1.07 1.80 3.0 2.3 Low Continues shift toward ag/bioscience with planned spinoff of performance chemicals, story gets more interesting but dividend appeal still modest.

F Eaton ETN QQQQ 84.00 72.45 0.86 1.68 2.3 12.1 Avg Once heavily reliant on deeply cyclical heavy truck market, now a diversi-fied industrial focused on electrical products w/respectable L-T div outlook.

Edison International EIX QQQ 48.00 48.07 1.00 1.35 2.8 2.2 Low Appealing SCE all that’s left of once-diversified utility. Would like higher payout, but funds may be diverted to non-regulated acquisitions instead.

Eli Lilly LLY QQQ 52.00 50.55 0.97 1.96 3.9 2.9 Low Promising new product pipeline, but massive patent expirations create flat sales profile for perhaps a decade. Higher-yielding GSK offers growth.

P Enbridge Energy Partners EEP QQQQ 35.00 29.05 0.83 2.17 7.5 2.9 Low Selling 40% of natural gas unit (Midcoast) helps, but coverage still very poor, huge expansion plans may yield little by way of per-unit distr. hikes.

P Energy Transfer Partners ETP QQQQ 63.00 52.52 0.83 3.62 6.9 0.4 Low Kelcy Warren pulled it off: M&A spree and simplification drive allows distr. growth to resume after 5-yr lull. IDR burden still weighs on L-T growth.

Entergy ETR QQQ 70.00 62.79 0.90 3.32 5.3 5.2 None Merchant units in better shape than Exelon’s, but div may be “right-sized” after transmission spinoff. Regulated assets far less profitable than SO.

P Enterprise Products Ptrs EPD QQQ 64.00 60.88 0.95 2.76 4.5 5.8 High One of the highest-quality midstream MLPs with simple organizational structure and healthy distr. growth despite some commodity-sensitive ops.

Exelon EXC QQQQQ 42.00 28.06 0.67 1.24 4.4 Cut None Despite yield, very little appeal for income buyers following dividend cut. Still a play on the uncertain path of natural gas/merchant power prices.

ExxonMobil XOM QQQ 97.00 92.59 0.95 2.52 2.7 9.7 Avg Still the industry’s preeminent operator, nice to see dividend growing faster (21% for ‘12, 11% for ‘13), but CVX offers higher yield, L-T div growth.

R Federal Realty Investment FRT QQQ 100.00 105.64 1.06 3.12 3.0 3.7 High Appealing REIT with uninterrupted div hikes since 1967, strong balance sheet, nice growth potential and good mgmt … but yield is still too low.

FirstEnergy FE QQQ 42.00 36.07 0.86 2.20 6.1 1.9 None Payout ratio hovering near 75% as wholesale profits shrink, coal plants are shuttered. Lofty current yield indicates elevated risk of a dividend cut.

Frontier Communications FTR QQQ 5.50 4.78 0.87 0.40 8.4 Cut None Further dividend cuts are possible as revenues continue to decline, competi-tive pressures remain intense, and cost-cutting opportunities are finite.

General Dynamics GD QQQ 92.00 87.08 0.95 2.24 2.6 17.9 Avg Like peers, defense spending cuts hurt revenue growth, offset by efficiency and capital redeployment. Low payout ratio leaves room for larger div.

Genuine Parts GPC QQ 65.00 81.76 1.26 2.15 2.6 6.3 High Sincerely hope to own this auto-parts distributor again someday, but with dividend yield at historically low levels, unlikely to buy anytime soon.

Hasbro HAS QQQ 53.00 52.95 1.00 1.60 3.0 23.7 Avg Reliance on licensed movie characters for toy lineup creates volatility, but likely aids results in next 2 yrs. Like rival MAT, offers attractive div policy.

R HCP HCP QQQQ 50.00 39.45 0.79 2.10 5.3 2.4 Avg Surprise dismissal of longtime CEO—who steered HCP through more than a decade of steady div growth—is a concern, best to wait and watch.

F HSBC Holdings ADR HBC QQQ 58.00 55.23 0.95 2.40 4.3 Cut Low Dividend up in last 3 years after slash during the crash. Still question ability of such large bank to control risk, but back-to-basics push is promising.





Fair Value

Last Price

Price/Fair Value

Divi-dend

Yield (%)

5-Yr Div Grth (%)


Illinois Tool Works ITW QQQ 76.00 79.25 1.04 1.68 2.1 8.6 High Like 3M, keeping ITW in the Bellwethers for appeal of business (enhanced by restructuring plans) and record of dividend growth, but no buy here.

Iron Mountain IRM QQQ 26.00 26.45 1.02 1.08 4.1 — Low Ample cash generation and 4% yield—even before planned REIT conver-sion—are alluring, but best to stay on sidelines as IRS approval plays out.

ITC Holdings ITC QQQ 98.00 94.31 0.96 1.70 1.8 5.3 Low Not a Builder candidate, yet mid-double-digit growth potential justifies low yield. Key risk is FERC ROE rollbacks, but we think any cuts will be modest.

J.P. Morgan Chase JPM QQQ 52.00 54.14 1.04 1.52 2.8 — Low Regulators slamming the bank on multiple fronts as post-crash glow goes dark. First big bank to fully restore dividend, but income appeal still low.

Kellogg K QQQ 60.00 62.47 1.04 1.84 2.9 7.7 Avg 4.5% dividend hike for 2013 comes in relatively disappointing for second year, product innovation/marketing should help growth accelerate L-T.

Kimberly-Clark KMB QQ 93.00 108.84 1.17 3.24 3.0 6.9 High We expect growth to accelerate—7%–9% gains in EPS and dividend—based on competitive strength and cost controls, but price discounts this.

Lockheed Martin LMT QQ 111.00 137.26 1.24 5.32 3.9 23.1 Avg Backlog, cost cutting, cash returns surprisingly effective in offsetting DoD spending cuts. Rising rates aid pension funding, but stock still overpriced.

Lorillard LO QQQ 45.00 52.08 1.16 2.20 4.2 27.8 Low Lowest yield in domestic tobacco, though best growth outlook thanks to Newport, e-cig biz. Mostly risk of menthol regulation that wards me off.

M & T Bank MTB QQ 101.00 111.67 1.11 2.80 2.5 1.5 Avg Strong, well-managed regional lender with a knack for acquisitions. Div flat since 2008 but never cut during crash, growth may resume in 2014.

Mattel MAT QQQ 46.00 45.55 0.99 1.44 3.2 10.6 Avg Long-term headwinds for traditional toys a minus, but story aided by foreign exposure and prudent capital allocation—incl. rapidly-rising dividend.

Merck & Co. MRK QQQ 52.00 47.34 0.91 1.72 3.6 2.1 Low Flat top-line prospects thru 2018 as patent expirations offset likely new products, puts emphasis on cost cuts/buybacks to drive EPS/div growth.

Microchip Technology MCHP QQQ 42.00 43.44 1.03 1.42 3.3 3.1 Low Early adopter of a generous payout in tech, but other chipmakers are catching up on the dividend policy front, and div hikes have been very small

Microsoft MSFT QQQ 38.00 38.16 1.00 1.12 2.9 15.7 Avg Payout ratio now tops 40%, though I’d prefer 60%. Possible for a new CEO to improve capital allocation, though L-T business headwinds persist.

F Nestle ADR NSRGY QQQ 76.00 72.72 0.96 2.23 3.1 13.6 Avg Wide economic moat rating reflects expansive global footprint, strong brands. Decent L-T div growth, but UL slightly more attractive for income.

NextEra Energy NEE QQQ 80.00 86.10 1.08 2.64 3.1 7.9 High Leader in renewable energy w/o much market risk, decent regulated assets too, but peer-leading dividend growth not enough to justify 3% yield

Norfolk Southern NSC QQQ 86.00 87.62 1.02 2.08 2.4 15.1 Avg Declining coal traffic has been matched with cost cutting, performance that reflect wide moat. Wish payout ratio target was higher than 33%.

Northeast Utilities NU QQ 36.00 42.17 1.17 1.47 3.5 11.3 High Heavy investments in electric transmission are key earnings/dividend growth driver, but possible rollbacks in FERC allowed returns creates risk.

F Novartis ADR NVS QQQ 80.00 78.85 0.99 2.50 3.2 9.6 Avg Solid all around with multiple business lines and geographic diversity, but growth is modest—trailing rival J&J—and yield struggles to compensate.

Nucor NUE QQQ 56.00 52.39 0.94 1.47 2.8 5.3 Low Better than rivals, good dividend policy, but needs faster economic recovery (especially in construction) to get earnings/dividends out of low gear.

Occidental Petroleum OXY QQQ 102.00 97.00 0.95 2.56 2.6 18.1 Avg History of solid dividend growth is encouraging, as are recent moves to cut costs, enhance focus on Texas. Prefer CVX, but wouldn’t rule OXY out.

Old Republic International ORI QQQ 16.00 17.17 1.07 0.72 4.2 7.0 Low Rebounding profitability, falling mortgage insurance claims help support generous dividend, though outlook for dividend increases remains muted.

P ONEOK Partners OKS QQQ 58.00 52.63 0.91 2.90 5.5 5.4 High NGL glut pushed coverage below 1x and crimped N-T distribution growth, but OKS retains appeal for those willing to ride commodity px swings.

People’s United Financial PBCT QQQ 14.00 14.65 1.05 0.65 4.4 4.2 Low Sold from Harvest on Oct. 14. Still see dividend as reliable, but low rates hurt, efficiency targets are questionable, bigger div hikes still years away.

PepsiCo PEP QQQ 88.00 85.95 0.98 2.27 2.6 8.4 High Trails KO in beverages, but the clear leader in salty snacks (Frito-Lay), performance improving after rough 2012. L-T div hikes in high single digits.

Pfizer PFE QQQ 30.00 31.87 1.06 0.96 3.0 Cut Avg Past the worst of patent cliff, sales flat over next 4–5 years. Cost cuts, buybacks allow div hikes, but yield still low given lack of internal growth.

16



Fair Value

Last Price

Price/Fair Value

Divi-dend

Yield (%)

5-Yr Div Grth (%)


PG & E PCG QQQQ 46.00 40.97 0.89 1.82 4.4 4.8 Low Current appeal limited as penalties over San Bruno explosion still unclear, but once those issues are resolved, a much better story may reemerge.

Piedmont Natural Gas PNY QQ 27.00 33.24 1.23 1.24 3.7 3.8 High Small but conservative and well-run utility stays on Bellwethers despite persistent overvaluation, hoping for chance to buy for Harvest someday.

Pinnacle West Capital PNW QQQ 55.00 54.33 0.99 2.27 4.2 0.2 Avg Second straight year of dividend growth reflects mgmt optimism that ROEs will improve, Arizona regulatory environment better than it once was.

P Plains All American PAA QQQ 48.00 50.92 1.06 2.40 4.7 5.2 High Ideally positioned to capitalize on rising tide of domestic crude prod’n, not perfect (gas storage biz a drag) but see high single dight distr. growth.

PPL Corporation PPL QQQQ 35.00 30.33 0.87 1.47 4.8 3.4 Avg Acquisition-led shift in business mix shores up safety of dividend, but ongoing exposure to wholesale power prices limits medium-term growth.

R Public Storage PSA QQ 123.00 160.26 1.30 5.60 3.5 17.1 High Another hefty div hike (12%) reflects PSA’s moat, would surely consider buying at fair value. Yet growth is bound to slow L-T, shares overpriced.

Raytheon RTN QQQ 83.00 85.46 1.03 2.20 2.6 14.4 Avg Raised FVE 24% on better-than-expected 2013 performance, shrinking pension deficits, though longer-term rev growth outlook remains stagnant.

Reynolds American RAI QQ 42.00 52.12 1.24 2.52 4.8 7.8 Low Shares U.S. cigarette oligopoly with Altria MO & Lorillard LO, but weaker brands hurt L-T growth potential, and RAI is most expensive on price/FV.

F Royal Bank of Canada RY QQ 55.00 68.02 1.24 2.56 3.8 4.7 Low Div rising fast (2 hikes in ‘13 totaling 12%) as Canadian banking and its largest bank are admirable, but inflated house prices too much of a threat.

Sempra Energy SRE QQ 74.00 89.49 1.21 2.52 2.8 14.1 Avg State-regulated units in CA haven’t had much luck with rate cases, yield too low, but LNG projects and other unregulated ops should aid growth.

R Simon Property Group SPG QQQ 153.00 149.68 0.98 4.80 3.2 4.6 Avg Leading mall operator goes on raising dividend as taxable income rises, but even trading a bit below fair value, a low-3% yield is hard to swallow.

Sysco SYY QQQQ 38.00 33.40 0.88 1.12 3.4 5.5 Low Profit growth stalls as internal restructuring initiatives fail to offset macro headwinds. Still rated wide-moat, but revival in growth several yrs away.

Texas Instruments TXN QQ 36.00 42.39 1.18 1.20 2.8 19.1 Avg Has joined other chipmakers like INTC in offering above-average yield despite cyclicality and capital intensity. Not a buy here, but worth watching.

Time Warner Cable TWC Q 84.00 120.14 1.43 2.60 2.2 — High Wide moat network generates lots of cash despite occasional strategic miscues, but valuation inflated by takeover expectations we find unlikely.

F TransCanada TRP QQQQ 52.00 44.93 0.86 1.76 3.9 5.4 Avg Uncertainty regarding Keystone XL project clouds the medium-term story, but it’s not great to begin with as gas output falls in Western Canada.

Verizon Communications VZ QQ 42.00 49.99 1.19 2.12 4.2 4.0 Avg Finally buys rest of Verizon Wireless, hefty price tag offset by favorable financing, net effect on dividend is minimal—but appeal remains mediocre.

R Vornado Realty VNO QQQ 94.00 88.67 0.94 2.92 3.3 Cut Avg Core property portfolio (NYC/D.C.) forms narrow moat/decent growth potential, shedding noncore assets, but div growth likely to be inconsistent.

Wal-Mart Stores WMT QQ 74.00 78.90 1.07 1.88 2.4 12.6 Avg Sales growth has shriveled—law of (very) large numbers applies. Payout becoming more generous, but erosion of competitive strength a concern.

Waste Management WM QQ 35.00 44.18 1.26 1.46 3.3 8.1 Avg No change in view since sale in May: Devoted to its dividend, but subpar EPS growth/high payout ratio limit growth prospects, stock looks pricey.

Westar Energy WR QQQ 31.00 31.99 1.03 1.36 4.3 4.1 Avg Sold in May when SO presented superior long-term opportunity at compa-rable valuation. Could consider again in future if price becomes cheap.

Williams Companies WMB QQQ 33.00 34.39 1.04 1.46 4.2 25.1 High As GP, levered to distribution hikes and unit issues at WPZ. Holds to aggressive investment 2015 despite near-term commodity price headwinds.

P Williams Partners WPZ QQQ 55.00 49.77 0.90 3.51 7.1 9.0 Avg Big fee-based projects diluting commodity px sensitivity, current coverage weak but should top 1x in 2015 even as distr. continues to rise 6%/yr.

Windstream WIN QQQ 8.50 8.28 0.97 1.00 12.1 0.0 None Market clearly pricing in big dividend cut. As cash flow remains in secular decline, firm will struggle to reduce leverage while maintaining payout.

Wisconsin Energy WEC QQ 35.00 41.06 1.17 1.53 3.7 19.1 Avg Still looks pricey, but 4%–6% EPS growth in a favorable regulatory envi-ronment and the phasing-in of a more generous payout ratio are pluses.

Xcel Energy XEL QQQ 28.00 28.51 1.02 1.12 3.9 3.2 High Diverse, low-risk utility in fairly-regulated jurisdictions. Div hikes planned in line with EPS growth (4%–6%), lower px could trigger Harvest buy.



Josh’s ViewWhile the yield is alluring, I’m not enthused by the exposure here to natural gas industry conditions. Core Harvest holding AmeriGas Partners APU offers a slightly higher yield and better growth prospects.

Morningstar’s TakeBoardwalk BWP operates 3 interstate pipeline systems and 11 underground storage facilities span-ning from Texas to Ohio. The firm’s 14,000-plus miles of pipelines weave among many of the nation’s top tight oil and gas plays, including the Barnett, Haynes-ville, Fayetteville, Woodford, and Eagle Ford. Prox-imity to emerging supply sources dovetails nicely with Boardwalk’s access to myriad pipeline interconnects, local distribution companies, industrial end users, power plants, and others on the demand side. In particular, forecast growth in natural gas-fired power generation in the Southeast will benefit Boardwalk.

Despite generally favorable fundamentals, Boardwalk faces several challenges. For one, it must avoid cost overruns that have affected certain growth projects, hurting returns on capital and diluting limited partners. The firm has also expressed concern about contract renewal rates, which are affected by currently poor basis spreads and the available capacity among

various markets. While we expect gas prices to improve long term, basis spreads between delivery points have also fallen since a few competing large-scale interstate pipelines came on line in recent years. This detracts from interruptible and short-term firm transportation revenue.

The Distribution: Is It Safe?Although Boardwalk derives about 80% of its revenue from capacity reservation fees that don’t depend on near-term commodity prices or volume, the more volatile remainder of revenue and cash flow has been a disappointment in recent years. Cash coverage of distributions has slipped below 1.0 times twice in the past four years; we estimate coverage of 0.95 times for 2013. We don’t believe this shortfall raises the risk of a distribution cut: Though the balance sheet is more highly leveraged than most peers (net debt about 4.5 times EBITDA), Boardwalk enjoys a solid underpinning of contracted cash flow as well as the support of a very well-heeled parent in Loews L. Instead, we see view poor coverage primarily as a hindrance to distribution increases.

The Distribution: Will It Grow?We expect distributable cash flow to increase at a 10% average annual rate through 2017, as cash flows from current pipeline and storage investments in the Gulf Coast region come through and an improved commodity price environment brings better long- term contract rates, renewals, and interruptible parking and lending volume. We are cautious, however, on the pace of the ramp-up of the recently acquired midstream services operation, as its partner in the Marcellus recently slows its drilling plans. Further-more, as additional equity is raised to fund expansion and the burden of general partner incentives remains heavy, we see per-unit distributions rising at a meager 2% annual rate over the next five years.

The Distribution: What’s the Return?Though Boardwalk looks slightly undervalued relative to our $30 fair value estimate, and its 7.7% yield makes it one of the highest-yielding midstream part-nerships we cover, its per-unit distribution growth potential is among the lowest. This leads to expected long-run total returns averaging 9%–10% annually. œ

Boardwalk Pipeline Partners BWP The Dividend Drill | Josh Peters, CFA, and Connie Hsu, CFA


p Unit Price p Distribution Rate

Boardwalk Pipeline Partners: Unit Price and Distribution Rate ($)

32

24

16

8

2.28

1.71

1.14

0.57

2006 2007 2008 2009 2010 2011 2012 2013

Boardwalk Pipeline Ptrs BWP

Star Rating QQQQEconomic Moat Wide

Uncertainty Rating Low




Dividend ($) 2.13

Yield (%) 7.7

Est’d Coverage 0.95x

5-Yr Growth (%) 4.2

Credit Rating —

Before You Buy: MLP Taxation While MLPs have unique tax characteristics that may benefit some investors, others—particu-larly those dealing in tax-deferred accounts such as IRAs, 401(k) plans, and Roth accounts—may find these securities to be unsuit-able. Before investing in BWP or any other MLP, we urge you to consult a tax professional.

33

18

Josh’s ViewVornado’s VNO recent moves toward simplifying its portfolio are encouraging, and I wouldn’t rule out a purchase if the stock got cheap, but I generally prefer more-predictable real estate investment trusts.

Morningstar’s TakeWe like the characteristics of Vornado’s core office and retail properties, situated mainly in and around New York and Washington, D.C. These markets benefit from constraints on building competitive supply, local, national, and foreign demand for space, and favorable demographics. However, a 32-year streak of uninter-rupted cash flow growth from Vornado’s core portfolio ended in 2012 amid weakness in the D.C. market, where federal spending cuts have sharply decreased occupancy. Uncertainty surrounding the federal budget in D.C. and the potential for increased supply from new developments in New York may damp the leasing environment in these markets. We expect Vornado to perform below its potential in the near term, but longer term we think its quality properties will generate moat-worthy levels of internal growth that slightly exceeds inflation.

A portion of Vornado’s value is attributable to invest-ments in debt and equity of other companies with real

estate exposure, as well as joint ventures. Among these holdings, the company owns chunks of retailer Toys ‘R’ Us, two publicly traded REITs, and mezzanine and mortgage debt securities. It recently liquidated a stake in J.C. Penney JCP at a loss. These ancillary investments divert management’s attention from its core business and make it more difficult to analyze and value the shares. Along these lines, Vornado has embarked on a strategy to simplify its balance sheet and sell noncore assets, particularly in retail.

The Dividend: Is It Safe?Vornado is in fine financial health, with plenty of liquidity and a manageable debt maturity profile. By our measure, debt is 7.4 times consolidated EBITDA—reasonable for an office REIT, even though this does not consider the contribution from Vornado’s $3 billion of nonconsolidated investments. The dividend is running at about 87% of funds available for distri-bution, a measure of recurring cash flow. Like most REITs, Vornado reduced its dividend in early 2009 to preserve liquidity, but barring another crisis of compa-rable magnitude, we would not expect another cut.

The Dividend: Will It Grow?The dividend rate has recovered 92% from what was paid in 2009, but has yet to reattain its precrash rate of $3.80 a share. Vornado’s stated policy is to pay out its taxable income, supplementing regular divi-dends with one-off payments if necessary to maintain compliance with the tax rules for REITs, but otherwise retaining cash flow in excess of taxable income. Based on the prospects for its core portfolio, we esti-mate the dividend can grow at a roughly 5% annual rate going forward. However, despite a steady pattern of advances until 2008, we doubt that future dividend increases will be consistent from year to year.

The Dividend: What’s the Return?With the shares trading at a modest discount to our $94 fair value estimate and yielding 3.3%, Vornado offers the potential for long-run total returns slightly exceeding our 8% cost of equity assumption. But given the complexity of the organization and its historical disposition to making nontraditional invest-ments, many investors seeking consistent income and growth will find other REITs more attractive. œ

Vornado Realty Trust VNO The Dividend Drill | Josh Peters, CFA, and Todd Lukasik, CFA


Vornado Realty Trust: Stock Price and Dividend Rate ($)


*Based on funds available for distribution (FAD); see text.

104

78

52

26

3.24

2.43

1.62

0.81

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Vornado Realty Trust VNO

Star Rating QQQEconomic Moat Narrow

Uncertainty Rating Medium




Dividend ($) 2.92

Yield (%) 3.3

Payout (%)* 87

5-Yr Growth (%) Cut

Credit Rating —


ratio for the S&P was 53%. By 2010 and 2011, divi-dends disposed of only 27% of operating earnings. Lately, however, I can see some signs of improvement. In the past two years, dividends have grown faster than earnings, lifting the operating payout to 34%. Excluding periods of depressed earnings in 2001–02 and 2008–09, that’s the highest payout since 1998.

Share repurchases are still larger than dividends in terms of total dollars, but the mix is shifting in favor of dividends. Since buybacks are easier to dial up and down than dividend rates, this nascent trend expresses confidence on the part of big corporations in the durability of profits going forward. The 2% yield of the S&P is still low by historical standards, but if—as I expect—the market gradually demands more generous dividends, at least companies have ample resources with which to supply them.

Strategy for a Fairly Valued MarketCombining these factors—historically justifiable P/Es, sustainable levels (in my view) of corporate profits, and more generous dividends—gives me comfort that the current level of the stock market is reasonable. This is reflected in our bottom-up fair value estimates as well: The median stock that Morningstar covers is now priced at a 4% premium to fair value, which I would describe as within the margin of error.

Of course, if the economy tips into an unexpected recession (is there any other kind?), profits will slump for a time, and so will stock prices. Recessions aside, the market also seems overdue for a correction: It’s been over two years since the S&P fell 10% or more from its most recent peak. And if prices continue to

rise significantly faster than earnings, the P/E could move into historically overvalued territory, and even longer-term investors could have reason to worry.

So what’s the pitch for a more or less fairly valued stock market? From a starting point around fair value, investors can expect fair returns—8% to 10% a year on average over lengthy time horizons—along with the usual volatility in shorter periods. For long-term investors holding diversified portfolios, low purchase prices are advantageous. But I don’t think it’s necessary to hold out for bargains, particularly when the ready alternatives to stocks—bonds and cash—provide either very low or nonexistent returns. From there, our playbook is simple, and it continues to serve us well:

p Reliable dividends with above-average yields and solid growth potential. Leaning more on dividends within our desired total returns lessens our reliance on capital appreciation, but I still require both safety and consistently rewarding dividend increases.

p Wide and narrow economic moats. Identifiable and sustainable competitive advantages protect the profits that fund our dividends during downturns and encourage long-run dividend growth.

p A tilt toward economically defensive businesses. Sectors like staples, utilities, telecoms, and energy tend to underperform the S&P during bull markets, but they make up for the lagging stretches with far less downside in tough times.

p A long-term commitment. Over the years I’ve often been bearish on the market as a whole. I noted earlier that I didn’t realize at the time how attractive the market’s P/E was in 2011; I figured it deserved to be low. But I didn’t need to be overtly bullish then to do well, and I don’t now. Dividends give us the luxury of focusing less on the market and more on our strategy and the stocks it helps us select. If the S&P hops up to 25 or 30 times earnings—historically perilous levels—the time may come to shift gears. But unless and until that happens, I’ll stick with our policy of remaining fully invested, and manage our risks by holding high-quality, highly reliable dividend payers whatever the market or economic trend may be. œ

Seems Reasonable, So Let’s Carry On Continued From Page 4

Gray bars reflect recessions. Data from 1997 through the four quarters ending Q3/2013. Source: Standard & Poor’s.

S&P 500: Operating Payout Ratio (%)

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

60

50

40

30

20

10

Morningstar DividendInvestorVolume 9, Number 11

Director of Equity-Income Strategy and EditorJosh Peters, CFA

Contributing AnalystsConnie Hsu, CFA, Erin Lash, CFA, Todd Lukasik, CFA,Thomas Mullarkey, CFA

Copy EditorSylvia Hauser

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PublisherPeggy Seemann

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President, Research Don Phillips

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