How to Strengthen Your Income Portfolio

Laura Lallos: Hello, I’m Laura Lallos with Morningstar. Dividend investing is always a popular topic here on Morningstar.com and at the annual Morningstar Investment Conference, which is slated to happen soon here in Chicago. The appeal is obvious. Dividend-paying stocks promise regular income and more stable performance, but a dividend isn’t a guarantee of those things. Here with me is Damien Conover, Morningstar’s director of equity research in North America. At this year’s conference, Damien is leading a session called “Building Portfolios for Income: Investing in Dividend and Paying Stocks With Moats.” Now, “with moats” is the key here because companies with durable competitive advantages are better long-term bets.

Damien, thank you for joining me for a preview of your session.

Damien Conover: Absolutely. It’s great to be here.

Lallos: Let’s start with a quick refresher. What is a moat, and how does Morningstar determine if a company has one?

Conover: It’s an important question, and it’s sort of foundational to what we do in the equity research analysis. When you think about an economic moat, it’s a structural ability to keep profits high. So, if you think about the capital markets, if there’s a firm that’s generating excess returns, a lot of other firms want to come in and get those profits. But sometimes structural advantages enable firms to keep profits for a very long time. And that’s what we call economic moats. And we’ve identified five different sources of economic moats. The first one is cost advantage. That enables a firm to produce something or sell something more cheaply than others. It gives them those excess returns. Another source is intangible assets. That can be brands, patents, things that enable higher pricing power. And then another one is switching costs. A lot of times, you’ll get a product embedded into a process for a client, and to move away from it, it’s very expensive. So, you stay with that particular product.

And then one more is what we call efficient scale. So, efficient scale is something where the market is really well served by the current producer, and it’s too expensive to come in because if another firm comes in, all the profits go below the cost of capital. And then lastly, network effect. Network effect is when you get a lot of folks into a particular product, the value of that product goes up, and then that attracts even more people.

So, a lot of different ways you can get an economic moat, but it’s not that prevalent out there. You don’t see a ton of economic moats. And that’s what we try to do at Morningstar, try to identify firms with economic moats that enable those strong returns for a long period of time.

Lallos: There are different sources of moats, but a company that has a moat, that’s a sign it’s a strong and healthy company. Is a dividend a sign that a company is strong and healthy?

Conover: Dividends are incredibly important for investors, and I do think it does signal certain things about firms. Generally speaking, as a firm kind of progresses through its lifecycle then becomes a little bit more mature, it’s more likely they’re going to be paying out dividends. Firms earlier in their lifecycle are going to be redeploying a lot of capital toward initiatives to help them grow. But as firms start to mature, you start to see that payout of earnings increase. And for investors, that’s an area where a lot of people really like to be positioned, to get those dividends with their portfolio.

Lallos: How do dividends and moats work together?

Conover: It’s an interesting dynamic. When we think about dividends, it’s pretty rare firms cut dividends, but it can happen. But firms with economic moats, those profits are protected. And so the likelihood for a dividend cut or even decreasing dividends going forward is reduced as firms have really strong competitive positioning, a positioning that we would recognize with an economic moat. So, I think when you look at dividends and you think about an economic moat, when you overlay those two, it sets you up for a little bit more security on those dividends.

Lallos: Your panel at the conference includes several other Morningstar analysts who cover consumer names, healthcare names, utilities. Why these sectors? Are these particularly good sources for people who want a moat and a dividend?

Conover: We do. We think these are sectors that are really important for dividends. These tend to have areas of industries within each one of those sectors that have more maturity with them, and you’re seeing a lot more cash flow going back to dividends. So, when you look about healthcare, for example, there are a lot of different industries in there, but the large-cap pharmaceutical firms are a little bit more mature, and they’re paying out close to 50% of their earnings in dividends. That’s why that industry is very well positioned for dividends. And it’s part of the reason why healthcare’s identified similar sorts of traits that we see with utilities and consumers. There are industries in those sectors that are paying out a lot of their cash flow to dividends.

Lallos: You have a moat, you have a dividend. Does that mean a company is a slam dunk for an investor? Are there caveats here?

Conover: Great questions. Definitely caveats here. So, when you think about dividends, you generally want to think about where the ability for that firm is going to be to continue to pay those dividends. And sometimes, when you see a large dividend yield that might be attractive, but you also have to be careful because sometimes if the dividend is getting very high in its yield, that might mean investors are concerned that there could be an upcoming dividend cut. What we try to do at Morningstar is look at not just the dividend itself, think about the yield, think about the ability of the firms to pay that dividend going forward. And importantly, we’re really looking at valuation as well. So, if you buy a stock that’s way overvalued just for the dividend, that could be a poor total return over time. You really want to combine valuation, the ability to pay the dividend, and the economic moat.

And if you do that, we think that’s going to position you best for investing for elements of dividends.

Lallos: Keeping valuation in mind, can you give us some picks that are attractively valued today?

Conover: Absolutely. At the conference, we’re going to unpack these a little bit more, but a couple of names that we’d highlight right now: Pfizer PFE is one of the names that we like. We think it’s undervalued. We think the market’s underappreciating its innovation to get through patent losses, and it’s a firm that’s paying a very nice dividend. And when you think about this firm as well, it’s a firm that carries an economic moat that protects its profits largely through patents, so that intangible moat source. So, Pfizer’s a name we like right now. Shifting gears to the consumer space. Campbell’s CPB is a name that we think is undervalued. Campbell’s derives its moat source more from brand power. Also intangible assets, but it’s a brand that’s very well-known. That brand enables stronger pricing power.

And then lastly, on the utilities side, a name that we’re highlighting is Portland Electric POR. Portland is an interesting name because it has one of the more rare moat sources, which is efficient scale. And basically, what that means is another utility really can’t come into the space and have excess returns as well because it’s already very well serviced by Portland. We think Portland’s undervalued, also a nice steady stream of dividends we’re expecting from the firm.

Lallos: Well, thank you. That’s a great slate of picks, and I look forward to learning more about them at your panel. And I’ll see you at the conference. Thanks, Damien.

Conover: Super. Thanks, Laura.