Dividend Investor

Day after day, week after week, the stock market just keeps going up. Yet it seems that the breakout into new all-time highs is creating more anxiety, perhaps even discomfort, than joy. Then again, after reading a bit of market history, isn’t that what we should expect in the early stages of a secular bull market?

If this is a new secular bull market—and by secular, I mean a trend that transcends the shorter-term cyclical ups and downs—we may have some adjusting to do. From the peak of the August 1982–March 2000 bull market until recently, the market was essentially range-bound. In such an environment, it might pay to anchor your expectations around certain price levels, capture your capital gains, and hold cash for the next pullback. But those conditions lasted so long that many investors—including most professionals, as far as I can tell—may have trouble coping with a market that is marching into new territory. There is also a strong but largely unfair impulse to regard all higher prices as evidence of bubbles. With a mentality shaped by the traumas of 2000–02 and 2007–09, skepticism is rational ... but not necessarily profitable.

Lately, I’ve been besieged by the question: Is it time to sell? It’s a fair question, but not the most important one. The question on which our decisions should turn is the follow-up: What do we do with the money? After all, that money has to go somewhere.

There’s no way to know, except with the benefit of hindsight, if a new secular bull market is under way.

However, I’m not sure it’s necessary to know. Through the dark days of 2008 and 2009, I deployed a concept I called the courage to do nothing. While I made the occasional trade to improve the position of our portfolios—especially where our dividend income was concerned—I stayed fully invested. I let the bear market drag the market values of our accounts lower without abandoning our strategy, which turned out to be a very profitable view to hold. Now that stock prices are setting new records and still rising, I think the same courage is equally valuable.

Temptations, Temptations ...Along with the rest of the market, our Builder and Harvest portfolios have enjoyed large gains in the past few years. As of this writing, fully half of our individual holdings were quoted within 3% of their 52-week highs, most of which are also all-time highs. A few of our results are little short of spectacular, with cumulative total returns surging into triple-digit territory for seven of our current portfolio positions.

These gains were made in part by my willingness to let our winners run. I measure our progress primarily on the basis of the income we’re collecting and the growth of that income through dividend increases. As long as a particular company is performing well—meeting or exceeding my expectations for dividend growth without taking unexpected risks—then I’d rather hang on to the stock. Even if the stock starts to look somewhat overvalued, I only act if and when there is a clearly better use of my capital in sight.

But let’s say we were to sell some of our stocks. What would our choices be? We could have some fun. If you’re inclined to buy a new car, take a vacation, remodel a room or two—by all means, go ahead. Gerald Loeb, one of Wall Street’s wise men a few

Builder Portfolio 4Chevron, Clorox, P&G, J&J ... the drumbeat of dividend increases goes on and on

Builder Focus 7Spectra Energy: Hurt by gas processing spreads, but the dividend is funded by fees

Harvest Portfolio 8All five of the Harvest MLPs raise our pay; American Electric Power and People’s United too

Harvest Focus 11AT&T: Will share buybacks aid dividend growth? We’ll have to see.

Income Bellwethers 12Kicking all no-moat stocks off the list; welcoming 9 new members

The Dividend Drill Air Products & ChemicalsMicrosoftNestle ADR

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

Continued on Page 2

Courage to Do Nothing: Bull Market Edition

DividendInvestorJune 2013 Vol. 9 No. 5

Quality recommendations for current income and income growth from stocks

SM

2

generations ago, once suggested that the best way to preserve the purchasing power of your money is to spend it. But this isn’t an investment decision so much as a lifestyle one. Furthermore, if you have some large financial obligation coming due in the near term (college tuition, for example), it isn’t wise to hold those funds in stocks in the first place.

But if the proceeds from any stock sales will stay in your portfolio, a close examination of the alternatives is very important. Conceivably a person worried about lofty stock prices could shift funds into bonds—but it’s very hard to argue that long-term Treasuries, or even high-grade corporates or mortgages, will beat the total returns of stocks going forward. As I noted in last month’s issue, stocks may not be cheap, but bonds are very dear indeed. Ben Graham identified the margin of safety for defensive investors as the gap between the earnings yield on stocks (the inverse of the price/earnings ratio: per-share profits divided by prices) and the yield offered by bonds. As shown below, this spread is unusually favorable for stocks right now. By no means does this prove that stocks are a bargain in an absolute sense, but it does make a convincing case for their appeal relative to bonds.

If you stick with stocks—the course I think is best—then it may be possible to pick some up that are cheaper than the ones you own now. This is a huge part of my job, and I’m always looking for opportunities to add extra dividend income or long-term income growth to our portfolios. However—echoing another one of Graham’s views that I cited last month—we must not sacrifice quality in the process. I could, for

example, boost the Harvest’s income significantly by selling Magellan Midstream MMP (the account’s biggest winner and, at a 3.8% yield, one of its lowest-yielding positions) to buy rural telecom Windstream WIN at a yield near 12%. But Magellan is on track to raise its payout by 10% or more for several years to come; more important, its business and balance sheet are well positioned to maintain our pay even under adverse circumstances. Windstream’s dividend is extremely unlikely to rise, and as its sales and cash flows continue to shrink, a heavy debt load could force a big dividend cut. This isn’t my idea of progress.In sticking with high-quality dividend payers, we run into a different challenge. Many of our holdings look fairly to fully valued at this point—but so do almost all of the ready alternatives. In discussing the recent results of the Builder and Harvest accounts this month, I mentioned several trades that I’m considering. But there isn’t a lot to consider; only two stocks on our Bellwethers watchlist are trading below their Dividend Buy prices. For better or worse, there simply isn’t a lot of value to be added on this front right now—and to realize capital gains in taxable accounts would involve a fairly significant cost by way of taxes.

There’s also the question of whether the high-quality, high-dividend stocks that have been so good to us are simply overvalued across the board and due for a fall. Given an appropriately long time horizon, I don’t think that’s the case (another issue I discussed last month), but I’ll grant that there may be profitable opportunities among other kinds of stocks. But to sell stocks like Magellan, General Mills GIS, or Realty Income O—proven winners that generate

Courage to Do Nothing: Bull Market Edition Continued From Cover

p S&P 500 Earnings Yield p 10-Year Treasury Bond Yield

Monthly data through April, 2013. Source: Robert Shiller, Yale University; Morningstar analysis

Stocks: May Not Be Cheap, But Much Better than Bonds

12

8

4

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Windstream WIN

Star Rating QQQQEconomic Moat Narrow

Uncertainty Rating High

Fair Value ($) 10.00

Dividend Buy ($) 6.00

Current Price ($) 8.37

Dividend ($) 1.00

Yield (%) 11.9

Payout (%) 227

5-Yr Growth (%) 0.0

Credit Rating BB-

3Morningstar DividendInvestor June 2013

healthy current income along with plenty of dividend growth ahead—means breaking with a strategy that has served us very well. I can’t offer a strong opinion as to whether Google GOOG will go up or down. But I know it doesn’t pay a dividend, and for that reason alone it shouldn’t be mixed with a strategy like ours.

Finally, we could sell some of our winners and hold cash until they get cheaper. I am happy to guarantee that all stocks—including ours—will have pullbacks from time to time. Within an income-agnostic, value-oriented strategy, cash has value in its ability to fund future purchases on more attractive terms. For us, though, it would mean grafting market-timing tactics onto our income strategy—which mix no better than oil and water. Cash generates no income at all right now, and there’s no guarantee that a future pullback will offer re-entry prices that are lower than where our stocks are trading now.

Let It RideThe stock market—as well many of our holdings—may well be ahead of itself. A 5% or 10% correction could happen anytime. But after running through alternatives to the status quo, I have to conclude that the best course of action is to stick with our tightly-focused approach, and make only buys and sells that are consistent with the strategy we have in place.

My confidence is boosted the progress of our portfolio income. The Builder’s annualized income has grown 5.9% thus far this year from dividend increases and is on track for full-year growth (before any reinvestment transactions) approaching 10.0%, nicely ahead of the estimates I made in the January issue. I expect the Harvest’s income to grow more slowly—that’s one of the trade-offs involved in collecting higher current yields—but dividend and distribution increases in the Harvest have already delivered growth of 3.0% thus far in 2013 with slightly north of 5% in view by year’s end. This growth of income is what creates lasting value within our strategy, not market-timing or trading. And even though stocks are no longer cheap, and we won’t see this level of dividend growth every year, I am still confident that both of our portfolios can earn long-term total returns averaging 9% to 11% a year.

The process won’t be steady, of course. Our style will not always be popular; it certainly won’t always outperform the S&P 500. It’s possible I may look back on some of today’s prices and wish I had made more sales; that’s the way hindsight always is. But I am willing to risk short-term underperformance—and, yes, even temporary declines in market value—in exchange for the large and growing dividends we’re collecting. It may take some courage to do nothing, but it’s a kind of courage I’m happy to supply. œ

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 179,193.32 +16.3 190,150.83 +19.3 369,344.15 +17.8 204,988.26 +15.4 +2.4 +16.5 +1.3

Totals (since inception) 179,193.32 +79.2 190,150.83 +90.2 369,344.15 +105.0 204,988.26 +64.1 +40.9 +60.4 +44.6

Annualized (since inception) +7.2 +10.6 +9.0 +6.1 +2.9 +5.8 +3.2

Data through May 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”.

Google GOOG

Star Rating QQQEconomic Moat Wide

Uncertainty Rating High




Dividend ($) 0.00

Yield (%) 0.0

Payout (%) —

5-Yr Growth (%) —

Credit Rating AA

3

4

Our Builder Portfolio registered a sixth straight month of gains in the period that ended May 13. Its year- to-date total return stands at 16.3%, narrowly ahead of the 15.4% return of the S&P 500. But while the Builder retained this small lead in terms of relative performance, the gap has been narrowing at late—defensive, high-yielding names are no longer leading the advance. Our top performer last month was the deeply cyclical Intel (total return of 11.3%), but our exposure to cyclical stocks—especially in the tech sector—is far smaller than the market overall.

No matter: Far more important is the fact that our income is rising swiftly. Five dividend increases—four of which bested my expectations—lifted the Builder’s annualized haul by 2.3% in just the last month.

p Leading the upward surge was Chevron, which raised its dividend 11.1% to an even $4.00 a share on April 24. This topped my estimate of an 8.9% hike. Annual profits haven’t changed much in the past few years as energy production and prices have flattened out, but the prospects for more rapid production growth a few years out continue to improve, and a very strong financial position allows Chevron to reward shareholders immediately for investments that will pay off decades into the future.

p Clorox provided the biggest upside surprise, with the 10.9% increase announced May 13 trouncing my outlook for 6.3%. The additional growth isn’t clearly supported by current earnings per share, which may rise only 5% for the fiscal year that ends in June. That said, a forward payout ratio around 61% is hardly unreasonable for a firm of Clorox’s resilience and competitive strength, and as in the case of Chevron, I believe it bodes well for future earnings growth.

p Procter & Gamble announced a 7.0% dividend increase on April 15, which extends the company’s

streak of uninterrupted dividend growth to 57 years. (My estimate called for a 6.8% hike.) As shareholders wait for reinvigorated financial performance with varying degrees of patience—the stock didn’t react well to March-quarter results—I take this hike as yet another sign of a management team that is confident in its ability to deliver rewarding long-term growth.

p The 8.2% dividend increase Johnson & Johnson revealed April 25, which led my 6.6% estimate, marked a second straight year of improved dividend growth (as well as a 51st straight year of enhanced shareholder pay). This represents a fair reflection of an acceleration of earnings growth thanks to limited patent expirations, a strengthening pipeline of new drugs, and a rebound for the beleaguered consumer unit. We raised our fair value estimate for Johnson & Johnson twice in the past month—$3 each time— to its current $87, and with the stock finally responding to the rising dividend (the price has risen a hefty 33% in the past year), I am quite pleased that J&J is currently the Builder’s second-largest holding.

p Kinder Morgan Inc., the only current Builder holding that raises its dividend on a quarterly basis rather than annually, chipped in with a 2.7% dividend hike April 17. (Year over year, the dividend rate is up 18.8%.) While the quarter’s dole met my expectations, the company went on to announce on May 13 that it expects to exceed its 2013 dividend target by $0.03 to $1.60 a share. We also raised our fair value estimate for Kinder Morgan by $1 to $41 a share in mid-April.

In addition to Johnson & Johnson and Kinder Morgan, two other fair value increases—and one decrease—bear mention. On April 29, we raised our fair value for United Parcel Service by $5 a share to $85, a change mostly attributable to the time value of money (the collection of expected cash flows as well as larger future flows being discounted by a lower amount of time). May 9 brought a $4 increase for Spectra Energy to $34 a share, which is discussed in a bit more detail this month on Page 7. The only retreat on the fair value front affected Emerson Electric, where poor near-term growth prospects (for which a slow global economy is fairly blamed) led to a $2 a share decrease

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 468.15Interest Income 0.00Total Income 468.15

Performance Update

Yield on Original Cost 4.2Yield on Current Value 3.3

Income Yield, Year Ago 3.3Income Growth (TTM) 10.6

Price/Fair Value–Portfolio 0.99Price/Fair Value–Market 1.03

Reporting Period: April 11, 2013 to May 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

Dividend Buy Price

Current Price

Div Rate

Yield (%)

First Purchase

# of Shares

Cost Per Share

Current Value

% of Acct

Total Rtn (%)

Annual Income

Stocks to Consider Buying

General Electric GE QQQQ Wide AA- 27.00 Med 24.30 22.85 0.76 3.3 04-17-08 465 23.95 10,625.25 5.9 5.4 353.40

Spectra Energy SE QQQQ Wide A- 34.00 Low 32.30 31.11 1.22 3.9 09-14-10 310 22.99 9,644.10 5.4 46.8 378.20

Wells Fargo WFC QQQQ Narrow A+ 43.00 Med 38.70 38.20 1.20 3.1 11-01-05 200 30.00 7,640.00 4.3 48.7 240.00

Stocks to Hold

General Mills GIS QQ Narrow A 41.00 Low 39.00 50.09 1.52 3.0 06-22-12 285 38.15 14,275.65 8.0 34.8 433.20

Johnson & Johnson JNJ QQQ Wide AAA 87.00 Low 82.70 85.85 2.64 3.1 01-10-05 165 65.13 14,165.25 7.9 51.8 435.60

Philip Morris Int’l PM QQQ Wide A- 95.00 Med 85.50 94.04 3.40 3.6 05-21-10 140 44.30 13,165.60 7.3 132.1 476.00

Kinder Morgan Inc. KMI QQQ Wide — 41.00 Med 36.90 39.49 1.52 3.8 11-17-11 315 28.60 12,439.35 6.9 44.8 478.80

Chevron CVX QQQ Narrow AA 125.00 Low 118.80 122.85 4.00 3.3 10-05-11 100 97.62 12,285.00 6.9 30.3 400.00

Paychex PAYX QQQ Wide — 38.00 Med 34.20 37.53 1.32 3.5 03-11-08 300 30.19 11,259.00 6.3 36.2 396.00

United Parcel Service UPS QQQ Wide A+ 85.00 Med 76.50 88.04 2.48 2.8 01-03-07 120 74.48 10,564.80 5.9 32.8 297.60

McDonald’s MCD QQQ Wide AA- 105.00 Low 99.80 100.38 3.08 3.1 10-22-12 95 87.56 9,536.10 5.3 16.4 292.60

Clorox CLX QQ Narrow A- 81.00 Low 77.00 86.22 2.84 3.3 10-22-09 110 58.43 9,484.20 5.3 62.4 312.40

Intel INTC QQQ Wide AA 26.00 Med 23.40 24.08 0.90 3.7 10-11-12 375 21.54 9,030.00 5.0 14.8 337.50

U.S. Bancorp USB QQQQ Narrow A+ 38.00 Med 30.70 33.50 0.92 2.7 11-18-05 250 31.38 8,375.00 4.7 23.2 230.00

Procter & Gamble PG QQ Wide AA 70.00 Low 66.50 78.59 2.41 3.1 04-12-11 100 63.02 7,859.00 4.4 32.6 240.60

Emerson Electric EMR QQQ Narrow A 58.00 Med 52.20 57.82 1.64 2.8 10-11-12 135 49.07 7,805.70 4.4 19.5 221.40

Sysco SYY QQQ Wide A+ 36.00 Med 32.40 34.26 1.12 3.3 11-15-05 170 30.38 5,824.20 3.3 34.4 190.40

Waste Management WM QQ Narrow BBB+ 35.00 Med 31.50 41.03 1.46 3.6 03-11-08 100 33.06 4,103.00 2.3 43.4 146.00

Cash Holdings 0.0 618.94 0.3 0.00

Dividends Receivable (INTC, KMI, PG, SE, UPS, WFC) — 493.18 0.3

Builder Portfolio Total 3.3 179,193.32 100.0 5,859.70

Trailing Return (%) Index Level This Month 12 MonthAnnualized

Since Inception

Builder Portfolio 1.6 23.5 7.2

S&P 500 Index 1634 2.7 23.5 6.1

M* Dividend Leaders 4440 0.5 23.8 5.8

Top Sectors (%) Style Breakdown (%)

s Consumer Defensive 28.2

p Industrials 20.4

o Energy 19.2

a Technology 9.4

y Financial 8.9

Value Core Grwth

Lrg

Med

Sm

p 51 – 100

p 26 – 50

p 11 – 25

p 0 – 10

37 44 7

0 12 0

0 0 0

Legend: Shares added Shares sold New holdingUR Under Review

Å

Í

C

Footnotes:Morningstar ratings and fundamentalsdata as of May 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.

Dividend Buy prices reflect the most we would typically be willing to pay for new shares. “Stocks to Consider

Buying” are those holdings trading below their Dividend Buy prices as of the portfolio valuation date.

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

Taxing the Builder:All of the stocks currently held in the Builder Portfolio are eligible for “qualified” dividend tax rates.

Cumulative Total Return Comparison (%)

2005 2006 2007 2008 2009 2010 2011 2012

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

100

75

50

25

0

-25

6

to $58. Even so, we think Emerson’s long-term competitive advantages and favorable capital-alloca-tion practices remain intact, and I still think the stock is an attractive purchase when it trades at or above a current yield of 3%.

All told, the Builder has rarely been on such a roll—its dividend income, fundamental value, and market value are all headed in the right direction and with an appreciable amount of speed. The only discouraging factor here is the lack of clear buys. The higher fair value for Spectra Energy placed the stock back in buy territory, but the rising price of Intel shares put them back in the hold camp, leaving just 3 of our 18 selections trading below their Dividend Buy prices (the same number we had last month).

That said, I hope to have some new stocks join the Builder within the next few weeks. I’ve been spending a fair bit of time with two of the 4-star stocks on our Bellwethers list: Rogers Communications (profiled in the April 2013 issue, which can be accessed online at mdi.morningstar.com) and, more recently,

Air Products & Chemicals (profiled this month on Page 17). These aren’t the kinds of finds that, for example, General Mills was when I picked up the Builder’s stake last summer at $38, but their ability to play modest supporting roles in pursuit of reliable and rising dividend income appears promising.

To fund any buys, I’ll look first to Waste Management, which is our smallest holding at present. With an overpriced stock (recently trading 17% north of our $35 fair value estimate) and an elevated payout ratio spelling little hope of a near-term revival in dividend growth, I’m about ready to move on. Sysco, another small holding with disappointingly low dividend growth of late, could be close behind. However, since Sysco still trades at a reasonable valuation, the hurdle for possible replacements is a bit higher. œ

© 2013 Morningstar, Inc. All rights reserved. Any opinions, recommendations, or informa-tion 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. Morningstar 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 05-24-13 06-11-13 0.66 Dividend up 8.2% on accelerating EPS growth, moved L-T div growth est. up to 7% 8.2 7.0

McDonald’s MCD 3, 6, 9, 12 late May mid June 0.77 Still a great L-T business despite recent headwinds, capital allocation drives returns 13.9 8.0

Waste Management WM 3, 6, 9, 12 06-05-13 06-21-13 0.365 Probable sell candidate given recent runup, dividend growth potential remains poor 8.1 6.0

Philip Morris Int’l PM 1, 4, 7, 10 late June mid July 0.85 Strong US$ hurts N-T growth, but wide moat/global diversity keep stock attractive — 9.0

US Bancorp USB 1, 4, 7, 10 late June mid July 0.23 18% div hike effective in Q2, but sub-30% payout ratio, sub-3% yield hurts appeal Cut 8.0

General Electric GE 1, 4, 7, 10 late June late July 0.19 Extending reach into global energy infrastructure/exploration, solid income appeal Cut 8.0

Sysco SYY 1, 4, 7, 10 late June late July 0.28 Possible source of funds amid disappointing div growth, pickup looks several yrs out 7.7 7.0

General Mills GIS 2, 5, 8, 11 07-08-13 08-01-13 0.38 Stock seems expensive, but high-single-digit div hikes still indicate good L-T returns 11.1 7.5

Procter & Gamble PG 2, 5, 8, 11 mid July mid Aug 0.6015 57th straight annual div hike comes in at 7.0%, turnaround is slow but promising 10.8 7.0

Clorox CLX 2, 5, 8, 11 07-22-13 08-09-13 0.71 Tops my view with 10.9% div hike, payout ratio rises a bit but still well-supported 14.9 7.0

Kinder Morgan Inc. KMI 2, 5, 8, 11 late July mid Aug 0.39 1 Lifts 2013 div target 2% on benefits of KMP acquisition of Copano, a great L-T hold — 9.5

Paychex PAYX 2, 5, 8, 11 late July mid Aug 0.33 EPS growth improving even without macro tailwinds, sets stage for larger div hikes 10.0 7.0

Intel INTC 3, 6, 9, 12 early Aug early Sept 0.24 1 Believe a 6.7% div hike in Q3 still doable, but PC downturn could keep div flat N-T 14.1 6.5

Wells Fargo WFC 3, 6, 9, 12 early Aug early Sept 0.30 Div up 36% YTD, yield tops 3%. Top pick among banks, though div growth will slow Cut 8.0

Spectra Energy SE 3, 6, 9, 12 early Aug mid Sept 0.305 Increased use of SEP for funding boosts our valuation, L-T div growth looks healthy 5.4 7.0

United Parcel Service UPS 3, 6, 9, 12 mid Aug early Sept 0.62 Attractive outlook for div growth despite cyclicality, wide moat produces lots of FCF 6.3 8.0

Chevron CVX 3, 6, 9, 12 mid Aug mid Sept 1.00 11.1% div hike a strong sign that productive exploration enhances L-T growth trend 9.2 8.5

Emerson Electric EMR 3, 6, 9, 12 mid Aug mid Sept 0.41 N-T econ. headwinds nudge our fair value lower, remains attractive at 3%+ yield 8.8 7.5

Data through May 13, 2013. 1Denotes an increase we expect, but which has not yet been announced.


Morningstar’s TakeWith large positions in gathering, processing, trans-portation, storage, and distribution, Spectra collects a large portion of the economic rents paid to move natural gas to end users. Growth opportunities remain compelling, thanks to the firm’s large, diverse, and well-positioned asset base. Pipelines and fee-based processing opportunities in the United States and Canada offer low-risk, bite-size, bolt-on growth oppor-tunities backed by firm contracts. DCP Midstream, which is 50% owned and the largest natural gas liquids player in the midstream industry, has its hands full trying to build out new infrastructure to support surging NGL production in the Eagle Ford, Permian, and Mid-Continent regions, but does not require addi-tional capital from Spectra. We also expect conver-sions of coal- and oil-fired power plants to natural gas in the Southeast and Northeast U.S. to be another significant long-term opportunity for Spectra, boosting throughput on Spectra’s existing pipelines and providing a chance to put additional capital to work with the construction of new laterals.

Spectra has a full plate right now, with $2.4 billion in projects being executed, the majority of which will enter service in the next 12 months. The biggest project under way, the New Jersey-New York

expansion, will funnel 800 million cubic feet of gas per day into Manhattan and should be completed in the fourth quarter. These projects will provide a solid fee-based cash flow uplift in 2014 and beyond, but it’s hard to overlook the impact of adverse commodity prices on Spectra’s processing businesses in the meantime. Western Canada and DCP are exposed to weak natural gas liquids prices, and the relatively strong performance of natural gas hasn’t helped.

Despite our initial qualms with the shift of focus, we now believe the decision to pursue investments in liquids, evidenced in the Express-Platte acquisition, will be a boon for the company. These assets add a visible source of fee-based cash flows with upside.

The Dividend: What’s New?Despite a severe downturn for Spectra’s commodity price-sensitive operations—these combined for a hit of $0.52 to earnings per share in 2012, without which EPS would have grown 10%—the dividend continues to grow. In 2011, management set a target for annual dividend rate increases of $0.08 through 2014; in October 2012, Spectra delivered a $0.10 bump (8.9%). These increases are backed by the growth of Spectra’s fee-based cash flows, which generally account for 80% of the firm’s total and will increase in scope over the next few years. Earlier in 2013, Spectra reaffirmed its commitment for dividend growth through 2014.

Following in the track of other successful midstream energy players, Spectra is moving quickly to make greater use of its captive master limited partnership (Spectra Energy Partners SEP). While Spectra is a long ways from becoming a pure-play general partner like Kinder Morgan Inc. KMI, we believe Spectra will be able to fund the majority of its 2013–15 capital spending with operating cash flow and proceeds from drop-downs to SEP, significantly reducing the need for external financing. Incorporating these factors into our forecast recently led to a $4 increase in our fair value estimate, which is now $34, and we continue to expect long-term dividend hikes averaging 6%–8% annually. We think these low-uncertainty shares appeal to income investors up to $32.30 each; at a recent $31, they yield 3.9% with the potential for 10%–12% average annual total returns. œ

Spectra Energy SE Builder Focus | Josh Peters, CFA, and Jason Stevens

32

24

16

8

1.16

0.87

0.58

0.29

p Stock Price ($) p Dividend Rate ($)

Data through May 13, 2013.

Spectra Energy: Stock Price and Dividend Rate

2007 2008 2009 2010 2011 2012 2013

Spectra Energy SE

Star Rating QQQQEconomic Moat Wide

Uncertainty Rating Low




Dividend ($) 1.22

Yield (%) 3.9

Payout (%) 80

5-Yr Growth (%) 5.4

Credit Rating A-

8

Thanks in large part to the soaring price of Realty Income, the Harvest bucked the market’s trend away from high-quality, high-yielding stocks to beat the S&P 500 yet again in the month that ended May 13. For the year thus far, the Harvest is up 19.3%, putting the account on track to beat its 9%–11% long-term total return objective for a fifth straight year. By no means do I expect this level of absolute performance, let alone relative outperformance, to persist indefi-nitely. In fact, while I won’t characterize it as a predic-tion, I’ll be surprised if the Harvest doesn’t suffer a sharp price pullback at some point this year.

For the time being, though, I’m content to focus on our income, which was nudged higher on seven separate occasions during the past month. The honor roll boasts all five of our master limited partnerships, led by the once-a-year increase from AmeriGas Partners of 5%. The nation’s largest propane distributor is bouncing back strongly from a freakishly warm winter in 2011–12, and even with this increase I expect cash flow coverage to remain strong around 1.3 times. At the same time, I expect some price volatility this year as Energy Transfer Partners ETP looks to sell some (or all) of the 29.6 million AmeriGas units it owns. These sales—which do not affect the intrinsic value or cash-distributing ability of AmeriGas in the slightest—could create some buying opportunities. A move lower for this reason, particularly below my Dividend Buy price of $41.40, is worth watching for.

As for the MLPs we own that make a point of raising their distribution each quarter, Kinder Morgan Energy Partners (up 0.8% from the previous quarter) and Magellan Midstream (up 1.5%) exactly matched my expectations, though Kinder Morgan later raised its forecast for distribution growth for the rest of 2013. Energy Transfer Equity (up 1.6%) notched a second straight quarter of growth; while cash flow coverage slipped slightly below 1.0 times in the quarter, I’m

impressed enough by the simplification moves ETE has made within the wide-ranging Energy Transfer family to call this my number-one candidate for an income-reinvestment purchase if it trades below $58.50. Best of all, Spectra Energy Partners raised its distribution 1.3% from the previous quarter, up from a 1.0% bump in January, and indicated that future increases should run at three fourths of a cent per unit each quarter going forward as parent Spectra Energy SE drops a bunch of assets down to SEP.

The frequency of MLP distribution increases gives me a lot to talk about every three months, but two more dividend hikes from the month just passed are just as worthy of discussion. One was the as-expected, penny-a-share annualized hike of People’s United Financial, which matches the (slow) progress of the dividend since 2009. I added this bank stock to the Harvest last summer in anticipation of only nominal near-term dividend growth, and as this environment of ultralow interest rates lingers on and on, it may be 2015 or 2016 before the dividend grows more quickly. At the time, though, I thought the 5.4% yield People’s offered was adequate compensation. While the stock now yields a somewhat smaller 4.8%, I see no reason to change my moderately optimistic appraisal.

The final enhancement to our income came from American Electric Power, which raised our pay 4.3% on April 23. This reflected a change in management’s payout ratio target from 50%–60% to 60%–70%; instead of being at the top end of the old range, the firm is now at the bottom end of the new one. But while profit growth has stagnated during Ohio’s deregulation process, AEP is confident enough in its overall earnings power and growth prospects to resume dividend increases after holding the rate flat in 2012—a sign I find quite encouraging as well.

Biomed in the DockWe raised fair value estimates for four of the Harvest’s holdings last month: $2 a share for Altria Group to $30, $2 a unit for Magellan Midstream to $47, $6 a unit for Kinder Morgan Energy Partners to $98, and $12 a share for Health Care REIT to $71. However, our view of Biomed Realty Trust is more cautious after

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

What is the goal of the Harvest Portfolio? To earn annual returns of 9%–11% over any three- to five-year rolling time horizon.

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

5%–7% current yield3%–5% annual income growth

Continued on Page 10

Income Update

Dividends Received 328.80Interest Income 0.01Total Income 328.81

Performance Update

Yield on Original Cost 7.0Yield on Current Value 4.7

Income Yield, Year Ago 5.3Income Growth (TTM) 7.2

Price/Fair Value–Portfolio 1.05Price/Fair Value–Market 1.03

Reporting Period: April 11, 2013 to May 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

Dividend Buy Price

Current Price

Div Rate

Yield (%)

First Purchase

# of Shares

Cost Per Share

Current Value

% of Acct

Total Rtn (%)

Annual Income

Stocks to Consider Buying

F Royal Dutch Shell ADR B RDS.B QQQQ Narrow AA- 79.00 Low 75.10 71.38 3.60 5.0 10-05-11 155 65.23 11,063.90 5.8 15.3 558.00

Stocks to Hold

PMagellan Midstream MMP QQ Wide BBB+ 47.00 Low 44.70 52.96 2.03 3.8 12-05-08 380 17.27 20,124.80 10.6 204.7 771.40

R Realty Income O QQ Narrow SUS 43.00 Med 38.70 53.30 2.17 4.1 12-29-06 300 26.64 15,990.00 8.4 107.5 652.43

P Kinder Morgan Energy KMP QQQQ Wide UR 98.00 Med 88.20 88.23 5.20 5.9 12-29-06 140 47.81 12,352.20 6.5 110.0 728.00

P AmeriGas Partners APU QQQ Narrow BB+ 46.00 Med 41.40 45.66 3.36 7.4 12-29-06 260 34.80 11,871.60 6.2 51.0 873.60

Kraft Foods Group KRFT QQQ Narrow BBB+ 53.00 Med 47.70 54.40 2.00 3.7 10-10-12 210 46.59 11,424.00 6.0 18.9 420.00

Altria Group MO QQ Wide BBB 30.00 Med 27.00 36.92 1.76 4.8 09-11-09 300 19.01 11,076.00 5.8 117.2 528.00

R Health Care REIT HCN QQQ Narrow SUS 71.00 Med 63.90 75.83 3.06 4.0 02-13-09 140 37.83 10,616.20 5.6 127.5 428.40

FNational Grid PLC ADR NGG QQ Narrow BBB+ 53.00 Low 50.40 63.70 3.06 4.8 07-09-09 165 43.29 10,510.50 5.5 70.6 504.32

P Spectra Energy Partners SEP QQQ Wide — 36.00 Low 34.20 37.38 2.01 5.4 11-19-12 275 27.99 10,279.50 5.4 37.1 551.38

American Electric Power AEP QQQ Narrow BBB+ 48.00 Low 45.60 48.67 1.96 4.0 04-12-11 200 34.66 9,734.00 5.1 52.6 392.00

Public Svc. Enterprise PEG QQQ Narrow BBB+ 33.00 Med 29.70 34.57 1.44 4.2 07-10-12 275 32.00 9,506.75 5.0 11.0 396.00

R BioMed Realty Trust BMR QQ None SUS 20.00 Med No 22.87 0.94 4.1 10-10-12 405 18.92 9,262.35 4.9 23.2 380.70

F Vodafone Group ADR VOD QQQ Narrow BBB+ 32.00 Med 28.80 29.66 1.46 4.9 06-22-12 305 27.31 9,046.30 4.8 10.5 446.67

People’s United Fin’l PBCT QQQ Narrow A 14.00 Med 12.60 13.54 0.65 4.8 07-10-12 595 11.75 8,056.30 4.2 20.7 386.75

AT&T T QQ Narrow A- 32.00 Med 28.80 37.00 1.80 4.9 03-16-11 165 27.51 6,105.00 3.2 48.9 297.00

P Energy Transfer Equity ETE QQQ Wide — 65.00 Med 58.50 59.25 2.58 4.4 03-16-11 100 39.73 5,925.00 3.1 63.2 258.00

Westar Energy WR QQ Narrow BBB+ 31.00 Low 29.50 33.36 1.36 4.1 01-14-09 150 19.32 5,004.00 2.6 100.6 204.00

Cash Holdings 0.0 1,050.68 0.6 0.00

Dividends Receivable (AEP, APU, ETE, HCN, KMP, MMP, O, PBCT, SEP) — 1,151.75 0.6

Harvest Portfolio Total 4.6 190,150.83 100.0 8,776.65

Trailing Return (%) Index Level This Month 12 MonthAnnualized

Since Inception

Harvest Portfolio 2.9 28.7 10.6

S&P 500 Index 1634 2.7 23.5 4.5

M* Dividend Leaders 4440 0.5 23.8 3.1

Top Sectors (%) Style Breakdown (%)

Value Core Grwth

Lrg

Med

Sm

p 51 – 100

p 26 – 50

p 11 – 25

p 0 – 10

o Energy 31.4

f Utilities 24.5

u Real Estate 18.9

s Consumer Defensive 11.8

i Communication Svcs 8.0

32 19 6

27 15 0

0 0 0

Legend: Shares added Shares sold New holdingUR Under ReviewSUS Rating Suspended

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 May 13, 2013. Harvest Portfolio inception: Dec. 29, 2006. Please refer to Page 5 or the DividendInvestor Owner’s Manual for other definitions.

Cumulative Total Return Comparison (%)

2007 2008 2009 2010 2011 2012

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

75

50

25

0

-25

-50

10

transferring coverage to a new analyst. While our fair value estimate fell only $1 a share (an initial drop of $2, offset by a subsequent increase of $1), we reduced our economic moat rating to none.

The key issue involves the ongoing costs of tenant improvements, concessions, and leasing commissions. We are now taking a more conservative view regarding these outlays than Biomed’s management; by our analysis, spending in these categories exceeds what Biomed characterizes as maintenance capital. Our accounting for these items reduced our fair value estimate as well as our forecast returns on capital. The latter declined to an extent that led us to doubt that this real estate investment trust possesses an economic moat at all, though it’s worth noting that most REITs earn returns not far from their cost of capital—it’s often a close call between moat ratings.

Because I wouldn’t consider buying a stock for the Harvest (or the Builder) with an economic moat rating of none, the Dividend Buy price for Biomed now reads simply “No,” and I plan to replace Biomed in the

Harvest as soon as I find a suitable replacement. At the same time, this isn’t a situation that requires hasty action: Our view has changed on what we think is a more accurate reading of the data, but the company itself—and the financial resources backing the dividend—are no different than they were before. We don’t expect Biomed to reduce its dividend at any point in the foreseeable future; instead, re-leasing costs should eventually take a toll on dividend growth.

At this point, GlaxoSmithKline GSK—a member of our Income Bellwethers feature—is the most prom-ising candidate to take Biomed’s slot. We recently raised our fair value estimate for Glaxo by $5 to $56 per American depositary receipt, primarily based on a lower discount rate for future cash flows, and the ADRs yield a Harvest-worthy 4.5% at their May 13 price of $51.67. I hope to have more to share about this next month, but you’ll learn of any trades I make in the Harvest much sooner if you’re signed up for our email alerts. If you’re not yet receiving these alerts, please visit our website at mdi.morningstar.com or call us at 800-735-0700 for help. 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, BMR, CLX, CVX, EMR,

GE, GIS, INTC, KMI, KMR, KRFT,

MCD, MMP, NGG, O, PAYX, PBCT,

PEG, PM, RDS.B, SE, SYY, UPS,

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

Realty Income O Monthly 05-30-13 06-17-13 0.181229 Stock now looks quite expensive, but mgmt leverages low-cost capital into growth 2.5 4.0

National Grid NGG 1, 8 late May mid Aug 2.02 1,2 Sets L-T goal of div growth exceeding UK inflation after rate cases, works for me 6.9 3.5

Public Svc. Enterprise PEG 3, 6, 9, 12 early June late June 0.36 Expanding regulated units, higher power prices should drive faster div growth L-T 4.0 6.0

Westar Energy WR 1, 4, 7, 10 early June early July 0.34 As capital spending tails off in 2014/15, div growth should improve on recent 3% 4.1 4.5

Vodafone Group VOD 2, 8 early June early Aug 1.04 2 Another big payout from Verizon Wireless, eager to see how div policy will evolve 5.9 6.0

Altria Group MO 1, 4, 7, 10 mid June mid July 0.44 Recent cig. px hikes affirm favorable industry dynamics, pricey but still worth holding — 5.5

BioMed Realty Trust BMR 1, 4, 7, 10 late June mid July 0.235 Planning to sell: New analyst reduces moat rating to none on higher re-leasing cost Cut 3.5

Kraft Foods Group KRFT 1, 4, 7, 10 late June mid July 0.50 Diverse brand portfolio with room to improve supports healthy L-T div growth view — 6.0

AT&T T 2, 5, 8, 11 early July early Aug 0.45 Sharp reduction in share count bodes well for div growth, but will mgmt deliver? 3.9 4.5

Kinder Morgan KMP 2, 5, 8, 11 late July mid Aug 1.32 1 Rabbit after rabbit out of the hat: KMP boosts 2013 distr. target on Copano deal 7.4 5.5

People’s United Fin’l PBCT 2, 5, 8, 11 late July mid Aug 0.1625 Hurt for now by low rates/excess capital, normalized profitability to raise div growth 4.2 5.0

AmeriGas Partners APU 2, 5, 8, 11 early Aug mid Aug 0.84 Distr. growth continues with 5% boost, look for buying opportunities as ETP sells 5.6 5.0

Energy Transfer Equity ETE 2, 5, 8, 11 early Aug mid Aug 0.655 1 See 1c/qtr distr. hikes with upside when ETP resumes raises too, hope to buy more 10.4 15.0

Magellan Midstream MMP 2, 5, 8, 11 early Aug mid Aug 0.515 1 Raised L-T distr. growth estimate 2pp as crude projects drive profitable expansion 7.4 10.0

Spectra Energy Ptrs SEP 2, 5, 8, 11 early Aug mid Aug 0.50875 1 Cut L-T growth outlook 3pp on higher equity issues, but L-T return still appealing 8.7 6.0

Health Care REIT HCN 2, 5, 8, 11 early Aug late Aug 0.765 Near-frenetic pace of dealmaking is adding value, now see 3%–4% div growth L-T 2.5 3.5

American Electric Power AEP 3, 6, 9, 12 early Aug mid Sept 0.49 Higher payout-ratio target results in 4.3% div hike, rate base growth to drive EPS 3.5 5.0

Royal Dutch Shell B RDS.B 3, 6, 9, 12 mid Aug late Sept 0.90 Top Harvest pick as mkt underappreciates L-T mid-single-digit div growth potential 4.0 5.0

Data through May 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 TakeAT&T has done a good job over the past couple of years of capitalizing on the wireless unit’s position, driving improvements in customer service, cutting costs, and securing exclusive rights to several phones. AT&T can now boast that its postpaid customer base is nearly as loyal as that of Verizon Wireless, long the industry’s distant leader. AT&T is investing heavily in its wireless network to meet customer demand, but these efforts point to another tricky issue, in our view. Voice (55% of wireless revenue) and text service (12%) still dominate, but competition and declining usage have put pressure on this revenue. Data is growing nicely, but the industry faces a transition as customers increasingly use data services, requiring new network infrastructure. The tiered and shared data plans that AT&T and Verizon Wireless now offer are a step in the right direction, but rivals Sprint and T-Mobile have yet to adopt these pricing frameworks.

In the fixed-line business, we believe the firm enjoys a strong position in the business services market. The reach of AT&T’s fixed-line networks is unmatched in the United States, and the firm has made a handful of niche acquisitions recently to augment its business service offerings. At the high end of this market, very few competitors can meet customer needs as well.

Management has been exploring alternatives for the residential service areas that haven’t yet received U-verse services, but we believe options are limited at this point. But while this unit gets a lot of attention, it accounts for less than a fifth of total sales, compared to half of revenue coming from wireless.

AT&T’s recent results have been mixed, with improved wireless profitability but weaker revenue growth than Verizon Wireless. We believe AT&T’s competitive position remains solid, but we also think modest long-term growth assumptions are appropriate.

The Dividend: What’s New?In early November, AT&T announced a penny-a-share bump to the quarterly dividend rate, an amount equal to the increases issued each year since 2008. This ran AT&T’s record of consecutive annual dividend growth to 29 years—each year since the breakup of the Bell System. However, the resulting percentage growth rate of 2.3% struck us as a disappointment, especially given that the company repurchased a net 5.8% of its shares during the year and cash flows hit record highs. An additional 2.8% of outstanding shares were bought back in the first quarter of 2013.

AT&T expects to continue share buybacks under a new 300 million-share authorization, albeit at a slower pace. The balance sheet remains in solid shape, supporting a Morningstar credit rating of A-, and despite a payout ratio of 72%, we have no fears regarding the sustainability of the dividend. However, a faster pace of dividend growth will be key for shareholder returns in future years. We believe AT&T can achieve a long-term dividend growth rate of 4%–5%, with a roughly 2% rate of revenue growth coupled to gently improving profitability and continued buybacks. Combined with a 4.9% current yield, we think an expectation of long-term total returns averaging 9%–10% a year is reasonable. Whether dividend growth will shift into higher gear in the near term is a matter of management’s discretion; fortunately, AT&T should have more cash at its disposal over the next few years than it was expecting, thanks to efficiencies embedded in its network plans (Project VIP) enabling it to cut planned capital spending by $2 billion in 2014 and 2015. œ

AT&T T Harvest Focus | Josh Peters, CFA, and Michael Hodel, CFA

AT&T T

Star Rating QQEconomic Moat Narrow

Uncertainty Rating Medium




Dividend ($) 1.80

Yield (%) 4.9

Est’d Coverage 72

5-Yr Growth (%) 3.9

Credit Rating A-

48

36

24

12

2.68

2.01

1.34

0.67



AT&T: Stock Price and Dividend Rate

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

12

The primary purpose of the Income Bellwethers list is not to provide a backup list of buy candidates for the Builder and Harvest accounts—only 26 of the 100 stocks listed (flagged with B and H icons) should be treated as potential purchases. The main idea in this segment of the newsletter is to provide ongoing coverage—Morningstar ratings and my own dividend-oriented commentary—for a wider group of stocks that are often held for above-average yields.

However, I’ve come to question the value of devoting scarce real estate to a group of stocks I would never expect to purchase—those with moat ratings of none. On last month’s list, six stocks held this dim distinction: five real estate investment trusts (AvalonBay AVB, Equity Residential EQR, Plum Creek Timber PCL, Prologis PLD, and Ventas VTR) plus Dow Chemical DOW. This month, these stocks have been replaced, plus another three—Hershey HSY, Time Warner TWX, and former Builder holding McCormick MKC—because their yields slid below 2%.

These nine deletions went hand in hand with nine additions, the first of which—Apple—I never expected to see here. I’ll admit that its dividend, recently raised 15.1%, is better than nothing, but I still don’t think the stock is worth owning because of its divi-dend. A person could buy the stock because he or she expects that profit margins will soon stabilize, or that some great new product introduction is at hand. By itself, though, paying a dividend hardly turns Apple into the reliable investment that say, General Mills GIS or American Electric Power AEP have proved themselves to be. On the other hand, Apple is more or less tied with Shell RDS.B as the world’s largest payer of dividends, distributing some $11.5 billion to shareholders through dividends annually. That, plus Apple’s above-average yield of 2.7% and extremely broad ownership, makes the stock too large for even your skeptical DividendInvestor editor to ignore.

The other additions are more routine. Baxter Interna-tional wins a slot after having more than doubled its dividend since 2008; I’m very glad to see this diver-sified health-care concern devote more of its profits to dividends. Dr Pepper Snapple Group has also raised its payout ratio in the past few years to offer a current yield north of 3%. Hasbro joins fellow toymaker Mattel on the Bellwethers; it’s been fun to watch these two rivals compete to offer shareholders the best cash returns in recent years. Other additions are analog semiconductor concern Microchip Technology, defense contractor General Dynamics, oil producer Occidental Petroleum, electric utility Wisconsin Energy, and Iron Mountain, a leader in document storage that is converting itself into a REIT—a story I plan to keep an eye on. I’ll be looking to profile these new members, as well as more of our existing Bellwethers, in future issues.

Baxter joins the list as one of the Bellwethers flagged as a potential purchase—a designation that Air Products & Chemicals (profiled this month on Page 17) received as well. Air Products and Rogers Communi-cations are the only Bellwether stocks currently trading below their Dividend Buy prices, and I’m considering adding both to the Builder.

In other news, Pitney Bowes PBI—previously a member of our Payouts in Peril list at left—finally bit the bullet and sliced its dividend in half April 30. A key tipoff came earlier this year, when management conspicuously failed to raise a dividend that had grown without interruption for 30 straight years. But the cut itself had been coming for a while, and as is so often the case with dividend cuts, a heavy-handed reduction was already baked into a stock that had lost about two thirds of its value since 2007. The new dividend rate of $0.75 annually looks far more sustain-able than the old $1.50, so I’ve removed it from the list. I also pulled Plum Creek PCL from the list, as it recently raised its dividend for the first time in six years—it seems the worst may have passed. Still, dividend cuts remain the number-one threat to income investors. With the ax finally falling on Pitney Bowes, Windstream and Frontier Communications now stand as the highest-yielding stocks in the S&P 500, and I think both are well worth avoiding. œ

Income BellwethersDividend Watchlist | Josh Peters, CFA

Payouts in Peril

Best Buy BBY

BGC Partners BGCP

Entergy ETR

FirstEnergy FE

Frontier Commmunications FTR

GFI Group GFIG

NuStar Energy NS

Old Republic Int’l ORI

R.R. Donnelly RRD

Southern Copper SCCO

Windstream WIN

Asset Management MLPs

Energy Production MLPs

Mortgage REITs

Ocean Transport

Oil Refiners

Rural Telecom

Specialty Financials

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. Some of these stocks—those we consider “best in breed”—are potential candidates for purchase if they trade below our Dividend Buy prices. These stocks are flagged as follows:

o Builder candidatec Harvest candidate

Other names are included to provide Morningstar ratings information and comments about the suitability of the stock for an income strategy.


Income Bellwethers

Company NameStar Rating

Fair Value

Dividend Buy

Current Price

Divi-dend

Yield (%)

5-Yr Div Growth (%) BIB Comments

3M MMM QQ 103.00 82.40 110.50 2.54 2.3 4.2 Greets investors in 2013 with a nice 7.6% div hike, starting to look like dividend growth is becoming a priority again for this R&D powerhouse.

AbbVie ABBV QQQ 41.00 28.70 44.54 1.60 3.6 — Long-awaited spinoff from Abbott ABT offers hefty yield, but overwhelming reliance on Humira and uncertain new-drug prospects limit appeal.

AGL Resources GAS QQ 38.00 30.40 43.22 1.88 4.3 1.1 As we expected, acquisition of Nicor creating no shareholder value, and gas storage ops hurt by industry glut. Above-avg yield but little appeal.

Air Products & Chemicals APD QQQQ 110.00 94.70 90.84 2.84 3.1 11.1 B Potential Builder buy: Cycles aren’t harsh enough to threaten dividend, which has strong record of growth thanks to favorable industry structure.

Alliant Energy LNT QQ 47.00 44.70 51.69 1.88 3.6 7.2 H Midwestern utility scores with good regulatory relations, healthy finances & top-tier rate base growth. 5%–7% L-T div growth justifies ~4% yield.

Ameren AEE QQQ 33.00 23.10 35.64 1.60 4.5 Cut Regulation in MO, IL still tough, subpar div growth outlook, but dumps midwestern merchant coal plants to become fully-regulated utility again.

American Water Works AWK Q 29.00 20.30 41.98 1.12 2.7 — Kicks up payout ratio with 12% div hike, respectable L-T prospects, but water is a hugely capital-intensive, low-return field—and stock is pricey.

Apple AAPL QQQQ 600.00 360.00 454.74 12.20 2.7 — Giant dividend in terms of sheer dollars paid, but it’s unlikely to be a prime driver of total return until business matures (whenever that happens).

Automatic Data Proc. ADP QQ 57.00 51.30 70.08 1.74 2.5 12.0 B No slouch as ADP has outperformed Paychex for some time, but sticking with PAYX for its higher div yield, greater leverage to economic growth.

Baxter International BAX QQQQ 80.00 65.30 70.46 1.96 2.8 16.9 B Wide-moat healthcare firm has increased its appeal with dividends rising faster than EPS, could potentially add to the Builder if the yield tops 3%.

BB&T BBT QQQ 33.00 23.10 31.74 0.92 2.9 Cut Regulators kill 2013 capital plan, add’l div hikes on ice after understate-ment of risk-weighted assets. Should be OK L-T, but strongly prefer WFC.

F BCE BCE QQ 43.00 30.10 47.51 2.30 4.8 9.2 Decent competitive position as wireless business, media/content acquisi-tions offset declining land-line biz, but growth is still an uphill challenge.

Bemis Company BMS QQ 35.00 24.50 39.94 1.04 2.6 3.6 Still raising the dividend (4% for 2013), but L-T growth/total-return appeal is limited as packaging firm’s narrow moat gets still narrower over time.

Blackrock BLK QQQ 270.00 189.00 279.39 6.72 2.4 17.5 Diverse asset manager with laudable dividend policy and record. Fees pressured by low-yield environment, offset by acquisitions & cost control.

P Boardwalk Pipeline Ptrs BWP QQ 28.00 22.40 30.65 2.13 6.9 4.2 Positioned well for long-term growth, distribution coverage rebounded in 2012, but hikes still on hold as gas glut hurts storage revenues in 2013.

Bristol-Myers Squibb BMY QQ 35.00 24.50 40.94 1.40 3.4 3.6 Struggling with patent expirations, even as dividend rises 3% for 4th straight year. Even after 13% fair value increase, stock still looks overpriced.

P Buckeye Partners BPL QQQ 63.00 44.10 67.15 4.20 6.3 5.2 Distr. growth resumes after four-quarter lull, balance sheet and cash flow have improved, key rate case resolved, but I still question mgmt’s skill.

Campbell Soup CPB QQ 36.00 25.20 46.41 1.16 2.5 7.7 Trying to revigorate domestic soup with investment, new products—but progress has been slow, div growth still on hold, stock is hardly cheap.

CenturyLink CTL QQQ 41.00 No 37.68 2.16 5.7 Cut Dividend cut 26% in February, aggressively buys in shares afterward. Mgmt says little has changed for L-T, but actions speak louder than words.

Cisco Systems CSCO QQQQ 24.00 16.80 21.27 0.68 3.2 — Third div hike (21%) since 2011 underscores improving capital allocation. Mid-single-digit internal growth now forms decent total-return outlook.

Coca-Cola KO QQQ 41.00 37.30 42.19 1.12 2.7 8.5 B 2013 brings another nice dividend increase (9.8%), marking 51 straight years of growth. Would yield 3%, become Builder candidate at $37.30.

Colgate-Palmolive CL QQ 100.00 90.70 120.91 2.72 2.2 11.8 B Hikes dividend 9.7% as firm continues to generate impressive cash flows, solid growth. Pricey like most of its peers, but fundamentally sound.

Compass Minerals Int’l CMP QQQ 94.00 72.70 88.33 2.18 2.5 9.1 B Dividend raised 10% for 2013, has now grown for 10 straight years. Follows another subpar winter for salt sales, but L-T outlook still attractive.

ConAgra Foods CAG QQ 28.00 19.60 35.46 1.00 2.8 5.7 Finally wins the hand of Ralcorp, though private-label business won’t help weak competitive stance of legacy CAG brands. Easily prefer KRFT.

ConocoPhillips COP QQQ 59.00 41.30 62.00 2.64 4.3 10.0 Asset sales help sustain both dividend and exploration spending as natural gas prices remain low, but L-T div growth outlook pales next to CVX.

Data through May 13, 2013. UR Under Review Master Limited Partnership REIT Foreign Stock Cut Div. reduced in past 5 years BIB “Best in Breed”, see Page 12

14

Consolidated Edison ED QQ 54.00 37.80 60.44 2.46 4.1 0.9 Sign of hope as annual div hike doubles in 2013 to 4c/share, but 1.7% is still far too low to drive decent L-T returns. Steady, but prefer AEP, PEG.

Darden Restaurants DRI QQ 47.00 32.90 53.16 2.00 3.8 30.2 Loses appeal as poor same-store sales suggest competitive problems are structural rather than cyclical, profit shortfalls lead to high payout ratio.

F Diageo ADR DEO QQ 109.00 92.10 124.53 2.76 2.2 5.2 B Top-shelf brands, global distribution create wide moat. Could see owning again someday, but lofty valuation reflected in current yield below 2.5%

Dominion Resources D QQ 54.00 48.60 59.69 2.25 3.8 7.6 H Merchant profits depressed, but above-avg ROEs for regulated T&D, Marcellus gas gathering, rising payout ratio could drive 7%-8% div hikes.

Dr. Pepper Snapple DPS QQ 44.00 30.80 48.92 1.52 3.1 — A distant #3 in the U.S. with limited exposure abroad, efficiency and capital allocation are key to shareholder returns; see 7%–8% L-T div growth

DTE Energy Holding DTE QQ 55.00 38.50 69.88 2.62 3.7 2.6 With Michigan economy stabilizing and nonregulated units helping growth, div rises another 5.6%. Could do worse, but prefer AEP’s higher yield.

Duke Energy DUK QQ 66.00 52.80 71.77 3.06 4.3 — Working on integrating its (value-neutral at best) Progress merger. CEO debacle hasn’t hurt much yet, but still threatens L-T regulatory relations.

E.I. du Pont de Nemours DD QQQ 54.00 32.40 54.45 1.80 3.3 2.3 Raises div for second year in a row, though growth rate is still mediocre at best. Agricultural & nutrition ops to grow while commodity units shrink.

F Eaton ETN QQQ 65.00 45.50 64.23 1.68 2.6 12.1 Cooper acquisition, increased debt load and global macro headwinds don’t stop Eaton from raising div 10.5%, retains appeal despite cyclicality.

Edison International EIX QQQ 49.00 34.30 49.84 1.35 2.7 2.2 Merchant unit now bankrupt, EIX now effectively a fully-regulated utility. Favorable regulation boosts SCE, but yield/div growth has been poor.

Eli Lilly LLY QQQ 52.00 36.40 56.28 1.96 3.5 2.9 Patent losses hammering revenues, stock now a bet on a promising new-drug pipeline. Dividend looks safe for now, but growth likely minimal.

P Enbridge Energy Ptrs EEP QQQQ 35.00 24.50 30.05 2.17 7.2 2.9 Dismal distribution coverage during 2012 as both natural gas and liquids units underperform. Growth projects to help L-T, but recovery looks slow.

P Energy Transfer Partners ETP QQQQ 63.00 44.10 49.89 3.58 7.2 1.6 Distribution growth likely restarts for ETP as recent M&A, projects to pay off, though gen’l ptr ETE remains the more attractive total-return vehicle.

Entergy ETR QQQ 72.00 No 67.29 3.32 4.9 5.2 In better shape to support dividend than Exelon, but payout may be “right-sized” after transmission spinoff. Reg assets can’t hold candle to SO.

P Enterprise Products Ptrs EPD QQQ 63.00 56.70 61.51 2.68 4.4 5.8 H Broad footprint, careful management, cost-of-capital advantage (no more GP incentives) combine to drive our forecast of 6%/yr distribution hikes.

Exelon EXC QQQQ 42.00 No 34.93 1.24 3.5 Cut Long-dangling ax finally falls: div slashed 41%, no rebound on horizon. May still appeal to income-agnostic value types, but no role in our strategy.

ExxonMobil XOM QQQQ 97.00 77.60 90.10 2.52 2.8 9.7 Clear industry leader, but big bet on natural gas with 2010 XTO deal has backfired. Despite 10.5% bump, continues to trail CVX on dividend front.

FirstEnergy FE QQQ 43.00 No 42.66 2.20 5.2 1.9 Like ETR, Exelon’s dividend cut doesn’t bode well for this merchant-heavy utility either as its payout ratio closes in on 75%. Prefer fully-regulateds.

Frontier Communications FTR QQQQ 6.50 No 4.12 0.40 9.7 Cut Took painful but necessary step of chopping div in early 2012 to bolster liquidity & reduce debt, but div remains at risk as L-T decline continues.

General Dynamics GD QQQ 82.00 57.40 75.20 2.24 3.0 17.9 Cuts to U.S. defense spending hurt long-term growth potential, but entrenched relationships with the military and capital discipline aid returns.

Genuine Parts GPC QQ 65.00 58.50 77.90 2.15 2.8 6.3 B Former Harvest holding becomes a top Builder candidate amid acceler-ating dividend growth, but lofty price now requires major pullback to buy.

F GlaxoSmithKline ADR GSK QQQ 56.00 50.40 51.67 2.33 4.5 7.5 H Advair (20% of sales) a risk factor, overall growth is modest, but 3%–5% div growth prospect plus yield around 4.5% creates possible Harvest buy.

H.J. Heinz HNZ QQQ 72.50 50.75 72.43 2.06 2.8 6.5 Being sold to Berkshire Hathaway BRK.B and Brazilian firm 3G Capital at $72.50 a share, price underscores enduring value of steady cash flow.

Hasbro HAS QQQ 48.00 33.60 47.46 1.60 3.4 23.7 Product and geographic mix not as strong as Mattel, working on turn-around for games business, but attractive record of div growth since 2004.

R HCP HCP QQQ 55.00 49.50 52.12 2.10 4.0 2.4 H Only REIT with 25-yr streak of dividend growth, though moat rating returns to narrow. Plausible replacement for BMR, but GSK is top candidate.

Income Bellwethers (continued)


Fair Value

Dividend Buy

Current Price

Divi-dend

Yield (%)




F HSBC Holdings ADR HBC QQQ 55.00 33.00 56.64 2.40 4.2 Cut Dividend recovering nicely from crash, solid capital position. Global foot-print provides above-avg growth profile, but high risk in future crises too.

Illinois Tool Works ITW QQQ 70.00 50.70 68.29 1.52 2.2 8.6 B Wouldn’t buy ITW at a yield below 3%, but would like to own someday. Cyclicality offset by capital-allocation acumen & operational excellence.

Iron Mountain IRM QQ 35.00 24.50 39.35 1.08 2.7 — Document and data storage giant intends to convert to a REIT in 2014 (if the IRS approves), which should lead to substantially higher payout.

J.P. Morgan Chase JPM QQQ 53.00 31.80 49.67 1.52 3.1 — Pre-crisis dividend rate fully restored thanks to 27% hike following stress-test results, but still put off by reliance on trading, derivatives, I-banking.

Kellogg K QQQ 60.00 54.00 64.42 1.76 2.7 7.7 B Focus on operational improvements & new products appears to be paying off, fair value up 15% on progress, potentially attractive on px pullback.

Kimberly-Clark KMB QQ 81.00 72.90 103.71 3.24 3.1 6.9 H Cash-cow biz has sizeable emerging-mkt exposure, solid dividend record, but recent price reflects more L-T sales/div growth than we see likely.

R Kimco Realty KIM QQ 19.00 13.30 24.86 0.84 3.4 Cut Nation’s largest shopping-center landlord is well-diversified, has had nice rebound in occupancy, rents since crisis. Four div hikes since 2009 cut.

Lockheed Martin LMT QQ 89.00 62.30 101.89 4.60 4.5 23.1 Wide moat reflects strong partnership with Dept. of Defense, but federal spending pressured, div hikes reflect rising payout ratio, not EPS growth.

Lorillard LO QQQ 43.00 25.80 43.30 2.20 5.1 27.8 Top performer in U.S. tobacco as market share gains drive volume higher even as industry shrinks—but menthol regulation threat is Achilles heel.

M & T Bank MTB QQQ 100.00 70.00 103.34 2.80 2.7 1.5 Strong operations, conservative underwriting, attractive acquisition of Hudson City. No dividend hike for 2013, but growth could resume in 2014.

Marsh & McLennan MMC QQ 33.00 23.10 39.90 0.92 2.3 3.4 Insurance brokerage and HR consulting are fundamentally attractive busi-nesses, though long pricing cycles for insurance rates require patience.

Mattel MAT QQQ 46.00 32.20 46.17 1.44 3.1 10.6 Largest global toy firm dishes out another nice (16%) dividend hike for 2013, secular headwinds in U.S. offset by emerging-mkt opportunities.

Merck & Co. MRK QQQ 51.00 35.70 46.17 1.72 3.7 2.1 Typical of Big Pharma today: Patents expiring, cutting costs, hoping new-drug pipeline fills the gap. Nice yield, but likely div growth is insufficient.

Microchip Technology MCHP QQQ 39.00 27.30 37.16 1.41 3.8 7.6 Leads in the 8-bit microcontroller field, diverse customer base, cyclical but financially strong. Could be veyr interested if div growth rate improves.

Microsoft MSFT QQQ 35.00 24.50 33.03 0.92 2.8 14.3 We expect revenues to continue growing, albeit with falling margins. Poor capital allocation still an problem, dividend should be at least doubled.

F Nestle ADR NSRGY QQ 67.00 53.60 69.92 2.18 3.1 13.6 World-largest food company is well run, strong finances, lots of emerging mkt opportunities, but 5%–6% mgmt growth target is a bit of a stretch.

NextEra Energy NEE QQ 72.00 64.80 79.62 2.64 3.3 7.9 B Mgmt lifts payout-ratio target to 55% but still sees 10% annual div growth, controlling risk with merchant hedges and focus on regulated units.

Norfolk Southern NSC QQQ 81.00 56.70 78.40 2.00 2.6 15.1 Too bad it’s become a derivative play on coal as low nat. gas prices, threat of carbon caps force top customers (coal-fired power plants) to close.

Northeast Utilities NU Q 35.00 28.00 43.51 1.47 3.4 11.3 Despite a few weak spots (CT electric, reach for merger synergies) and expensive valuation, transmission-led growth should drive solid div hikes.

F Novartis ADR NVS QQQ 78.00 62.40 74.65 2.40 3.2 17.8 Solid strategy, broadly diversified operations reduce risk and boost L-T prospects relative to rivals, but our outlook (3% sales growth) still modest.

Nucor NUE QQQ 53.00 31.80 44.89 1.47 3.3 — Competitively advantaged, good dividend policy given cyclicality (special divs to expand in boom), but cyclical nature requires big margin of safety.

Occidental Petroleum OXY QQQQ 102.00 71.40 90.53 2.56 2.8 18.1 Uses advanced technology to drive increased output from proven oil fields. Nice U.S. exposure, div up sharply, but Middle East assets carry risks.

Old Republic Int’l ORI QQQ 16.00 No 14.03 0.72 5.1 7.0 Mortgage insurance problems still a risk to div, though cut now appears unlikely—but EPS/div growth prospects are dim amid low interest rates.

P ONEOK Partners OKS QQQQ 62.00 43.40 52.47 2.86 5.5 5.4 Like WPZ, hurt by unfavorable gas processing spreads, but coverage still north of 1.0x, L-T growth story intact. Expect to profile OKS next month.

PepsiCo PEP QQ 75.00 71.30 83.03 2.27 2.7 8.4 B Weak 5.6% div hike follows tough 2012, but profit growth is improving, wide moat still intact, and L-T div growth looks likely in high single digits.



Fair Value

Dividend Buy

Current Price

Divi-dend

Yield (%)



16

Pfizer PFE QQQ 30.00 21.00 29.37 0.96 3.3 Cut Weathering patent losses with cost reductions, emphasis on R&D produc-tivity, improving drug pipeline, but J&J still offers superior L-T growth.

PG & E PCG QQQ 46.00 32.20 46.52 1.82 3.9 4.8 CA regulation/demographics are L-T pluses, but as the San Bruno after-math drags on and on, div growth looks unlikely for another few years.

Piedmont Natural Gas PNY Q 26.00 24.70 34.04 1.24 3.6 3.8 H Builds on resilient & well-managed regulated gas utility ops with pipeline projects. 35 straight yrs of div hikes, but stock is significantly overvalued.

Pinnacle West Capital PNW QQ 54.00 43.20 59.01 2.18 3.7 0.2 Improved regulatory environment raises our earnings outlook and reduces risk, reflected in recent dividend hike (3.8%) that was first since 2006.

P Plains All American PAA QQ 48.00 43.20 59.49 2.30 3.9 5.2 H Ideally positioned to capture benefit of rising domestic crude oil produc-tion, rewards partners with big distr. hikes, but valuation fully reflects this.

PPL Corporation PPL QQQ 35.00 24.50 31.73 1.47 4.6 3.4 Cut exposure to wholesale power mkts by acquiring more regulated assets, now permits continued (modest) div growth as merchant utes suffer.

R Public Storage PSA Q 121.00 108.90 165.35 5.00 3.0 17.1 H Rapid div growth (up 150% since Q3/07) reflects growth, rising payout ratio. See internal growth moderating to 3%–4%, making stock expensive.

Raytheon RTN QQ 57.00 39.90 63.93 2.20 3.4 14.4 Dividend rises another 10% despite sequestration, poor long-term outlook for defense spending. High-tech focus & cost controls help L-T outlook.

Reynolds American RAI QQ 39.00 23.40 47.97 2.36 4.9 7.8 Helped by product innovations, smokeless unit, but legacy brands still underperform Altria and Lorillard. Less appealing than Harvest holding MO.

F Rogers Communications RCI QQQQ 60.00 54.00 49.34 1.72 3.5 — B Likely Builder candidate as best wireless network in Canada benefits from consolidated industry, low penetration, solid capital allocation practices.

F Royal Bank of Canada RY QQQ 56.00 33.60 60.69 2.46 4.1 4.7 Healthy div growth for RY and peers, Canada’s mortgage mkt limits bank risks, but housing bubble still poses threat & isn’t reflected in the stock.

Sempra Energy SRE QQ 63.00 44.10 81.55 2.52 3.1 14.1 Appealing regulated utes in southern CA plus large & growing presence in midstream natural gas, but stock looks expensive with yield around 3%.

R Simon Property Group SPG QQ 158.00 110.60 179.96 4.60 2.6 4.6 Dividend being pushed up by rising taxable income (REITs must pay out 90%). Attractive portfolio, good mgmt, but yield below 3% is dangerous.

Southern Company SO QQQ 45.00 42.80 45.84 2.03 4.4 4.0 H Preeminent utility franchise deserves praise for consistency, strong regu-latory relations, 4% div growth. Would love to buy for Harvest below $43.

Time Warner Cable TWC QQ 75.00 67.50 98.17 2.60 2.6 — B Another big (16%) div increase for 2013 despite disappointing outlook. Still like the L-T story, but price would have to get much cheaper to buy.

F Unilever PLC ADR UL QQQ 40.00 28.00 42.62 1.40 3.3 7.7 Outperforms rival P&G lately, rationalization of far-flung operations gains traction despite economy. Emerging mkts, mid-priced brands a L-T plus.

Verizon Communications VZ QQ 40.00 28.00 52.55 2.06 3.9 4.1 Renews push to obtain 45% stake in Verizon Wireless held by Vodafone VOD, which would be nice, but barriers to transaction remain formidable.

R Vornado Realty VNO QQQ 94.00 65.80 86.76 2.92 3.4 Cut Attractive portfolio of NYC/D.C. real estate provides narrow moat and L-T growth, firm as a whole a bit opaque but good capital allocation overall.

Walgreen WAG Q 35.00 24.50 49.07 1.10 2.2 23.7 Has recovered nicely from the Express Scripts debacle, but stock now barely clinging to a Bellwethers slot with a yield closing in on the 2% mark.

Wal-Mart Stores WMT QQ 74.00 59.20 78.50 1.88 2.4 12.6 Continues trend toward more generous dividends with 18% hike for 2013, though we still see margins shrinking amid L-T competitive pressures.

Williams Companies WMB QQ 33.00 29.70 36.48 1.36 3.7 25.1 B WPZ general partner targets 20% div growth through 2014. Commodity conditions hurt S-T, but favorable L-T outlook creates Builder candidate.

P Williams Partners WPZ QQQ 55.00 49.50 52.09 3.39 6.5 9.0 H Unfavorable gas processing conditions hurts N-T cash flow and distribu-tion coverage, but hikes continue as big fee-based projects come online.

Windstream WIN QQQQ 10.00 No 8.37 1.00 11.9 0.0 Frontier, CenturyLink ... will Windstream join its peers with a dividend cut? Certainly can’t rule it out as legacy wireline remains in secular decline.

Wisconsin Energy WEC QQ 35.00 28.00 42.75 1.36 3.2 19.1 Like most regulated utilities, the stock looks expensive, but 4%–6% EPS growth plus the phasing-in of a more generous payout ratio are pluses.

Xcel Energy XEL QQ 27.00 21.60 30.03 1.08 3.6 3.2 Nice, steady utility with abundant opportunities for rate-base expansion, though heavy capital spending weighs on near-term div growth outlook.



Fair Value

Dividend Buy

Current Price

Divi-dend

Yield (%)




Josh’s ViewI don’t mind owning cyclicals as long as (1) the cycles aren’t so vicious that they threaten the dividend, and (2) the dividend grows even in tough times. This stock qualifies on both counts, and looks like a bargain too.

Morningstar’s TakeAlthough it represents a tiny portion of a customer’s cost structure, a reliable supply of industrial gas is vitally important in many production processes. As a result, major customers are willing to sign long- term contracts (15–20 years) that permit industrial gas producers like Air Products to index the main input costs for inflation. This lucrative structure has helped protect operating margins historically, and we anticipate it will continue to preserve the company’s profit margins and returns on invested capital, especially if an inflationary environment ensues.

Air Products is the third-best performer in the very profitable industrial gas industry, and its results lagged competitors’ during the previous cycle. The firm has shed some underperforming businesses, including health care and polymers, which should drive better operating margins and returns on capital. Still, the company has outsize exposure to electronics and hydrogen, two structurally weaker end markets.

The good news is that increasing operating costs have forced nearly 80% of domestic refiners to outsource their hydrogen production needs—hydrogen being a field where Air Products holds a commanding lead. Growth should continue, especially as foreign refiners begin to adopt this outsourcing model. The firm also participates in a plethora of less cyclical end markets, including medical and food and beverage.

The Dividend: Is It Safe?Although the firm is capital-intensive—capital spending has averaged 12% of revenue in the past decade—and subject to cyclical fluctuations, we believe Air Products is in strong financial health. Debt is typically in the range of 2 times annual EBITDA and has grown roughly in line with cash flow. Our credit rating of A- reflects Air Products’ strong competitive position and healthy cash flow. We’re also comfort-able with a dividend payout ratio around 50%, given that the largest annual drop in earnings per share in the last 25 years was the 18% decline in 2009.

The Dividend: Will It Grow?Like Emerson Electric EMR, Air Products boasts an impressive record of dividend growth for a cyclical. In March, the company raised its dividend for a 31st consecutive year. While the pace of dividend growth varies with economic conditions, the overall record is highly favorable: compound average annual growth of 10% over the past 5 years, 11.9% over the past 10, and 11.0% over the past 30 years. In the past 5 years most of this growth can be traced to an upward drift in the payout ratio (34% to 50%), and this will probably keep future dividend increases closer to the growth in earnings per share. That said, we expect Air Products to go on increasing its EPS at about 8% a year over the long run, driven primarily by a 7% trend of revenue growth. We also see modest gains in operating margins thanks to cost-reduction efforts.

The Dividend: What’s the Return?At a recent price of $91, Air Products offers a current yield of 3.1%, which compares nicely with a median yield of just 2.0% since 1993. Though near-term results will be affected by a sluggish global economy, we expect future dividend growth will lead to long-term total returns averaging 10%–11% a year. œ

Air Products & Chemicals APD The Dividend Drill | Josh Peters, CFA, and Basili Alukos, CPA, CFA

Air Products & Chem’s APD

Star Rating QQQQEconomic Moat Narrow





Dividend ($) 2.84

Yield (%) 3.1

Payout (%) 52

5-Yr Growth (%) 11.1

Credit Rating A-



Air Products & Chemicals: Stock Price and Dividend Rate

96

72

48

24

2.48

1.86

1.24

0.62

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

18

Josh’s ViewAgainst a backdrop of sharply lower profit growth, I would want to see Microsoft devote more of its resources to dividends before I considered buying.

Morningstar’s TakeMicrosoft has been a step behind as competitors and new technologies are slowly eroding the moat around its Windows PC operating system, culminating in our negative moat trend rating. Alternative operating systems and competing PC devices and smartphones continue to erode Windows’ market, albeit at a slow rate. We believe the moat trend for the wide-moat server and tools unit (25% of 2012 sales) is stable, but the online search business (Bing) has no moat.

With the introduction of Windows 8, the Surface tablet, and Windows phones, Microsoft is trying to change the recent downward trajectory of its Windows OS franchise. These changes complement earlier introductions of Office 365 and Windows Azure, Microsoft’s entries into cloud computing. We believe Windows phones and the Surface tablet face strong headwinds and will probably see limited success in the near term, while the cloud offerings are holding their own and should help offset revenue losses as the Windows OS franchise declines. We

expect the total revenue to continue increasing, but at lower margins, given the shift in product mix.

The Dividend: Is It Safe?Thanks to abundant free cash flows (some $2 billion a month), an $86 billion hoard of cash and investments, and just $14 billion of low-cost borrowings, Microsoft earns an AAA rating from Morningstar as well as other credit rating agencies. The dividend accounts for only 33% of earnings and 26% of free cash flow. In the foreseeable future, only a dramatic change in dividend policy could place the dividend at risk.

The Dividend: Will It Grow?Microsoft initiated dividends in early 2003; the rate then doubled in 2004 and again in 2005 before settling into a pattern of mid-double-digit growth. The payout ratio has moved up only modestly since 2005, leaving the bulk of the company’s dividend increases explained by growth in earnings per share. We expect that Microsoft’s revenue will continue expanding at 7%–8% a year over the next five years, a rate similar to the last five. However, as growth is increasingly driven by lower-margin businesses requiring heavier investment, we also believe that profitability will deteriorate: Our fair value estimate incorporates a 28.5% operating margin in 2017, down from the 37.9% recorded in 2012. This dynamic holds our forecast for net income growth to a low-single-digit rate. Share repurchases could assist per-share earnings growth—between 2007 and 2012, the diluted share count fell an average of 3% a year—but buyback activity has been rather modest in the past few years.

The Dividend: What’s the Return?Microsoft could plainly afford a much more generous dividend without depriving growth initiatives of proper funding. However, the timing of any step change in the firm’s dividend policy is impossible to predict. If profit growth slows as we expect, we think Micro-soft would keep raising its dividend perhaps 8%–12% a year by increasing its payout ratio over time. While we believe this would enhance shareholder value, long-term capital gain potential is more limited—perhaps 7%–8% a year on average. Combined with a current yield of 2.8%, probable total returns of 10%–11% a year appear satisfactory. œ

Microsoft MSFT The Dividend Drill | Josh Peters, CFA, and Norman Young

Microsoft MSFT

Star Rating QQQEconomic Moat Wide





Distribution ($) 0.92

Yield (%) 2.8

Payout (%) 33


Credit Rating AAA



Microsoft: Stock Price and Dividend Rate

48

36

24

12

1.28

0.96

0.64

0.32

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


Josh’s ViewAs the world’s largest food company, Nestle has all the hallmarks of a classic defensive investment—but dividends are paid only once a year, and Swiss with-holding taxes trim the stock’s appeal to U.S. investors.

Morningstar’s TakeNestle’s expansive product portfolio—which includes coffee, bottled water, ice cream, confectionery, and pet care—will enable it to wade through the tough operating environment relatively unscathed. Its narrow economic moat stems from the significant economies of scale the firm enjoys because of its vast global operations, which include more than 20 brands that generate in excess of CHF 1 billion in annual sales. In addition, we are encouraged that Nestle recognizes the importance of understanding local consumers, as it recently announced plans to open two more research and development facilities in China, where it is likely to generate more robust growth than developed markets for some time.

The firm is not content with the status quo, but continues to seek opportunities to enhance its compet-itive positioning. For instance, last year, Nestle announced its intentions to acquire Pfizer’s PFE infant nutrition business (which generates about 85% of

its sales from faster-growing emerging markets and realizes solid profitability with EBITDA margins in the mid-20s) for 5 times fiscal 2012 sales and nearly 20 times EBITDA. Despite the rich price tag, we think Nestle is all too aware of the attractiveness of this asset and sought to ensure that it didn’t lose out to its competitors (namely Danone DANOY and Mead Johnson MJN). We expect that Nestle will remain a consolidator in the global consumer product industry, particularly in light of its pristine balance sheet.

Competitive pressures from other branded offerings as well as lower-priced private-label products persist, and Nestle is far from immune to these headwinds. But for investors wanting broad exposure to consumer staples, Nestle might be an appropriate holding, especially with the current market uncertainty.

The Dividend: Is It Safe?Nestle has a very strong capital structure that we expect to be leveraged in the medium term in order to boost growth. Net debt of CHF 18 billion represents only one year’s worth of operating cash flow. The divi-dend represents roughly 60% of earnings, a level that is toward the high end of the staples peer group but still well supported by profits and free cash flow.

The Dividend: Will It Grow?Measured in its local currency, Nestle has raised its dividend each year since 1996, though the compound growth rate during this period (12.8%) will be very tough to match going forward. Aided by its presence in emerging markets—which make up around 40% of consolidated sales—Nestle targets internal revenue growth of 5%–6% annually, though we think the sheer size of the firm will make the upper end of this target difficult to achieve. However, we see some upside to profit margins, and acquisitions or share buybacks round out the potential for annual growth in per-share earnings and dividends of 7%–8% a year.

The Dividend: What’s the Return?At a recent yield of 3.1%, Nestle offers a respectable long-term total return profile of 10%–11% a year. However, we note that investors in tax-deferred accounts won’t be able to recover a 15% Swiss with-holding tax on dividends paid to U.S. investors. œ

Nestle ADR NSRGY The Dividend Drill | Josh Peters, CFA, and Erin Lash, CFA

Nestle ADR NSRGY

Star Rating QQEconomic Moat Narrow

Uncertainty Rating Low




Dividend ($) 2.18

Yield (%) 3.1

Payout (%) 61


Credit Rating —

p ADR Price ($) p Dividend Rate ($)

Data through May 13, 2013. Dividend rates shown for ADRs reflect currency translation effects (home currency is Swiss francs).

Nestle: ADR Price and Dividend Rate

64

48

32

16

2.08

1.56

1.04

0.52

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

Morningstar DividendInvestorVolume 9, Number 5

Director of Equity-Income Strategy and EditorJosh Peters, CFA

Contributing AnalystsBasili Alukos, CPA, CFA, Michael Hodel, CFA, Erin Lash, CFA, Jason Stevens, Norman Young

Copy EditorSylvia Hauser

Senior DesignerMeghan Winn

ProgrammerChristine Tan

Product ManagementPeggy Seemann

PublisherSusan Dziubinski

VP, Global and Credit ResearchHeather Brilliant, CFA

President, Research Don Phillips

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