Buy and hold with a dividend guidepost

Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com. In this month's Morningstar DividendInvestor [a newsletter available to Morningstar members in the US], editor Josh Peters discussed the demise of buy and hold or the potential demise of buy and hold. Here to discuss it with me is Josh Peters. Josh, thanks for joining me.

Josh Peters: Happy to be here.

Glaser: So do you think that buy and hold is dead?

Peters: Well, I will tell you a lot of people are acting as if buy and hold is dead but that doesn't mean that's necessarily the case. To write this month's cover story for DividendInvestor, I took a look at turnover statistics from the New York Stock Exchange.

If you go back to the 1950s, the average share of stock was held for 6.3 years, now the average share of stock is held for less than nine months and you have got massive amounts of money now that is being thrown at computer systems that are trading in milliseconds literally, trying to capture little tiny advantages.

It seems like the idea of actually sitting down, making a good judgment about a company, putting some money to work in a real operating business and earning a good return over the long run is something that people just don't have time for anymore.

Glaser: But don't you think a lot of investors maybe have felt burned by buy and hold after seeing two major market crashes in 10 years?

Peters: Well I will tell you one thing, buy and hold does not translate to buy at any price. The reason that we have had such a poor market return to the average investor over the last decade is that stocks were wildly overvalued back in 1999 and 2000 beyond any stretch of valuation history that I have been able to identify, historic market bubble.

If you pay prices like that, you are bound to wind up with disappointing returns. But the solution is not to abandon the stock market entirely and the solution is definitely not to think that you need to trade and time the market and you are chasing this ETF, or you are buying a gold fund, or something like that. That is not the solution.

The solution is to still try to really put your work as a owner/partner in a business, in exchange for a long-term return. But to do it in a way that you are paying close attention to the business' fundamentals, is this the business you really want to be a long-term partner in, and you pay attention to the kind of price you're paying.

Glaser: So when investors are evaluating price, what are some of the metrics that you think that they should look at?

Peters: I think the most important indicator is dividend yield. And of course that's probably what you would expect me to say editing a newsletter like DividendInvestor, but dividends unlike earnings, are paid in cash. The company actually has to sit down, evaluate its resources in order to make this payment, and then they actually have to cut the checks and send it out to investors.

It's a way of voicing an opinion about the ability of this business to return value to shareholders in cash. And you actually get that cash, and get the benefit of that cash. You combine that with the dividend growth rate that the company is on, a dividend growth rate trend. This gives you an idea of what kind of total return you can expect from a stock.

The one thing you want to remember is that the higher the dividend yield in its slow growth environment, the better the chances are that you are going to earn an adequate return. Because if you look at the many stocks out there, they pay no dividend at all, just pick on Google as one example.

Google needs to generate a tremendous amount of growth, tremendous amount of capital gains, people really have to love this stock in order for a Google shareholder to make any money. If I own something that's kind of boring like say utility like Southern Company that pays me 5.5% dividend yield, I don't have to worry about what's going on in the stock market. I don't have to worry about whether or not some pundit on TV is trying to pitch it and what that might do to do the stock the next morning.

I am getting paid from this company directly out of its earnings every three months. That really takes the pressure off. Now I can really start to be that long-term buy and hold owner/partner in a business.

Glaser: Now during the market downturn when stock prices were depressed so much, obviously that makes dividend yields look a lot higher, but some of those turned out to be at unsustainably high levels, at what point do you start getting worried that you see a dividend yield that's too high and that might indicate that a firm is actually in distress and not just cheap?

Peters: Well the interesting thing about those dividend yields, in a lot of cases double digits what we saw late in 2008 and earlier this year, is that almost all those dividends got cut, very few actually survived to actually generate those kind of current yields to the owners of those stocks.

Right now in the market, there aren't a lot of vulnerable dividends; most of the dividends that were going to be cut have been cut. For the most part what you see is what you get, but in any kind of market environment, you want to be looking at let's say 8%, 9% as kind of a speed limit.

You get yields much into that type of a range or higher, that's starting to become more like a turnaround investor, a special situation, it is not something that the market is suggesting to you through that dividend is necessarily sustainable.

You got to do a lot more homework and frankly I wind up buying very few stocks with yields of that level. There is just too much risk of a dividend cut.

Glaser: So buy and hold is still is a good strategy but just make sure you are buying at the right price and dividend yields can be a good way to figure out that you are getting a great deal?

Peters: Yeah. And the right kind of company; dividends play into that too. If I am going to be a real owner/partner in a business, I also want the company to behave like they want me as that kind of a shareholder who's not just there to speculate on something that is going on on the stock chart or something that is going on on a message board on the Internet.

That it's really about a long-term commitment of my capital to this management team that they are going to use it to productive business end, and share those profits with me. When I have a meaningful dividend in which I'd say dividend yield, 2, 3% or better, payout ratio as a percentage of earnings, you know, let's say at least 25%. Now I am really being treated like a partner. I am getting that income. I can hold up my end of the bargain and be that long-term investor too.

Glaser: Right. Sounds great, Josh. Thank you.

Peters: Well, thank you.

Glaser: For Morningstar.com, I'm Jeremy Glaser.