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©2015 Morningstar, Inc. All rights reserved. Josh Peters, CFA Director of Equity-Income Strategy Editor, Morningstar DividendInvestor Morningstar’s Dividend Playbook

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  • ©2015 Morningstar, Inc. All rights reserved.

    Josh Peters, CFA

    Director of Equity-Income Strategy

    Editor, Morningstar DividendInvestor

    Morningstar’s Dividend Playbook

  • gJosh Peters, CFA is Morningstar’s director ofequity-income strategy, the founding editor ofDividendInvestor, and manager of its DividendSelect model portfolio

    g Launched in January 2005

    gReleased companion book in 2008:The Ultimate Dividend Playbook

    gReceived over 1,200 dividends thus far fromour active portfolio holdings—all of whichreflect actual, trades in real money,Morningstar-funded brokerage accounts

    gReceived 398 dividend increases sinceinception; just 16 dividend cuts

    2

    Introduction to Morningstar DividendInvestor

  • Why Dividends?

    3

    gPractical advantages for investors

    /For retirees, cash to fund regular portfolio withdrawals without having to sell shares

    /For savers, cash funds income growth/wealth accumulation through reinvestment

    /Better class of companies—typically well-established, defensive, financially healthy

    /Makes stocks easier to analyze and easier to owngMuch-needed discipline for issuers

    /Demonstrates ability willingness to reward shareholders directly

    /Represents a long-term commitment, enabling investors to return the favor

    /Helps block potentially self-serving or dubious allocations of capitalgDividends are the ultimate source of security values

    /Bottom line is cash flow—not just to the firm, but directly to the investor

  • Best Reason of All: Superior Performance

    4

    gNumerous academic studies show that high-yielding stocks outperform the market over the long run

    gOur study: Highest 30% of yields beat the market in 53 of 60 rolling 10-year CAGRs beginning in 1945

    /Average beat of 206bp per year—or an extra $575 after 10 years on each $1,000 invested

    Annual data 1945-2014. Source: Data from Kenneth R. French (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html), Morningstar analysis.

    -1%

    4%

    9%

    14%

    19%

    24%

    1955 1965 1975 1985 1995 2005

    U.S. Market TotalReturn

    30% HighestDividend Yields

  • Step 1: Defining an Investable Universe

    5

    gWhile the S&P 500 pays only 2.0%, much higher yields are available, especially in certain sectors—consumer staples (2.6%), energy (2.9%), utilities (3.6%) and telecommunications (4.9%)

    gHeavy share buybacks and/or rapid dividend growth without a decent yield are no substitute foradequate current income

    gOur basic stock screening parameters:

    Premium Stock Screener available at http://screen.morningstar.com/AdvStocks/Selector.html#AnchorSelector, results as of 3/19/2015.

  • 6

    Step 2: The Dividend Drill

  • The Dividend Drill: Is It Safe?

    7

    gDividend safety is the number-onepriority for income investors—more than interest rates, changes ineconomic trends, even valuations

    gHow to avoid dividend cuts:

    /Economic moats, which defendprofitability and cash generation

    /Healthy balance sheets

    /Payout ratios that balance incomeagainst internal reinvestmentneeds and a cyclical safety margin

    /Continued dividend growth is thebest indicator of safety, thougheven this isn’t perfect ...

    Outcomes reflect realized total returns for full holding periods of each active DividendInvestor portfolio position. Data through 3/19/2015. Source: Morningstar

    -100%

    -50%

    0%

    50%

    100%

    150%

    200%

    250%

    300%

    350%

    Our Record: Outcomes by Dividend Action

    IncreasedDividends (89%positive returns)

    Flat Dividends(71% positivereturns)

    ReducedDividends (19%positive returns)

  • The Dividend Drill: Will It Grow?

    8

    gDividend growth drives total return by:

    /Furnishing additional income over time

    /Encouraging long-term capital appreciation

    gKey drivers of dividend growth:

    /Earnings growth: Consider volume expansion,pricing power, future for operating margins,role of acquisitions/share repurchases

    /Dividend policy: Will dividends risefaster/slower/equal to per-share earnings?

    gUseful approach: “extend the trend”

    /Latest 5- or 10-year rate as a stepping-off pointfor consideration of future performance

    Data as of 3/19/2015. Source: Morningstar, company reports

    0.38

    0.76

    1.14

    1.52

    1.90

    12

    24

    36

    48

    60

    1995 2000 2005 2010 2015

    General Mills GIS Stock Px (LH) Div. Rate (RH)

    10-Year Earnings and Dividend SummaryDivPaid Payout DivPaid Payout

    FY04 1.43 0.55 39% FY11 2.48 1.12 45%FY05 1.37 0.62 45% FY12 2.56 1.22 48%FY06 1.45 0.67 46% FY13 2.69 1.32 49%FY07 1.59 0.72 45% FY14 2.82 1.55 55%FY08 1.76 0.79 45% CAGR: 7.1% 10.9%FY09 1.99 0.86 43%FY10 2.30 0.96 42% FY15e 2.82 1.67 59%

    CoreEPSCoreEPS

  • The Dividend Drill: What’s the Return?

    9

    gTotal return is always the bottom line, notincome alone or growth/capital gains alone

    g Is the absolute return indicated by a safe currentyield plus sustainable long-run dividend growthacceptable?

    /Hurdle returns of 7.5% for low risk companieswith above-average yields;

    gAm I paying a sustainable valuation: willtotal return = dividend yield + dividend growth?

    /Consider valuation: Our main indicator isprice/fair value (preferred below 1.0)

    gPreferred outcome is total return > yield+growth,valuation discipline necessary to avoid shortfalls

    Data as of 3/19/2015. Source: Morningstar

    0.74

    1.48

    2.22

    2.96

    3.70

    12

    24

    36

    48

    60

    1995 2000 2005 2010 2015

    Realty Income O Stock Px (LH) Div. Rate (RH)

    0.00

    0.56

    1.12

    1.68

    2.24

    2.80

    28

    56

    84

    112

    140

    1995 2000 2005 2010 2015

    Johnson & Johnson JNJ Stock Px (LH) Div. Rate (RH)

  • Dividend Drill in Action: Verizon Communications

    10

    gThe Dividend: Is It Safe?

    /Free cash flow is the best indicator; coversdividends about 1.5 times

    /Economically defensive business;narrow moat and BBB credit rating

    gThe Dividend: Will It Grow?

    /Dividend increases each year since 2005

    /Modest but accelerating growth recently

    gThe Dividend: What’s the Return?

    /Trading slightly below $50 fair value

    /4.5% yield plus 4%-5% estimated dividendgrowth suggests roughly 9% total returns

    Data as of 3/19/2015. Source: Morningstar, company reports

    0.62

    1.24

    1.86

    2.48

    3.10

    14

    28

    42

    56

    70

    1995 2000 2005 2010 2015

    Verizon VZ Stock Px (LH) Div. Rate (RH)

    10-Year Earnings and Dividend SummaryDivPaid Payout DivPaid Payout

    FY04 2.59 1.54 59% FY11 2.15 1.96 91%FY05 2.56 1.60 63% FY12 2.32 2.02 87%FY06 2.54 1.62 64% FY13 2.84 2.08 73%FY07 2.34 1.65 70% FY14 3.35 2.14 64%FY08 2.54 1.75 69% CAGR: 2.6% 3.3%FY09 2.40 1.86 77%FY10 2.21 1.91 87% FY15e 3.66 2.22 61%

    CoreEPS CoreEPS

  • Step 3: Portfolio Management

    11

    gWhat drives an individual stock’s returns works even better for a portfolio as a whole

    /Our Dividend Select portfolio targets 3%-5% yields, 5%-7% dividend growth, 9%-11% total returns

    /Currently yielding 3.9% with 6.1% long-run income growth profile

    gEarning yields that are double the market average requires embrace of different results:We go where the (safe and growing) dividends are ...

    Data as of 3/18/2015. Source: Morningstar

    0

    5

    10

    15

    20

    25

    30S&P 500

    Dividend Select

  • 12

    Our Results: Beating the Market Without Even Trying

    Data from inception (1/7/2005) through 3/19/2015. Source: Morningstar

    -50

    0

    50

    100

    150

    200

    2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

    Cumulative Total Return: DividendInvestor Portfolios vs. S&P 500

    Standard & Poor's 500 (CAGR: 7.9%)

    Combined DividendInvestor Portfolios (CAGR: 9.2%)

    -40

    -20

    0

    20

    40

    60

    80

    2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

    Cumulative Price Appreciation

    S&P 500

    DividendInvestor

    -40

    -20

    0

    20

    40

    60

    80

    2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

    Cumulative Dividend Return

    S&P 500DividendInvestor

    32.8 percentage pointadvantage (2.4%/yr)

    19.4 percentage pointdisadvantage (-1.2%/year)

  • Josh Peters, CFA, owns all of the stocks held inthe Dividend Select portfolio, including GIS, JNJ,O, VZ.