Morningstar’s “Qualitative” Dividend Index Approach (HDV)

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November 13, 2012 3:09pm NYSE:HDV

Dominic Maister: With interest rates at historically low levels, many investors are looking to augment the income earned in their fixed income portfolios with dividend income from equities.  Not surprisingly, this has led to significant interest (pun intended)

in dividend ETFs – the category now includes 116 products globally with $66.3B in assets and year-to-date flows of $14.1B.

Clearly there are plenty of dividend ETFs to choose from, but significant differences exist among the indexes these funds seek to track.  Among the five largest US dividend ETFs, there is no more than 45% overlap (on a cap-weighted basis) among any two of their indexes.  In other words, 55% or more of each index’s exposure is unique vs. another.  With such significant variations in exposure, how is an investor supposed to choose the fund that’s right for their portfolio?

With this question in mind, I sat down with Josh Peters, CFA, Director of Equity-Income Strategy at Morningstar and editor of the firm’s Dividend Investor monthly newsletter, to talk about how the Morningstar Dividend Yield Focus Index benchmark for the iShares High Dividend Equity Fund (NYSEARCA:HDV) differentiates itself from the other dividend indexes out there.

Dominic Maister (DM): You’re obviously a bit of a “dividend enthusiast”, like myself.  Can you tell me what your philosophy is around dividend investing?  What kind of investor should be considering dividend income for their portfolios?

Josh Peters (JP): I’m a proponent of dividend investing as a long-term strategy.  I don’t believe dividends are only for retired people – I think they’re for anyone who expects to retire at any point in the future.  The difference is that a younger investor would reinvest the dividends because they don’t need them for withdrawals.

DM: The Morningstar Dividend Yield Focus Index has a pretty robust methodology.  Can you give us an idea of what sets it apart from the other dividend indexes out there?

JP: Many dividend indexes are based entirely on backward looking data. For example, an index might require each company it includes to have a long history of dividend payouts, which I generally consider a plus but should not be absolutely necessary if everything else checks out.  By contrast, the Morningstar Dividend Yield Focus Index uses a unique security selection strategy, which is basically an attempt to quantify what for me is largely a qualitative process.  I crunch numbers and look at valuations, but what I really want to know is “What in the real physical world makes this business tick, and does it have sustainable competitive advantages that are likely to ensure current dividend sustainability as well as the potential for future growth?”

The strategy itself is based on two pillars: business quality and financial health.  In the Dividend Yield Focus Index, business quality is indicated by our economic moat ratings, and financial health is measured by distance-to-default.

DM: Let’s talk about economic moat for a second, because I don’t think that’s a term every investor is familiar with.

JP: Sure – I actually talked about this in the September issue of DividendInvestor.  Economic moat is a proprietary rating we use here at Morningstar, and it’s at the heart of our equity selection process. It essentially reflects a company’s long-term competitive advantage – the wider the moat, the greater and/or longer-lived the advantage.

For me, requiring an economic moat is an unbreakable rule.  I’m not going to buy a stock that has no economic moat protecting its business.  I look at it this way: dividends are coming out of the stream of profits that are being generated by a company.  If the company can’t preserve that level of profitability in the face of competition over the course of a cycle, then I can’t really have confidence that the dividend will be safe.

And dividend safety is really my number one priority, because if the dividend gets cut, I don’t get the income I expect, and chances are very good that the stock price is going to get absolutely clobbered.  So that’s the number one thing I want to avoid.

Economic moat plays into dividend growth as well.  Let’s take a company like General Mills (NYSE: GIS), for example.  In order for General Mills to continue to grow, every so often they have to increase capacity – say, by producing more Cheerios or Haagen-Dazs.  They have to add more capital to the business in order to support that growth.  General Mills is actually better off not paying out 100% of its income and instead retaining some of its earnings to spend on increasing capacity for existing products.  That money that goes back into the business this way typically yields a very high return on capital and contributes to future dividend growth.

So economic moat plays into both dividend safety, which is critical from a risk management standpoint, and the potential long-term growth of a dividend.  It’s not the only factor, but as far as I’m concerned, it’s the biggest factor.

DM: I know there’s a lot more to discuss with regard to economic moat, but for the sake of time let’s move on to distance-to-default.  Here’s my question: How would you explain it to your grandmother?

JP: (Laughs) Now we’re talking option-pricing theory, so it’s going to take me a while to come up with a clever example.  But for now, distance-to-default is basically a measurement of the safety cushion that’s being expressed by a stock’s price.  If the stock becomes more volatile and the company already has a lot of debt, it’s going to suggest that the dividend could be at risk–even if a qualitative fundamental review of the business might lead you to conclude that it’s going to be okay. It’s a market signal, and even though markets aren’t perfect, it’s worth paying attention to.

DM: So how do economic moat and distance-to-default relate when it comes down to selecting stocks for inclusion in the index?  In other words, if a company has a wide moat but distance-to-default has become troubling, does it get kicked out of the index?

JP: The three prongs are additive, meaning a company needs to earn good marks on these two tests plus a third (our analysts’ uncertainty ratings, which can capture risks not explicitly included in the first two). Can a high quality business get into financial distress?  Unfortunately, it can, if it borrows too much money against a good business.  So a narrow or wide moat company that has too much debt is something that would likely be flagged during the index selection process.

DM: We’ll have to get into “narrow” vs. “wide” moat in our next discussion. I know that will be a question for some of our readers.

JP: Sounds good – maybe by then I’ll have come up with my “grandmother-friendly” description of distance-to-default.

Sources: Morningstar, BlackRock Investment Institute, Bloomberg

Dominic Maister, Director, joined BlackRock in 2010 on the iShares ETF Due Diligence Team. The team reviews models, recommended lists and platforms for partner firms and delivers collaborative implementation guides and timely new product, product enhancement, educational and competitive intelligence content.

Most recently, Dominic was an Executive Director at Morgan Stanley and head of Exchange-Traded Fund (ETF) and Closed-End Fund (CEF) Research. He led a team that provided research commentary on the ETF industry and over 900 ETFs listed in the United States. Under his leadership, Morgan Stanley was recognized by Capital Link as having the best ETF research team in 2009 and 2010. In addition, the team provided research recommendations on over 100 CEFs. Dominic began his professional career at Raymond James Financial and he joined Morgan Stanley in 1998. His prior roles at Morgan Stanley included six years in Equity Capital Market Sales. Dominic graduated from the John M. Olin School of Business in St. Louis, MO., with a major in business and a minor in legal studies.

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