Jason Parker Interviews Steven Alley who is the  President of Alley Company on investing in dividend paying stocks.
If you enjoy this interview on dividend investing you may also be interested in a recent blog post I wrote on the topic.  Click Here to read it now.
Here is a link to Alley Company where you can learn more about investing in stocks that pay dividends. http://www.alleycompanyllc.com/
Below is the full transcript:

Announcer: Welcome back, America, to Sound Retirement Radio, where we bring you concepts, ideas, and strategies designed to help you achieve clarity, confidence, and freedom as you prepare and transition through retirement. And now, here is your host: Jason Parker.

Jason Parker: Seattle, Tacoma, Olympia, Gig Harbor, all the good people right here in Kitsap County, and for those of you tuning in from around the country, thank you so much for coming back to another round of Sound Retirement Radio. You know, for years now, we have been trying to bring real experts onto this program that can add significant meaningful value to your financial life as you prepare for and transition through retirement. We’re always looking to bring experts onto the program that can help us do just that, and I’ve got one of those people I believe, today, that I think you’re really going to appreciate. As people prepare for retirement, one of the concerns, one of the questions I hear a lot is: how do we generate the cash flow that we need from our investment portfolio? One of the tools that people look at are dividend pay and stock. We’ve got an expert on the program today to share more specifics on investing and dividend pay and stocks and why that might be part of your portfolio consideration.

 So, without further ado, I have Steven Alley on the program. Steven is with the Alley Company, a separate account investment management firm. He is the president of Alley Company, LLC, and has investment experience dating back to 1983. He founded the firm in 1998 after a 12 year career with Morgan Stanley, including five years as managing director of private client services in the institutional equity department in Chicago. He earned a Bachelor’s Degree in business administration, an MBA in finance from the University of Wisconsin, where he was a student in the Applied Securities Analysis program. Steve also played hockey at Wisconsin, on the U. S. Olympic Hockey Team in 1976, and in the National Hockey League. I just thought that was so cool when I was reading through his bio. That was kind of a surprise for me.

 Alley Company LLC is a separate account investment management firm based in Lake Forest, Illinois. The firm was founded to operate under a discernible and disciplined investment philosophy, which is believed to be the key to success. In 2006, the firm established the Alley Company dividend portfolio to capitalize on investment opportunities and quality companies with strong dividend paying cultures. The firm believes, as is true historically, that dividend income will be an important component of investor total return in the future. Further, the firm believes that companies that pay consistent and rising dividends tend to have attractive fundamental characteristics as well. Finally, growth and dividends is something that the Alley Company investment team believes can provide long term investors with a hedge against the risk of inflation.

 Boy, that was a mouthful, but Steven Alley, welcome to Sound Retirement Radio!

Steven Alley: Thank you, Jason, it’s a pleasure to be here.

Jason Parker: Yeah, yeah, I sure appreciate you taking time out of your busy schedule. So, Steven, over the last, well … we’ve been doing this program for a little over four years now, but over the last year and a half or so, I’ve been starting every program off with a joke for our listeners, and I’ve got one to share, so I thought I’d share that after I introduced you. You’re in for a real special treat here.

Steven Alley: Ha ha. Thank you.

Jason Parker: Here’s my joke. This one’s become one of my daughter’s favorites. She’s five. It’s funny, at five years old the kids, they’ve heard the joke before but they keep asking for it over and over again. Here it is: there’s a pirate, and he’s out at sea, and his first mate comes running up to him, and he says, “Pirate, pirate! There’s a ship on the horizon!” And the pirate says to his first mate, “Bring me my red shirt”. The first mate runs off and he comes back with the red shirt. The pirate puts his red shirt on and he goes to battle and they win. Later, the first mate goes to the pirate, and he says, “Pirate, why did you have me bring you your red shirt?” And the pirate said, “Well, in the event that I were to be injured, if I were to get shot or stabbed in battle, I wouldn’t want the enemy to know that I was hurt”. The first mate said, “Oh, that makes sense, that’s a good strategic decision”. The next day they’re out at sea and the first mate comes running up to the pirate. He says “Pirate, pirate, there are 50 ships on the horizon!” The pirate looks at the first mate and he says “Bring me my brown pants”. Ah, you can see why my five-year-old- [crosstalk 00:04:43]

Steven Alley: I hope I’m never in that position.

Jason Parker: Steve, you can see why my five-year-old likes that. These jokes have really got a reputation for being pretty corny, but, it’s always fun to share them with your family.

Steven Alley: Well, thanks.

Jason Parker: I wanted to … let’s talk some more about income investing, and specifically dividends. This is what you guys specialize in. Steve, tell us a little bit more about your investment philosophy there at Alley Company.

Steven Alley: Well, first of all, thank you, Jason, for having me today. We’re looking forward to this discussion. We’re very passionate about dividend investing over long periods of time. Dividend stocks have tended to do better than non-dividend paying stocks, and our philosophy is really two main points: we’re trying to find companies that pay an absolute attractive current yield. In today’s world, that would be stocks that are yielding somewhere in the 3.5-5% range. Typically, you’ll find those kinds of companies in the electric utilities, telephone utilities, maybe tobacco stocks, pharmaceuticals, certain industrials. We can find names that are yielding, again, in this 3.5-5% area. That’s a very attractive yield relative today’s money market or fixed income marketplace.

 The second half of the portfolio is made up of companies that are growing their dividend at a significantly above-average rate. I’m talking about growing their dividends on an annual basis in the 8, 10, 12, recently we’ve seen 15-20% dividend growth in some companies.

Jason Parker: Oh, that’s phenomenal.

Steven Alley: These companies … yeah, that is a very … that is phenomenal. That is an astounding level of growth in a world that some people would say is sort of starved of growth. Those companies tend to yield maybe 2 to 3.5%.

 What I just said, to summarize, we sort of have two segments of the portfolio. One half, that half of the stocks are yielding in the 3.5-5% range. They tend not to grow their dividend quite as fast, although you can find companies, like, for example: Phillip Morris yields 4.4% today, and recently increased its dividend over 10%. That’s kind of nirvana where you’ve got an absolute high yield plus a company that’s willing to grow it, the dividend, at a rapid rate.

Jason Parker: Yeah.

Steven Alley: But the other half of the portfolio yields between 2-3.5% are companies like McDonalds, [inaudible 00:07:29] laboratories just raised their dividend 57%, Comcast has been raising their dividend at a very rapid rate, DF Corp is a name like that. These companies, again, are raising their dividend in double digits. In fact, our entire portfolio taken together in the last 3 years, has experienced significant double digit dividend growth on average. In 2011, I think it was like 10.5%. 2012 it was over 15%. This year it’s running just under 13%. So, the average dividend increase- [crosstalk 00:08:05]

Jason Parker: Wow

Steven Alley: Of the stocks in our portfolio. You said it before, you said this is amazing that companies are, you know, collectively growing their dividends at very rapid rates.

Jason Parker: Is that sustain- [crosstalk 00:08:19] Do you think that’s sustainable for the long haul, Steve? Do you think companies will be able to continue double digit – 10, 12, 15% dividend growth within their portfolio? Or, is this more of a strategic play for companies, because they know that people are so starved for income that it’s a way to attract new dollars into their companies?

Steven Alley: There’s a couple ways … there’s a couple points to make on that. Number one, the dividend-payout ratio in the S&P 500 today is about 32%. Payout ratio meaning the amount of dividends that are paid out of earnings. 32% of earnings are paid out in dividends today on average, in the S&P 500. Historically, it’s been over 50%.

Jason Parker: Oh, wow.

Steven Alley: So, companies are paying out less today than they historically have, and because of what you just said, which is 0% money market rates, and bonds yielding way lower than they normally have through history. You’re in a situation where companies are looking to pay out more because they feel that the investor public is demanding it. They feel as though the investor … they would be ingratiating themselves to their investors. We think that you’re going to see that trend continue where dividends are going to grow. Now, let’s just be very clear: electric utilities, which are growing their earnings at the rate of GDP 2, 3, 3.5, 4% at the most, they’re going to be raising their dividends at about that rate.

Jason Parker: Mm-hmm (affirmative).

Steven Alley: 3, 4%. Telephone utilities, AT&T and Verizon, that’s what they … Verizon just raised their dividend 4%.

Jason Parker: Mm-hmm (affirmative).

Steven Alley: The slower growing companies that are able to pay an average … they’re yielding at a very attractive rate today … Verizon, over 4% … they’re not going to grow their dividends very fast because they’re not growing that fast. Companies that are growing at a more rapid rate… You take McDonalds hamburgers: the last increase they had was 15% [crosstalk 00:10:28]

Jason Parker: Yeah.

Steven Alley: You have big companies inhabit this 57%, they decided to make a big jump. Proctor & Gamble. Some of these big behemoth companies with 6, 7, 8% earnings growth are willing to raise their dividend at that level or above because their cash flow generation is so strong, their balance sheets are so strong.

Jason Parker: You know, you talked a minute ago about yields on fixed income, and comparing the yield on dividend portfolio that you’re overseeing compared to that, so I just pulled up the current 10 year treasury. The yield on the 10 year treasury is currently sitting at 2.8%. Now, I have to tell you, Steve, that seems like a real losing proposition to me. I mean, if you buy a 10 year treasury today paying 2.8%, and we’re in a 0 interest rate environment, it doesn’t seem like there’s a whole lot of opportunity there for those folks. Would you agree? What are your thoughts?

Steven Alley: Yeah, I would definitely agree. I think … in a word, I think bond market is now entered a bare market as of May 20th or 22nd, when Bernanke had his QE speech and told the world that he was going to start tapering and pulling in the punch bowl at some point in the future. Bond yields went from … the 10 year went from 160 to 3%, he said it’s about 280 now. It’s likely that over the next 2, 3, 4 years that interest rates continue to rise. I can’t tell you exactly how much it’s going to rise. But, to your point: at 2.8%, if inflation is 2% and then after taxes, you know, you are not going to make any money [crosstalk 00:12:07]

Jason Parker: Yeah

Steven Alley: In the ten year … in investment in the ten year bond. [crosstalk 00:12:09]

Jason Parker: Steve, I want to continue this conversation. We need to take a quick commercial break, and we’ll be right back to talk some more about this.

 [00:12:30] Alrighty, folks, welcome back to another round of Sound Retirement Radio, I’m your host Jason Parker. We are always looking to bring guests onto this program that can add real, significant meaningful value to your financial life. We have Steve Alley on the program with us. He is the president of Alley Company, which, they specialize in separate account investment management with a dividend emphasis … an emphasis on dividends. Steve, I’m sorry, just before the break we were talking about the bond market and the yield and the fact that back on May 22nd, have entered into this – as you see it – a bare market for bonds and, for the foreseeable future, in a rising interest environment. It just looks pretty darn dismal. I think that you could probably make the argument that’s one of the things that’s been fueling a lot of the growth in the dividend stocks, wouldn’t you agree? People kind of fed up with the low yield that they’re getting on these other investments, that they’re willing to take a little bit more risk?

Steven Alley: Yeah, I think that’s right, because as we were saying before the break, if you’re going to get 2.8%, and after inflation, after taxes, you’re basically breaking even or losing money at best. What you get in a dividend portfolio, what we’re trying to construct is a dividend strategy that does give you an attractive current yield. Our portfolio today’s got about 35, 36 stocks and it yields about a 3.25%.

Jason Parker: Okay.

Steven Alley: That stacks pretty well as far as plain old current yield to bonds or money markets [crosstalk 00:13:58] anything else in the fixed income marketplace.

Jason Parker: Yeah.

Steven Alley: Importantly, the dividends are growing. 3.25% again over time with the dividends in that portfolio continue to grow, maybe they’re not going to keep growing at a double digit, but even if it’s 7 8 9% a year, that’s significant. Your income level is growing. If you’ve got a blue chip company … or list of blue chip companies in that portfolio, who are going to continue to pay their dividends and grow their dividends, I think that’s a really good proposition.

Jason Parker: Yeah, you mentioned blue chip companies. A lot of those companies that you’re mentioning that you guys hold in the portfolio right now, are companies that people are pretty familiar with. I think that’s one of the things that makes dividend investing attractive, is because usually companies that pay dividends tend to be a little bit more mature and have the ability to return some of those profits to their shareholders. Maybe talk to our listeners about that, about the fact that it tends to be more established companies that pay the dividends.

Steven Alley: Well, there’s a couple reasons for that. Companies that have had … we’re looking for companies that have had a long track record of dividend growth [crosstalk 00:15:14]

Jason Parker: How long? What’s the require [crosstalk 00:15:16] …

Steven Alley: We’ve got some in there for 60-70 years, but 50 years, or, that’s not the only thing. We’d love a long track record. Companies like Genuine Parts, Anderson Electric, Procter & Gamble, AvidLat, these are companies that’ll increase your dividend for 50-some straight years.

Jason Parker: Is it a requirement for you guys, when constructing a portfolio? [crosstalk 00:15:36]

Steven Alley: No, it’s not a requirement. What we’ve recently done is … we’re also looking for companies that decide that they want to increase their dividend, that they want to institute and then continue to increase their dividend. Companies that are newbies in this area- maybe Comcast, Apple, Cisco Systems, these are companies with great balance sheets, great cash flow generation, that have now decided that they’re going to be on a dividend program. Again, because of the balance sheet characters, they have the wherewithal to pay, and frankly, they’re getting pressure from shareholders to pay. Apple’s got like, 150 billion dollars in cash on their balance sheet. You’re seeing Carl Icon ?? And others get in there and say, you know, you’ve got to buy in your stock, you’ve got to pay more in dividends, you’ve got to return more to shareholders, because that cash is sitting there burning a hole in your pocket earning zero in money market account.

Jason Parker: Yeah.

Steven Alley: You’re seeing those kinds of companies, we’re interested in investing in too because we feel that they have the wherewithal to begin to pay dividends at attractive and growing rates for probably as far as the eye can see right now.

Jason Parker: In 2008, that was a really, … the financial crisis, really bad time for the stock market in general. What was your experience? Did a lot of the companies quit paying their dividend in 2008?

Steven Alley: That’s a really good question, and I think it’s one of the reasons why we, as an active manager, we think having advantage over some of these quantitative models. There’s some dividend strategies out there. For example, DOW Jones dividend index. The symbol is DDY. It’s an ETF, and they’re a rules-based strategy. What do I mean by that? They have various rules such as: when a dividend cut is instituted, they sell the stock. I don’t know what all their other rules are in terms of waitings and various industry hoops, but they have rules that they go by.

 In that crisis, what wound up happening was … you take a company like CitiBank, I’ll give you a war story version: we’ve made mistakes before, but this is one of the good moves we’ve made. In that period in 2007 leading up to 2008, we noticed that the mortgage market was really turning south. The companies that were big in the mortgage business, like CitiBank, their quarterly earnings reports were showing that. The stock at the time $48 with a 4% dividend yield, or something of that nature. We basically said, “The fundamentals of this company are deteriorating, let’s sell the stock”. We didn’t have any idea that crisis was coming. This was like, the summer of 2007. We sold it at $48. The DDY, the rules based strategy, didn’t sell that stock until it was a single digit, which is when they cut their dividend.

Jason Parker: Ah.

Steven Alley: Okay, so, we’re a fundamentally based organization that is making decisions based on what we see fundamentally with our companies [crosstalk 00:18:49] companies are deteriorating …

Jason Parker: A lot of our listeners may not really understand what fundamental … the difference between a fundamental investment philosophy is. Help our listeners understand what you mean. When you guys are evaluating a stock from a fundamental standpoint, what are some of the characteristics that you’re looking for that would determine whether or not it’s a good fit for owning?

Steven Alley: It depends. If it’s a financial stock, then, obviously, you want to see the economy doing well. You want to see loan growth, you want to see whatever part of the lending market there [inaudible 00:19:24] continuing to grow. In the case of CitiBank, because I used that as an example, their book of business was starting to decline. Their growth rate in loans was declining because the housing market had already peaked. It was starting to head south, and they were also in a position where a lot of these mortgages were starting to go bad.

Jason Parker: Yeah.

Steven Alley: Nobody knew it was going to go as bad as it did. That would be an example there. Somebody like McDonald’s hamburger restaurant, you obviously want to see their same store sales trends, and their innovation with new product offerings, and traffic in the stores continuing to move in the right direction. [crosstalk 00:20:01]

Jason Parker: Yeah, yeah.

Steven Alley: Then you start to say, well, the fundamentals are deteriorating, let’s move out of this stock. You’re always looking for positive fundamental trends.

Jason Parker: Okay. Thank you for clarifying that for our listeners.

Steven Alley: Mm-hmm (affirmative).

Jason Parker: You have this strategy that says, “We’re going to own individual stocks”, and how many stocks usually … Oh, you know, we didn’t get the answer on … in 2008. In terms of dividend cuts, you gave an example of Citi.

Steven Alley: Yeah.

Jason Parker: Was there, in the portfolio, did you see a lot of companies just stop paying their dividend altogether in 2008? The reason I’m asking this question: one of the things people are looking for when they’re structuring income in retirement is consistency. A retirement dividend paying portfolio looks pretty good. I know a lot of these companies have a long track record of paying dividends, and typically, once a company starts paying a dividend, it looks really bad to stop paying the dividend. Was the experience that 100% of the stocks in the portfolios said 2008, due to the financial crisis, they just pulled back and didn’t pay a dividend at all that year?

Steven Alley: No. For us, it wasn’t the case. We had one dividend cut. We do not … One of our tenements here is we do not want any dividend cuts. We’re not reaching for high dividend yields. If you see a company today that’s yielding 6 or 7%, there’s usually something wrong. It usually means that they may be in trouble financially. They don’t have that much cushion, they may have to cut their dividend eventually. We’re not looking for those kind of companies. We’re looking for companies with strong balance sheets that have the wherewithal to maintain, if not increase, and grow their dividend. When we went through that period in ’07 and ’08, we were fortunate. We sold CitiBank, as an example, way before they cut their dividend. There was a couple of other stock that we sold, luckily, I guess you could say, before they cut their dividend. The overwhelming majority of our companies were never in a position where they were going to have to cut their dividend. They’re just too strong financially.

Jason Parker: Yeah. One of the reasons that I bring this up, I’ll never forget, I was talking to a gentleman one time and he owned a … it was actually a stock in a utility, and I want to talk to you some more about those, because you mentioned those. The absolute return side of the portfolio may be helping to increase the dividend a little bit. The dividend payout ratio or the dividend payout yield overall for your guys’ portfolio. He said to me, “Jason, if I own XYZ stock, and it’s paying me 5%”, he said, “the only reason I own that stock is for the 5% income. I could give a hoot what the price of the stock goes to. I don’t care if it’s down 50% or up 50%, as long as my 5% dividend continues. That’s the reason I bought it”. What are your thoughts about that?

Steven Alley: It’s a really good thought on his part. We would like to see appreciation in the company; we think we’re going to get that as well, but here’s the point that he’s making. A very, very good point, that is: during that crisis, when the stock market went down basically 57% from top to bottom, our dividend strategy, obviously … our portfolio went down too with the stock market. Not as much as the stock market, because dividend paying companies tend to have less downside than non-dividend payers. We had a pretty good experience relative to the overall stock market in that period. The point was for people … we have some clients that like to live off their quarterly distributions.

Jason Parker: Uh huh.

Steven Alley: If they’d been asleep during that two year period when that bare market was going on and then woke up, they would’ve noticed that all of their quarterly dividend payments would’ve come through and been paid out to them. Then the stock market had gone down and all the way back up again, they would say, “Gee, my portfolio’s back where it was, I collected all my dividends”, because that’s exactly what happened.

Jason Parker: Yeah, and [crosstalk 00:24:07] I think that’s the point. That’s exactly the point.

Steven Alley: The dividends … that’s the point that the guy’s making. The dividends kept clicking out because we were buying. We own very high quality companies, like Proctor & Gamble, who didn’t cut their dividend. In fact, they increased their dividend during that period.

Jason Parker: Yeah, so, in a really extreme market environment- one of the most extreme market environments we’ve been through in the last 100 years, the strong companies that have good fundamentals, even though their share price may have been in the tank, just because there was fear in the streets, people were still collecting their income and ultimately, retirement’s all about cash flow. It’s not your net worth that will determine your lifestyle. Steve, really enjoying this conversation so much. Unfortunately, we’re at that point again where I need to take our next break. We’ll be back in a minute to continue talking to you some more about dividend investing strategies.

 [00:25:13] Alrighty folks, welcome back, this is Jason Parker, the host of Sound Retirement Radio. As always, I just want to say thank you once again for tuning into this program. I want to say thank you to everybody who has … when you go to iTunes today, our little program, Sound Retirement Radio, is like, number four slot now. Right behind Morning Star and Van Guard and U. S. Nightly News. Really neat to see this program catch on around the country. I really hope that the work that we’re doing is adding significant value to your financial life. If it is, I’d like to ask you a favor. This isn’t something I’ve done a lot. Next time you’re on iTunes, or however you happen to get this podcast, if you’d go in and rate us. iTunes, for example, lets you do a star rating. Give us a rating, write us a review, let us know what you think. That would mean the world to me.

 Today we have Steve Alley on the program. Steve is the president of the Alley Company. Their company specializes in dividend paying stocks. We were just talking about this idea that there could be a lot of volatility in the price of a stock, in its share price. In many cases they’re able to maintain paying the dividend. Retirement’s all about cash flow, Steve. I wanted to ask you, regarding portfolio construction: when you guys are putting together a portfolio, one of the things we want to do is diversify and make sure that we don’t have too much exposure to any one company. How do you guys go about diversifying a portfolio?

Steven Alley: Well, that’s a good question. We probably get anywhere from 10-12 industry groups at any one time represented. There’s a happy hunting ground, historically, and the dividend universe, as I mentioned before, electric utilities, telephone utilities, tobacco stocks, today, pharmaceutical stocks, a lot of them have very nice yields. We start with screening for really high quality companies that are paying and growing their dividends. We do try to have some representation of various industry groups. Technology has always been a very hard group because it allows companies that have resisted paying dividends, they feel like if they start paying a dividend, they’re giving into the idea of growth. A company like Apple, with 150 billion in cash … spending a little bit on dividends is certainly not going to compromise your ability to spend money and grow. They’re paying dividends now and growing their dividend. There’s not that many technology companies, for example, that have had a history in paying dividends [crosstalk 00:27:54]

Jason Parker: Do you think we’re going to see that change-

Steven Alley: I do-

Jason Parker: -just because so many people are seeking yield?

Steven Alley: I do. I think one of the reasons why these technology companies have massive balance sheets. If you look at the Googles, the Oracles, the Cisco Systems, the Intels, the Microsofts, the Apples, these companies have phenomenal balance sheets. Tremendous cash generation, in many cases, no debt, in fact, in some cases they’ve been borrowing here lately on very low interest rates. 2%, 2.5%, Apple issues bonds somewhere in that range, and they’re able to take that money and buy in stock, pay their dividends … They have tremendous financial flexibility and wherewithal to continue to grow their businesses and at the same time reward shareholders through share repurchase and dividend growth, so, I do think that’s [crosstalk 00:28:53] –

Jason Parker: You just brought up a good point, though. A lot of these companies that are sitting on big piles of cash have been borrowing money. What are your thoughts on that? Do you think there’s an opportunity to be captured with this ultra low interest rate environment? They’re saying “heck, even though we have 30 billion dollars in cash” … I remember when Microsoft did this, they were sitting on a ton of cash, and yet they still went out and borrowed a bunch. They had always been a debt free company. Is it just an opportunity to take advantage of the interest rate environment? You think that’s what’s going on there? [crosstalk 00:29:25]

Steven Alley: Yeah, I think so. I think it’s an opportunity to take advantage of historically low interest rates and at the same time to leverage your balance sheet just a little bit. It’s not like they’re in any leverage position, you know?

Jason Parker: Yeah.

Steven Alley: Why not take advantage of the balance sheet dynamics that they have.

Jason Parker: Yeah. Yeah. You try to diversify across 10-12 industry groups. How many stocks do you say you usually keep in the portfolio at any one time?

Steven Alley: We say that it can range from 25-40. There’s a couple schools of thought in the area of diversification. Some people think that the optimal diversification in portfolios is owning 25-40 stocks. Others thing you should have over 100 stocks. Those are two general schools of thought that academics have looked at. We’re of the mind of that, if you own 100 or more stocks, you’re over-diversified. Can you really follow those companies that closely, you know? We like to own 25-40 stocks. Right now we have about 35, 36. We follow those companies very closely and know what we own. That’s what we thing is an advantage.

Jason Parker: Yeah. What about … what if one company becomes too large of a position?

Steven Alley: We don’t like any one stock to become more than 6% of the portfolio, that’s kind of our rule. 6%, we almost automatically start trimming the stock.

Jason Parker: Okay.

Steven Alley: Very seldom do we- [crosstalk 00:31:05]

Jason Parker: Why is that? Why don’t you want one company to represent more than 6% of the portfolio?

Steven Alley: Well, diversification. It’s portfolio management. If we were that confident in our ability … Great example: Apple was a great stock. Now it’s starting to become a good stock again, but, we’ve had 6 or 7 times our money in that stock. It suddenly becomes 6% of your portfolio.

Jason Parker: Mm-hmm (affirmative)

Steven Alley: All of a sudden you say to yourself, “Well, how good can this thing continue to be?” And well, you need to have discipline. When it gets to 6%, we trim it.

Jason Parker: Yeah.

Steven Alley: It’s served us well because, as we know, the stock did have a fairly good correction here last year. [crosstalk 00:32:05]

Jason Parker: Yeah, so- [crosstalk 00:32:07]

Steven Alley: That’s typically what happens. No trees grow to the sky, and that’s typically what happens with common stocks too. They will have their day of reckoning and corrections. Apple computer’s still a great company, we still like it, although we don’t think it’s a stock that it once was. It’s still a great company. It’s going to probably do well.

Jason Parker: You use that word, discipline, and one of my “aha!” moments for this year, I’ll just share this with you real quick, share it with our listeners. Urgency always wins always important without discipline. I just have found that, frankly, if you don’t have discipline, urgent items in your life always seem to take precedent. It triggered that thought in my mind.

 When you talk about discipline, obviously, trimming stocks that are over 6% is one piece of a discipline strategy. How else do you guys exercise discipline when constructing a portfolio of dividend payers?

Steven Alley: Fundamentally, we always do look at the fundamentals, and want to have companies whose fundamentals are moving in the right direction. Where they’re going to be able to not only maintain but increase their dividend. If it’s a utility, we want to see it increase its dividend at least 2 or 3%. If it’s a faster growing company that can grow it at high single digits or double digits, we obviously like to see that. There’s some of the fundamental characteristics.

 On the sell discipline side, once we own a stock, if the fundamentals are starting to deteriorate and it looks like it’s going to take more than 2 or 3 quarters to correct itself, we may make a decision to sell the stock and move on to something else. Our portfolio turnover is very low, we’re about 20, 25% at the most. On average, over time, we’ve been right around 20% turnover. We tend to like our companies and live with our companies. The reason we’re able to do this is because they’re high quality in nature. They tend to be really well positioned companies in the markets they serve. Number 1, number 2 at worst in what they do.

Jason Parker: Okay.

Steven Alley: Just about every one of our companies is a leader. You’re able to generally hang on to things like that for a long period of time. The fundamentals usually don’t deteriorate too badly.

Jason Parker: Okay, Steve, we’re at that point again. We need to take another break, and we’ll be back to talk some more about dividend stocks.

 [00:34:48] Alrighty folks, welcome back to another round of Sound Retirement Radio. I’m your host, Jason Parker. We have Steve Alley from the Alley Company. He oversees the Alley Company dividend portfolio. We’re talking about investing for income. Dividend stocks have been the sweetheart in many ways, especially recently, with yields so low on fixed income. And so much risk in fixed income. Most of our listeners know that as interest rates start to rise, and you own a bond, your bond’s going to be worth less money if you had to go out and sell it before maturity in a rising interest rate environment. People are looking at other means in generating income. When you have a dividend paying portfolio that also is not just paying a nice attractive dividend today. Steve was mentioning 10.5% dividend increase in 2011, 15% dividend increase in 2012. 13% dividend increase in 2013. I think I got those numbers of yours right, Steve.

Steven Alley: Pretty close, yeah.

Jason Parker: One of the things I wanted to ask you when it comes to dividend investing is this question of interest rate sensitivity. We all know what’s going to happen to the bonds when interest rates start to rise. Should we expect a lot of volatility in dividend stock portfolios due to a rising interest rate environment?

Steven Alley: I don’t know. That’s a really, really, really good question. Some people would say that there’s certain areas of the stock market, like electric utilities, maybe telephone utilities, that traditionally have been interest rate sensitive, that may stall out and not do very well. That could be the case, we’ve seen little bouts of that when interest rates have risen here in the last 6 months. The other side of that coin is: if interest rates are going to go … let’s just say your ten year bond’s going from 2.8% to 4, 4.25%, 4.5% over the next 2 or 3 years. Let’s say that’s what’s going to happen. My guess is that that means the economy got stronger. Earnings are growing at maybe a little more rapid rate. If anything, companies are going to raise their dividend even more.

Jason Parker: Okay.

Steven Alley: I don’t know that … I would say it’s good news for stocks.

Jason Parker: Okay.

Steven Alley: It’s what I would say.

Jason Parker: In a strong, healthy environment, yeah.

Steven Alley: Yeah, healthier environment. I would also say this: for people that are going to move money from fixed income over to equities, I don’t think their first move is going to go from bonds, which, they’ve owned them because it’s conservative. They’re not going to go from a conservative posture all the way over to small-cap and mid-cap, which would be among the more aggressive areas of the stock market, and small and mid trade at 20, 21 times earnings today.

Jason Parker: Yeah.

Steven Alley: I don’t think that’s where they’re going first. I would say the gateway into equities is probably through dividend stock, because you get that- [crosstalk 00:37:49]

Jason Parker: Large, large company blue chips that people are comfortable and familiar with.

Steven Alley: I think so. If you’ve been in fixed in … because you’re looking for income … Why wouldn’t you go to a dividend strategy like ours that yields 3.5%. We have blue chip companies, and if the stock market keeps going up, you’re going to participate as well. [crosstalk 00:38:06]

Jason Parker: Yeah.

Steven Alley: [crosstalk 00:38:07] -experience a dividend growth.

Jason Parker: And all we’ve talked about so far is dividend growth and dividends. We haven’t talked about total returns. I think this one piece that sometimes people miss out on, or they forget, is that you also have the opportunity for capital appreciation. Unlike a bond, where you don’t have the opportunity for capital appreciation. In a zero interest rate environment, interest rates aren’t going to go any lower. In a dividend paying stock, you have the opportunity for capital appreciation just based on growth of that company. How have you guys fared as a result of positive fundamentals over the last couple of years?

Steven Alley: Well, very good. The portfolio has tracked the stock market very, very well. Through the month of November, I think our dividend strategy’s up 26 or 27%. Right in that range. Including income.

Jason Parker: Yeah.

Steven Alley: That’s very close to the major averages, which surprised me. I would have thought that in a really risk-on year, where the stock market’s doing great, that a conservative dividend strategy like ours would lag, then. Maybe, instead of being up 27 or 28%, we’d be up 19 or 20%. Which is still good-

Jason Parker: Sure.

Steven Alley: -but very conservative. We’ve been up more than that, and I think it’s partly because our dividend growth names in our portfolio have really done well. People are looking for that kind of growth.

Jason Parker: You’ve probably seen, as I have, some of these articles that have been floating around saying that dividend stocks are overpriced, that it’s a bubble, and it’s just a matter of time before they come crashing down. Have you seen or heard any of this chatter?

Steven Alley: Yeah, we have. I don’t know where that comes from. I look at … I don’t see that. I don’t know why … so, what does that mean? If the economy keeps doing better and the companies in our portfolio keep raising their dividends, on average, at a double digit rate, does that all of a sudden mean that the stocks are going to … why would the stocks go down in that environment when they’re trading at very reasonable valuations. When you think about the competition, fixed income and money market give you nothing, basically. They’re in a fixed income in a bare market. That’s what I think it is in. Not everybody would agree with me, but I think that we’re in a bare market in fixed income. We’ve seen the lows and yields, and that yields are likely to continue to rise over the next 2, 3 years. If the 10 year bonds go in to 4, 4.5%, that means we’re in a bare market in fixed income.

 I don’t know why somebody would say that dividend payers are frothy.

Jason Parker: Especially when you talk about the payout ratio on the S&P 500 being 32% of earnings. Isn’t that the number that you mentioned up front there?

Steven Alley: Yeah.

Jason Parker: Yeah, so it seems like – and that’s a historical low – in terms of companies returning profits to shareholders, they’re actually a little bit below the median.

Steven Alley: Right. I couldn’t agree more. Let’s take a company like Verizon, symbol DZ. The stock’s trading with a 4.3% dividend yield right now. We know that it’s, yeah, it’s a company that’s going to grow at pedestrian rates – 3, 4, 5% a year – right in line with GDP. Their dividend’s going to go right around that rate, but, if interest rates go up to 4, 4.5% as I was suggesting, does that mean that Verizon’s going to be now yielding 5 or 6%? I mean, why would that be the case?

Jason Parker: Mm-hmm (affirmative).

Steven Alley: For a company that’s as solid as they are, in an environment where their business prospects are actually getting better-

Jason Parker: Yeah, yeah.

Steven Alley: -because the economy’s better. [crosstalk 00:42:12]

Jason Parker: More profits to return to shareholder.

Steven Alley: Yeah! [crosstalk 00:42:14]

Jason Parker: Is the payout ratio a consideration? How much of a dividend, compared to a company’s earnings, is that a consideration for you guys when choosing a stock to be included in the portfolio?

Steven Alley: Yes and no. Yes in the sense that if somebody’s got a payout ratio that’s quite high, in the 60, 70, 80% range. Some of these utilities, telephone utilities, that’s where they’re going to be. They’re going to be above 50%. If it’s quite a bit higher, if it looks like there’s not much room for growth or possibly that they could even get in trouble and there could be a reason to cut it, we’ll look at it from that perspective.

 But maybe, better yet, we might look at it from the other perspective, where somebody has a 20, 25% payout ratio, and they’re on the move, they’re raising their dividend at a fairly rapid rate and there’s a lot of room to go.

Jason Parker: Yeah.

Steven Alley: To raise it to even higher levels … that may be a stock that you really want to look at more closely from the standpoint of having the ability to grow their dividend sustainably over a longer period of time at higher rates.

Jason Parker: I think that’s a key component. You don’t just want a good dividend payer today, you want somebody that has the ability to pay dividends continuously. Even better would be to raise those dividends every year as an inflation hedge. I want to ask you about an inflation hedge here with dividend portfolio, but, before I do, I want to just take a minute. Steve, there’s probably going to be a lot of people out there listening to this program today that are going to be interested in the work you’re doing and want to learn more about the work that you’re doing. For folks out there that are tuning in, how can they learn more about the work that you folks are doing there at the Alley Company?

Steven Alley: Well, they can go on our website: www.alleycompanyllc.com. The first thing I would do is go to our dividend commentary. It’s called the Case for Dividends. Dividend investing, the case for dividends. It’s about a 4 page light paper that talks about some of the things that you and I are talking about right now, relative to why dividend paying stocks have been great investments through time, why dividend payers have outperformed non-dividend payers through time. We talk about the bird in the hand; that you can get 3.25% rate up front, and if you think the stock market can go up 8 or 9% a year over the next however many years. Historically, the stock market, over the past 90 years, has gone up about 9.6% a year. If you think it’s going to do anything like that over the next 10 years, you can get 3.25% up front, we call that the bird in the hand. We talk about that in our piece, but [crosstalk 00:44:53]

Jason Parker: What, yeah –

Steven Alley: It makes the case for dividend investing.

Jason Parker: A bird in the hand is worth two in the bush, the old saying there. The bird in the hand, in this case, is the dividend. You know right upfront what you’re getting and it’s some return, whereas as if you’re just investing in a gross stock that has no dividend associated with it, it’s just pure speculation. You’re just hoping the company’s going to actually perform in a way that’s going to grow your money, whereas dividends provide some income to add to the total return. Total return is made of up dividends plus capital appreciation. You have the best of both worlds, really. Plus, you tend to be investing in companies that are more established because they have the opportunity to pay dividends. The fact that your experience with dividend payers in 2008, a really bad year, was that almost all of the companies in the portfolio continued to pay that dividend.

 I think consistency is so critical, especially for people getting ready to retire. If they’re looking at a portfolio of dividend payer and stocks for income, you don’t want to have to worry about whether or not that cash flow’s going to continue from month to month. Most people are retiring, Steve, as you know, they’re used to getting a paycheck every 2 weeks. They’d kind of like to keep that consistency in their life.

Steven Alley: Right. No question about it. The thing about the bird in the hand theory is that too many investors lose sight of that when the stock market starts doing well. Now, fortunately, this past year – when I say this past year – 2013 has been a year where our dividend strategist kept up with the averages. People start to forget about the income generation, the bird in the hand, when you’ve got so much appreciation.

Jason Parker: Mm-hmm (affirmative)

Steven Alley: Next year, I don’t know what the stock market’s going to do. Let’s say the stock market only goes up 7 or 8% the next year-

Jason Parker: Mm-hmm (affirmative)

Steven Alley: -which could very easily happen. Now all of a sudden this bird in the hand concept comes back into vogue again. People start paying attention to it. Our feeling on dividend investing is if you can stay committed to it over long periods of time, not only does history prove that it tends to win the game, but the compounding effect of this dividend growth concept is something people don’t tend to talk about. If you think about starting with 3.25% current yield, and that yield, on average … like I said, we’ve been growing it at 10% the last few years, but let’s say it planes out at 7 or 8% growth per year in that portfolio. That’s a powerful number, that kind of growth. That income component of your portfolio is growing at a very strong rate. That’s what we’re seeing right now. We think that the baby boom generation is becoming a larger and larger part of our population. They need income, they want income. I think that they, the older they get, the less risk they want to take. Dividend investing is a less risky proposition in the realm of the total stock market-[crosstalk 00:47:58]

Jason Parker: The other –

Steven Alley: – our five year, our downside capture … For those in the audience that don’t know: the downside capture ratio is an interesting statistic that talks about how much a portfolio goes down in a market decline. If the stock market goes down 10%, our downside capture’s been about 6.5, which means the portfolio should theoretically go down about 6.5%. That’s a five year number, that’s what the experience, over a five year period of time, on average, we’re going to go down quite a bit less than the overall market. In 2008, the stock market went down 37%. Our portfolio went down about 26%, which would sort of equate to that downside capture that I just mentioned to you.

Jason Parker: Sure.

Steven Alley: When you look at the whole picture, dividend investing has proven to have superior characteristics to non-dividend payers over all the market cycles.

Jason Parker: A rising dividend … one of the other concerns you mentioned that people are looking for is: people are concerned about inflation. We’ve been burning a lot of money in our country, a lot of quantitative ease in, a lot of bond purchases. If we do end up in an inflationary environment, what a great idea to have a portfolio where you income is growing over time with you as you transition through retirement. I think that’s a powerful concept for battling inflation.

 Steve, we’re out of time, I sure appreciate you taking time out of your busy schedule to join us on Sound Retirement Radio. Thank you for being a guest today.

Steven Alley: Jason, my pleasure. I could talk about this for another hour if you want to.

Jason Parker: I know.

Steven Alley: This is … we’re passionate about this thing and I hope that people start to appreciate what dividends can do for them over time.

Jason Parker: I agree with you, I think this has been a great interview. It’s always amazing to me how fast the time goes. My stupid jokes always eat up a lot of that time. I do appreciate you listening to my joke and being a guest, and sharing all of this knowledge, this wisdom that you’ve gathered over the years as you’ve been implementing these strategies. Thanks again for being a guest on the program.

Steven Alley: It’s a pleasure. Thank you for having me, and thank you to those who are listening.

Jason Parker: Take care, Steve.

Steven Alley: All right. You too, bye.

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