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Fidelity Viewpoints: Reboot your income strategy

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Use dividend growth to help outpace inflation.

Excerpt from Fidelity Viewpoints interview with Todd C. Ahlsten, Chief Investment Officer and Portfolio Manager

ToddAhlstenBond yields are at historic lows, and this environment makes it difficult for income investors to beat inflation over the long term. I believe that owning companies with strong, time-tested businesses that can increase dividend payments over time is an attractive way to potentially generate income that can stay ahead of inflation over time.

But it is important to avoid being intoxicated by current yield. If you go after only high-yielding stocks, it can be like sailing a ship too close to the rocks: The risk is that a company with a high yield might not be able to sustain its dividend. I’d much rather invest in a company that’s yielding 3% with strong potential to grow its dividend than in a company yielding 5% that has poor growth prospects. The best companies are those that can grow their income stream while also being able to withstand economic shocks.

I look for three main criteria when considering investing in a business:

  • Products and services that will be increasingly relevant to our lives—this trait enables a business to grow over time.
  • Sustainable competitive advantage (moat)—competitive advantages give a company pricing power and downside protection.
  • A quality management team—good corporate governance and ethics help to make sure the company is managed for the benefit of shareholders.
  • If a company meets these criteria, our investment team will then perform a detailed valuation analysis, resulting in a three-year range of outcomes for the stock. I want to invest in businesses that are still attractive after taking into account the downside risk. This last criterion is especially important in uncertain environments like today.

    Pockets of potential
    Dividend stocks have had a run-up in the last year. The bargains that were available a year ago are no longer there, but I have still been finding a lot of attractive, dividend-paying stocks. I think there is tremendous long-term opportunity among companies involved with logistics: firms involved in shipping, waste disposal, food distribution, and so on. Rising gas prices increase costs for these companies, but they can pass on the cost to customers through fuel surcharges. Moreover, if inflation picks up, some of these companies will be able to raise their prices further. I have found several firms in this space that dominate their industries, have wide economic moats, good management teams, and strong balance sheets. They should weather whatever kind of economic outcomes might occur, and they have paid dividend yields of 3% to 4%. I think there is tremendous opportunity here for dividend growth.

    I see similar dynamics among many consumer staples companies. Some of these firms have products that are in almost every household in America, and are poised to expand dramatically overseas. They dominate their niches, have very shareholder-friendly management, and, again, are likely to thrive in a wide range of economic scenarios. Therefore, it is easy to make the case that in 10 years, these companies should be more valuable and their dividends larger.

    Uncertainty on taxes
    The lack of clarity surrounding future tax rates on dividends is a wild card. If the strategy in Washington is to raise tax rates significantly, especially on dividends, that would create a definite after-tax headwind. I don’t think that tax rates alone will prevent a company from paying a dividend. But I do think a higher tax rate would make dividends less attractive, and might lead companies to favor share buybacks. I don’t expect any movement on this issue until at least 2013.

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    The views expressed on this site are not in any way endorsed by Fidelity Investments.

    Mutual fund investing involves risk, and loss of principal is possible. Common stock prices fluctuate based on changes to a company’s financial condition and on overall market and economic conditions. Small-and mid-cap companies can be particularly sensitive to changing economic conditions and have fewer financial resources than large-cap companies.

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