Dividend-Paying Stocks: Overpaying for Income

No, my title this week isn’t a lame attempt at an “April Fool’s” joke. And, yes I’m still very much a believer that the sure thing–cash interest and dividends, when it comes to investing–is almost always a better bet than the uncertain potential for capital gains.

The bird in hand, in other words, is always worth more than two in the bush. But how much more? What if the bird in hand is priced at three times his or her counterpart in the bush? Does it still make sense to pick the high-yielder over a low- or no-yield growth stock?

If you’re living off your investments, you’re always going to want to have income coming in via dividends and interest. That’s the only way to ensure you won’t be eating vital seed corn during the market’s proverbial winter months.

Just ask the investors who followed the foolish advice to swap dividend-paying stocks for growth stocks under the presumption they could always get “income” by selling pieces of perpetually rising stocks or funds. The same is true for pension funds, for which the only way to meet the requirements of actuarial tables is to ensure a yield.

The question is when is a dividend yield no longer attractive relative to the risk it presents and the available alternatives? And that’s well worth asking here in at the dawn of the second quarter of 2011, with interest rates still near generation lows and many dividend-paying stocks at or near post-2008 crash highs, or even all-time highs, as is the case for many master limited partnerships (MLP).

Many investors have asked me recently if dividend-paying stocks and other high-yielding investments are already fully valued or worse. They wonder if they’re better off not buying now but instead waiting for an inevitable correction. Others wonder if it’s time to abandon positions in anticipation of mounting inflation pressures and a falling US dollar.

Those are exceedingly difficult questions to answer. To be sure, we’ve seen some staggering gains across the board since March 2009 in dividend-paying stocks, particularly our favorite MLPs and Canadian high-yielding equities, but also in real estate investment trusts, small banks and utility stocks. 5 to 10-year investment grade bonds once yielded 10 percent to maturity and more. Now those numbers are down to a couple of percentage points and worse.

Fearful of a reversal, investors have started to take some notice of quality differences, mainly by harshly punishing stocks that don’t live up to expectations. But relative yields still reveal a market that doesn’t require much of a premium to buy riskier fare, as opposed to safer alternatives.

Any hint that the economy is slowing could widen that yield premium in a hurry, driving down prices. So would a real indication that inflation is picking up steam in the US and the dollar is going into freefall.

On the other hand, risk to dividends and interest has dropped markedly since 2009 when the bull market began. In fact, it continues to drop as the recovering economy boosts business conditions in many industries, and companies take advantage of still-generation low corporate borrowing rates to slash interest costs, fund growth and eliminate refinancing risk.

This latter bit all but rules out a repeat of the historic 2008 credit crunch. If conditions start to contract markedly and the terms of selling bonds worsen, companies can simply pull in their horns for a while until conditions improve. That’s precisely what happened in early 2010, when European credit worries temporarily tightened conditions, companies pulled back and then came back when conditions loosened again. And with another year of low interest rates under its belt, American corporations’ position is even stronger now.

Most compelling, however, are the implied returns at select, high-quality, dividend-paying companies. In the near term even the most secure company’s share price is subject to wild volatility. Enterprise Products Partners LP (NYSE: EPD), for example, opened and closed Mar. 15 at $40 and change. Intraday, however, the stock actually touched under $28 briefly.

Ironically, that day there was no hard news on Enterprise, which had recently announced its 34th consecutive quarterly distribution increase, robust fourth-quarter numbers and an accretive takeover of affiliate Duncan Energy Partners LP (NYSE: DEP). Enterprise units were also coming off of two consecutive up days. Some relatively mild early selling, however, apparently triggered stop-losses and forced cash-outs of leveraged positions. The result was a wave of sells that temporarily overwhelmed buy orders and pushed the stock in freefall.

The Enterprise incident illustrates clearly the dangers of using stop-losses and other gimmicks to increase leverage in a market like this where so many are so fearful. It also shows that this type of selling never does permanent damage, provided the underlying company is strong. And it demonstrates how investors can score huge gains in this market from unexpected bargains, by setting buy limit orders at “dream” prices that will only be filled on extremely volatile days.

Several companies besides Enterprise underwent similar if less dramatic temporary selloffs, including fellow MLP Genesis Energy Partners LP (NYSE: GEL). Each time, they flushed out investors who thought they were gaming the system in their favor, either to limit risk or leverage dividends/gains. But they presented huge opportunities to buy in cheap. Those who bought at Genesis’ bottom, for example, are now up 30 percent. Those who bought at Enterprise’s on Mar. 15 are up more than 50 percent.

I’ve highlighted ways to take advantage of this strategy in recent alerts sent to Utility Forecaster readers, as well as the April issue of the advisory, which will be posted at www.UtilityForecaster.com on Saturday, April 2. Get instant online access to the new issue the moment it’s posted when you accept this risk-free offer to try Utility Forecaster. The lower you set your buy target, the greater your gain if it’s filled, though the less chance it will be.

The only real risk is if the underlying company is coming apart and truly justifies the drop. Such weakness, however, hasn’t been at the root of any of the dramatic drops we’ve seen in recent months. And if one of our picks does weaken, we should have plenty of warning via first-quarter numbers, which we’ll start seeing in about three weeks’ time.

That being said, what about current prices? In other words, is there any merit to buying dividend-paying stocks at these prices when we could see more single-stock crashes that present truly stunning values?

The answer lies in what drives dividend-paying stock prices over time, namely dividends. A stock can and will move for many reasons. But a dividend-paying stock’s baseline for value is always the level of its dividend. As that dividend is increased over time, the stock achieves a higher baseline value. Similarly, dividend cuts establish a lower baseline value, which is why investors should generally limit exposure to high-yielding stocks where dividend safety is a real question mark.

Here at the start of second-quarter 2011, there are several strong companies in a wide range of industries yielding between 5 and 10 percent, and they’re growing dividends 5 to 10 percent as well. That’s total-return potential of 10 to 20 percent annually, a strong return in any market, for those who buy in now.

Of course, not every company meets this criterion. In fact, there are quite a few companies that yield in the 5 to 6 percent range–including MLPs–that have no dividend growth potential to speak of. Others in this category carry substantial risks to the payout. But we are still finding stocks with a high level of revenue security, generous current yields and robust potential for dividend growth. They’re still definitely worth buying now, despite the fact that many have scored powerful gains the past couple years.

Equally important to company quality is portfolio diversification and balance. Readers know I advocate a strategy based on buying and holding companies from a wide range of industries, with no one sector comprising more than 20 to 25 percent of the whole.

My strategy also includes owning representatives of sectors you may feel leery about due to your perceptions about the economy or even the specific sector. For example, I continue to hold REITs, despite my strong conviction the sector never got the comeuppance it deserved after the 2008-09 meltdown, and the pressures still faced by the US property market.

The reason is simple: We have a far greater chance of being right about individual companies than we do about the economy’s direction. It’s important to ensure your portfolio is prepared for all economic contingencies. It’s equally important you don’t bet the farm on a particular outcome–for example, higher inflation and a crashing US dollar–that nobody can forecast with certainty.

Owning the best of a range of sectors ensures you’ll always have at least something of what’s hot to stabilize your portfolio. Even in the darkest days of 2008, for example, the short- to-intermediate-term bond fund recommendations I’ve made in Personal Finance held their own. And even in fourth-quarter 2006–following Canada’s trust tax announcement–a diversified income portfolio did well, as the exodus of money from trusts bid up prices of everything from utility stocks to REITs and bonds.

With that in mind, here’s my outlook on key dividend-paying sectors. I’ve reviewed briefly all the Utility Forecaster Portfolio companies in The Roundup for subscribers.

Utilities. Utility stocks are arguably now the cheapest dividend-paying stock group. That’s the result of the accident at Japan’s Fukushima-Daiichi nuclear plant, which has ignited a heavily emotional  global debate about the future of nuclear power. Unlike Germany, however, the US government approach to the crisis has been measured.

There will likely be higher expenses to be borne by companies, as the lessons from Fukushima are digested. But the Obama administration remains strongly supportive of nuclear power in the US, both the building of new reactors and relicensing the current fleet. Since the accident in Japan, the Nuclear Regulatory Commission (NRC) has approved the relicensing of the Vermont Yankee nuclear plant, over the vociferous opposition of the state’s governor and despite the fact that it shares design with the Fukushima reactors.

No doubt the fact that a tsunami hitting Vermont is a low-probability event had something to do with it. But Entergy Corp (NYSE: ETR) has also improved plant performance from an operating rate of just 78 percent to 94 percent of capacity. And, despite the overblown controversy about tritium leaks at the plant, it has a strong safety record as well.

The NRC also stated that it has no safety concerns about the Indian Point nuclear plant, which New York’s governor has been on the warpath to close. And it stated Southern Company’s (NYSE: SO) construction of a new nuclear plant in Georgia raised no environmental concerns. Finally, the Environmental Protection Agency’s (EPA) plan for water usage at power plants is also far more benign that expected.

The upshot: some higher costs at nuclear plants that are well priced in, with utility stocks pricing in much worse. Throw in the fact that even non-nuclear utilities sold off on the nuclear news–the result of being included in exchange traded funds (ETF)–and you’ve got a real case for undervalue–and potential growth. The formula: 5 to 6 percent yields with 5 to 10 percent dividend growth equals 10 to 16 percent annual total returns.

MLPs. As long as you’re sticking to unleveraged and stop-less positions in energy-related master limited partnerships, you have few worries, despite today’s higher market prices and the possibility of Enterprise-like incidents.

Your efforts should focus on setting “dream” buy prices and picking up MLPs yielding 5 to 9 percent, growing distributions 5 to 10 percent a year. Energy MLPs have a clear road to growth, as exploding demand for shale gas has created a severe infrastructure shortage, and record-low capital costs have enhanced their ability to meet demand profitably.

That’s what ensures the robust dividend growth will continue until we actually see MLPs building speculatively, rather than only after they lock up customers on long-term contracts. Beware any MLP not involved in energy. They could be targeted by new tax legislation.

Telecoms. AT&T’s (NYSE: T) blockbuster move to buy out T-Mobile USA from Deutsche Telekom (OTC: DTEGY) has already generated quite a bit of print. My take is it’s not a game-changing move but rather the latest development in ongoing industry consolidation that will continue to accelerate, even if the Federal Communications Commission (FCC) ultimately doesn’t approve this transaction.

That trend is driven by growing global demand for connectivity and the expense of running networks able to meet it. The deal’s loser is also a loser if the deal fails at the FCC, Sprint (NYSE: S), which is still floundering under the after effects of its merger with Nextel and can’t afford to keep pace. Sprint is petitioning Uncle Sam to come to its rescue against the onslaught of market forces. Don’t bet on it. Stick to the industry giants.

Also note that high-yielding rural phone companies aren’t immediately threatened by this deal but rather should continue to be watched on a quarterly basis to ensure cash flow covers dividends. Potential returns are also in the mid-teens range now, though with current dividends a more important part of the mix than potential dividend growth–particularly for high-yielding rural wireline companies.

Banks. Big banks are likely good speculations now that the US economy is recovering. But small banks, particularly regionals, are  the best sector bet for income investors. I like the deposit/local loan-based institutions with low default and bad asset rates. Merger activity is also robust here, though the acquirers are benefited most, as there are still a number of financially weak sellers.

REITs. Canadian real estate investment trusts’ more conservative approach to growth than US counterparts ensured they’d fare better when the bottom fell out. And that’s carried over to a successful acquisition boom that’s locking in 10 percent-plus annual returns this decade. In the US, low debt and high occupancy are also key drivers. Avoid the high flyers yielding 3 percent or less.

Canada. If you’re worried about the future health of the US dollar, Canadian stocks pay dividends in Canadian dollars and are priced in that currency as well. A US dollar decline directly leads to capital gains and triggers what amounts to an automatic dividend increase.

Canada’s trusts are now few in number, owing to a new tax that kicked in Jan. 1. But the country still boasts yields paid monthly by high-quality companies of up to 10 percent, and many companies are boosting dividends besides. That’s a far better hedge against US dollar troubles–which the commodity-laden loonie would benefit from–than raw metals, which only sleep in a vault.

Energy Producers. For the most part energy producers have rallied strongly in the wake of political turmoil in the Middle East. The ability of such disruptions to move oil prices so dramatically is a clear sign that global supply and demand remains very tight.

On the other hand, politically spurred rallies in energy are rarely lasting. That suggests investors should be a bit cautious about new purchases in this sector. But there are still some cheap companies out there, particularly in natural gas, Canada’s oil sands and special situations like Eni (NYSE: E), the Italian giant that has substantial investment in Libya.

Bonds. Bonds will get killed if inflation really picks up steam. I don’t think that’s likely soon, mainly because there’s no wage-push inflation with unemployment so high. But short- to intermediate-term paper would not be overly affected in any case, owing to near-term maturities. Owning such bonds in a mutual fund–such as the low-expense fare offered by Vanguard–is preferable as it affords diversification.

And if we do see a reprise of 2008, bonds will protect you, as they did then. Avoid long-term bonds, however, as they have little yield advantage over shorter-term fare but infinitely more inflation risk.