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Dividend-Paying Stocks and Riding Rough Seas

By Roger Conrad on March 9, 2012

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This week I’ve been aboard the Westerdam on the Money Answers Investment Cruise. One of my objectives has been to talk to as many fellow travelers as possible–a large number of them are Utility Forecaster readers–to hear their concerns and answer their questions.

Here are some of the highlights. Note that our own Investing Daily Wealth Summit will be held in Palm Beach, Florida, May 4-5, 2012, at the Four Seasons Hotel. Visit www.InvestingSummit.com for details.

Question: Today’s ultra-loose monetary policy by Ben Bernanke and the Federal Reserve has to add up to rapid inflation sometime.

Won’t this pummel all dividend-paying stocks, and what can we do to protect ourselves?

Answer: The problem with trying to devise an investment strategy from 30,000 feet is there’s always a lot happening on the ground that may or may not fit pat theories concocted from the heights.

Last year there was almost a unanimous consensus that a downgrade of US government debt would set off a massive spike in interest rates. What happened when Standard & Poor’s did cut, though, was exactly the opposite: The mother of all rallies for Treasuries and plunging interest rates. In fact, US Treasury bond yields are still a stone’s throw from their lowest levels in history.

This is why I’m always a lot more comfortable managing my investment strategy from the ground, that is based on the prospects of the stocks I own.

But, to look at the question another way, we really are in no-man’s-land as far as monetary policy goes, and I’m not sure how far the old rules apply.

We’ve just lived through the worst deflationary event since 1929–the crash in the US housing market–and the impact is still playing out across the economy. That’s what the Fed has been fighting, by doing in most cases exactly the opposite of what the central bank did in the 1930s. And the results have undeniably been different: In the 1930s, for example, it took until 1935 for commodity prices to recover. This time around the upside action started in early 2009, just a few months after the crash itself.

Maybe this does bring on real inflation in the long term, as the Austrian economists forecast. The price of some goods and services has indeed continued to rise, and we’re hearing once again that the US government is hiding the real inflation by cooking the books. Equally, though, the inflation scenario is still missing a key element: any kind of upward push on wages such as drove up prices in the 1970s. As long as that’s the case, price increases are arguably more contractionary than inflationary, as they take money out of consumers’ pockets.

I guess what I’m saying is that these broad-ranging economic discussions can consume ink by the barrel. But when it comes to making informed investment choices, they’re really not that useful. I’ve always believed very strongly that income investors need to buy and hold to get the benefits of dividends and dividend growth, which means living with and being prepared for both credit risk and inflation risk.

Sooner or later we’re going to see more inflation. It’s almost certainly going to come when almost no one expects it, rather than when so many do. But the way to prepare for it is to diversify and balance your dividend-paying stocks, not run for the hills.

One way to accomplish this is to always make sure the dividend-paying stocks you own have a growth angle. Growth keeps you ahead of inflation, and it’s also the best possible assurance that the dividends you’re receiving are safe.

Another way is to own stocks that pay dividends in a currency that’s tied to commodity prices, such as Canadian and Australian dollars. If we do get real inflation going forward, it’s going to have to be fueled by rising commodity prices. That will increase the value of these currencies against the US dollar, with the result that dividends and stock prices will keep pace.

This would offset possible losses in other dividend-paying stocks. But in the meantime, you can still stick with high-quality, growing companies from a range of sectors that will build your wealth and income streams up over time.

That’s the secret to superior returns.

Question: What do you see for oil prices and, by extension, the world economy if Israel attacks Iran’s nuclear facilities?

Answer: If there’s anything where the information is less clear than on the economy, it’s geopolitics. This, in my view, makes it foolhardy to base your investment strategy on a question like this one.

I don’t think it takes rocket science to figure out some of the likely consequences of this kind of Middle East war. For one thing, oil prices would likely spike up, which, if sustained over several months, would have a contractionary impact on the global economy.

We’d also probably see a selloff in global stock markets, as investors absorbed the uncertainty for future political and economic stability.

Based on what’s happened in recent market panics, we’d probably see a flight back to safety. And US Treasury securities are still the only market large enough to accommodate such a push. That would bring rates down once again in the US. I also think it’s reasonable to assume gold and oil stocks would benefit.

If you’re really worried about this kind of event, make sure you own some energy stocks. But based on what’s happened in these situations in the past, the market reaction would be violent and short-lived, i.e. more of a trading opportunity than a reason to change your investment strategy.

And keep in mind that this is a situation where watching the news isn’t going to inform you. The players in this game keep their cards close to the vest.

Question: High-yield bond funds don’t score very highly under mutual fund ratings systems. Is there any reason to own them?

Answer: High-yield bond funds are the most volatile part of that market, and performance data for most rating systems is going to include 2008. That was a year when high-yield bonds were slaughtered, along with almost everything else this side of US Treasuries.

From my perspective the appeal of high-yield bond funds is two-fold. First, yields are much higher than for higher-quality bonds. Second, they actually benefit when economic growth is picking up, as investors rightly perceive less risk to principle and interest.

Whether they actually benefit from inflation depends on how fast market conditions are changing. But they have been shown to keep pace, even if higher-quality types of bonds are falling fast. That’s means added diversification that actually reduces overall portfolio risk.

If I’m pushed on the point, I definitely prefer to hold dividend-paying stocks to any kind of bond. That’s because stocks, unlike bonds, can increase dividends over time. And individual high-yield bonds can also default, which makes wise selection just as important as it is with individual stocks.

But held in a fund, they provide yet another measure of diversification and balance for income investors, and that’s ultimately the key to earning superior returns safely.

Question: What happens to pipeline master limited partnerships (MLP) if there’s a spike in inflation?

Answer: In general, pipeline contracts actually do have automatic rate-adjustment clauses that are tied to inflation. They would theoretically keep pace over time, though there would be at least some lag in the near term that could affect profitability, particularly if inflation really spiked up.

MLPs are very capital intensive and use a lot of debt to finance projects. A rapid increase in inflation would erode the real cost of the debt they have on the books versus the earning power of their assets, which would be bullish. But it would also surely increase the interest rate they’d have to pay on new debt to finance new projects.

They could still lock in margins at that higher cost, if they’re able to get contracts providing enough revenue. But MLPs would no longer be in the sweet spot where capital is cheap and there’s a wealth of new projects to take advantage of.

Inflation in general does depress stock market returns, as we saw during the 1970s. One little-known fact is that dividend-paying stocks did hold their own in the latter part of that decade, as the cash they paid out offset lower share/unit prices. And to the extent they can grow, these stocks will keep up with inflation. But all else equal, they would perform better if there is little or no inflation.

Question: What if President Obama wins re-election? Won’t taxes go up across the board and dividend stocks crash? Shouldn’t we be lightening up?

Answer: Letting your politics guide your investment decisions is always bad business. There’s just too much room for emotion to enter in. Just ask all the people who stayed out of the market in early 2009 because they were afraid of new regulations. They missed one of the most explosive three-year bull markets in history.

This is an election year. The president and the Democrats are trying to rally their core voters, and so are the Republicans. One time-honored way to do that is to hurl invective and issue dire warnings about what will happen if the other side wins.

After the election, however, everyone in Washington–as well as in the states–is going to have to come together and reach a compromise on some critical issues and everything to do with taxes, spending and regulations is going to be on the table. My own view is that taxes are going up, and very likely some of those higher levies will be on investments, particularly for anyone in the higher tax brackets.

The president is campaigning on eliminating the Bush-era tax cuts for income of over $250,000 for couples but basically keeping them in place for earnings below that level. His principal challengers are campaigning on reducing taxes even further, including eliminating levies on capital gains and dividends entirely. What will almost surely happen is something in between.

How will this affect the market for dividend-paying stocks? It depends on the details. But it’s worth noting that dividend-paying stocks, including utilities, didn’t rally immediately after the Bush tax cuts passed Congress. Rather, their strong performance over the past decade came together as their underlying businesses returned to health and supported dividend growth.

In the near term perception is everything in the stock market. And I wouldn’t rule out a selloff of some sort depending on what does get passed by Congress and signed by the White House.

If you’re really worried about this, however, I wouldn’t turn everything upside down. Instead, just make sure you own some dividend-paying stocks that wouldn’t be affected by a change in dividend tax rates–any Canadian and Australian stocks, or in fact any European stocks. They’re primarily owned by people who don’t pay US taxes and therefore won’t be investing based on any changes here. You can also pick up some master limited partnerships, which are taxed entirely differently.

In a worst-case these investments would gain value to offset losses elsewhere. But the main point is a higher tax rate for some doesn’t change the fact that anyone living off their investments needs income.

Dividend-paying stocks are still the only alternative that pays a living wage and keeps up with inflation. That won’t change no matter how they’re taxed. And that will limit downside from any change in taxation.

Question: What impact would a collapse of Europe have on the US economy and stocks?

Answer: As we’ve seen several times since this stock market rally began in early 2009, anytime Europe’s news gets worse, investors flock to the one safe-haven market that can hold them: US Treasuries. My prediction is the same will happen again when we get the next batch of bad news from the Continent.

Europe has problems. The austerity measures taken in Greece and elsewhere continue to slow these countries’ economies, which is worsening the budget situation. I wouldn’t be surprised if several countries actually ditch the euro, though there still seems to be political will to keep things together.

One thing I don’t think will happen, however, is for Europe’s woes to trigger a credit crunch here along the lines of what happened in 2008. The main reason is US corporations have used the low interest rates of recent years to eliminate near-term debt maturities. If conditions tighten, they can simply take a step back and wait for conditions to loosen again before selling any bonds. In fact, we’ve seen that happen several times the past couple years.

Credit conditions, like everything else, are subject to the law of supply and demand. And if companies don’t have to borrow, the institutions that buy them will have no choice but to pay up, which will keep rates low. That’s a far cry from the situation in 2008, when so many were caught out by the tough conditions and were forced to borrow at loan-shark rates. And it’s why Europe’s woes are likely to stay on its shores, at least when it comes to affecting the underlying health of companies.

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  1. avatar
    julius menn Reply March 24, 2012 at 8:51 AM EDT

    Please name the dividend bearing stocks you talk about. Thanks, JJM

  2. avatar
    Timoteo Reply March 24, 2012 at 7:55 AM EDT

    So I stuck a toe into Valener as it knocked out the 6.4% yield mark below US$15.40. What happened in GYB? I don’t know but I took off 18% of my position @$18.28. Valener’s situation will probably not improve a great deal until next winter. But meanwhile they will keep up the distributions. So then there are still buying opportunities even in a over bought market. Glad I sold another 30 of SDRL at $42.23 as I was able to buy those shares back this past week at $37.44.
    The ETF SDIV coming up on it’s quarterly outsized distribution ex date looks like a sell!

  3. avatar
    Timoteo Reply March 17, 2012 at 5:42 AM EDT

    I have recently sold 80% of my CPL & ABCS , & some tranches in ENY, SDRL, NPIFF, and ATGFF all on valuation. I would not be buying here. I await the inevitable Summer sell off and the special situations. So Valener coming off the very weak winter heating season is a decent value near US$15.50? The MCQPF will provide plenty of time to add to or take a new position in AFTer they announce the dividend cut. Exceptionally weak 1st and 2nd quarter hydrology may create the buying opportunity in Brookfield Renewable when they report and provide guidance. I like stocks like ATGFF a lot more with $24 to $26 handles.

  4. avatar
    Timoteo Reply March 17, 2012 at 5:23 AM EDT

    And the tease but no names? Some of the usual suspects are in Canada AT/Atlantic Power, Brookfield Renewable LP /BRPFF, Bell Aliant /BLIAF, Alta Gas/ ATGFF,Fortis/ FRTSF, the beaten down buying opportunity in the bad news already fully aired out Capstone/MCQPF (be aware of the pending dividend cut from 16% to 7-8%), NPIFF/Northern Power, Valener/VNRCF. “….stocks that pay dividends in a currency…”, that is a commodities currency so we can then look at the strong ags rally and consider AGGZF, AG Growth just upgraded by Scotia Bank to outperform and it did rising 10% on the upgrade coincident with a strong wek in stocks, Ag Growth for the yield and growth which has slowed a bit but does continue. The other commodities plays forest products with CanFOR/CFPUF & ACAZF/ Acadian which recently merged with Cell-For. In Brazil we have the CPL. The pesky newer ETF showing the coincidence in a recovering commodities stroy oof the last 4 months mirrored in ABCS which basically does for you what these tease suggests. It is getting hard to get these shares as these countries are increasingly trying to set up curbs to prevent these profligate drowning in liquidity polluted currencies from flooding their countries and driving up the value of their currencies with inflationary pressures leading to higher interest rates . That then hampers their exports. The Froggies like it near par but $1.06 was killing them. The Real shot out of the gate this year to a 9.5% advance on the US Pe$o before falling off on stronger measures against the polluted US Pe$o. The Aussie $ continues to hover on the endue of 1.10. The Noaky just cruising along, SDRL making a move from $38 to $42 in less than 3 weeks. STO more complicated for the singular annual distributions. Fertilizer still down against the impending record US corn crop and the pressure that puts on soybean and cotton acreage? The ETF SOIL with it’s many Canadian and chinese picks in phosphates, potash, & and nitrates.

  5. avatar
    Robert Stoff Reply March 9, 2012 at 4:03 PM EDT

    I had taken Roger’s advice on Frontier Communications at $7.00 per share and now am trying to dig myself out of a hole waiting for it to come back. What happened?