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Dividend Investing: It’s Hard to Generate Income Without Growth

By Roger Conrad on April 20, 2012

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You don’t have income for very long without growth.

That’s why stocks are always superior long-term investments to bonds–even for the most yield-hungry investor. Bonds steadily lose ground to inflation because their yields never change.

And it’s why any dividend-paying stock you buy should have at least some catalyst for growth. Steady, reliable dividend growth is the surest, safest way to get both growth and income and is therefore my preferred strategy.

My Big Yield Hunting advisory is set up to take advantage of speculative opportunities in very high-yielding stocks. Here the game is to buy when expectations are so low for dividend sustainability that they’ll be difficult NOT to beat. And surmounting a very low expectations hurdle is all that’s required to make a hefty capital gain, even if there is a dividend cut.

Companies that have consistently raised dividends, however, have given us incontrovertible proof that they’re growing their businesses. And you can only do that with good assets, savvy management, a strong balance sheet and a growing niche that allows management to invest in its business, year-in, year-out.

Where are the invest-to-grow opportunities now? That’s the primary focus of my paid advisories, Canadian Edge and Utility Forecaster, as well as those I co-edit, Australian Edge and MLP Profits. And despite markets that show signs of a traditional spring-summer retreat, opportunities abound in all of these areas.

One of the biggest in North America for the past few years is energy infrastructure, which includes pipelines, processing centers and storage facilities. The key is the explosion of production of oil and natural gas from shale reserves, which were inaccessible up to a few years ago due to costs and technology limits.

These impediments no longer exist today. And the result is output from shale is now limited only by the lack of infrastructure to bring it to market. Companies that build and operate pipelines pretty much lock up profits as soon as they announce a new project, as producers pre-sign for the new capacity under long-term contracts before the first spadeful of earth is turned. Meanwhile, the operators are currently able to raise both debt and equity capital at the lowest cost in their history.

The success of this invest-to-grow strategy has been passed onto shareholders as consistent and robust dividend increases, particularly from the master limited partnerships (MLP) that increasingly dominate the business.

MLPs are able to pass on their income to shareholders without first paying corporate taxes, so the payouts are larger than with ordinary corporations. Many have now boosted distributions 30 consecutive quarters and more.

Most are also tax-advantaged, as they’re considered return of capital (ROC) for accounting purposes.

This doesn’t mean they’re winding up the business and selling the furniture. In fact, they’re relentlessly investing to grow the value of the business. But such tax treatment means you don’t pay any tax until you sell. Rather, the amount designated as ROC is subtracted from your cost basis and you pay a capital gain on the difference when you sell.

MLPs have been a fantastic investment story, particularly the past three years as the Alerian Index has roughly doubled from capital gains alone. Contrary to the conventional and dead-wrong “wisdom,” they’ve been anything but interest-rate sensitive, rallying when the economy has picked up steam.

I see one thing that could derail this profit train. That’s what amounts to speculative building, as MLPs and other pipeline companies start expansion projects before they line up customers.

Fortunately this hasn’t happened yet. In fact the crash in natural gas prices–which some have worried will hurt the economics of owning pipelines–is the strongest possible incentive to keep demanding long-term contracts from shippers before doing anything.

The upshot is MLPs still have plenty of upside left. Some have pushed well above levels where they’d be good buys in the near term. Investors have in effect chased them to new heights on the assumption that a rising price means more safety, a kind of momentum income investing I’ve warned about here many times.

There are still, however, plenty of first rate pipeline MLPs and other companies that are investing for growth with no end in sight. And more than a few still yield more than 7 percent, even as they’re growing dividends every quarter.

That’s a solid formula for growth that’s proven itself in what’s so far been a turbulent decade and will continue to for the rest of 2012 and beyond.

The electricity business has been an invest-to-grow story since its inception in the late 19th century. America’s appetite for power has occasionally dropped off, as the economy has contracted and/or mild weather has depressed heating/air conditioning demand. But for more than a century, there’s been no surer trend than rising demand for electricity. And that’s not about to change with power-sucking devices such as smartphones proliferating and needs for data transmission surging.

The country is also seeing a surge in manufacturing, as multinational corporations reverse a decades-old trend and locate facilities in the US to take advantage of cheap energy, falling labor costs and reliable regulation. Today’s Wall Street Journal, for example, has some solid facts on the epicenter of the country’s industry revival–South Carolina–which is very bullish news for the utility operating there, SCANA Corp (NYSE: SCG).

Electric companies invest to grow by tapping into this inexorably rising demand. SCANA, for example, this month received Nuclear Regulatory Commission (NRC) to build two new AP1000 nuclear reactors at its Summer site. This project will continue to add billions to rate base under already approved plans that recover costs in rates as incurred rather than when the plant is completed.

The real key to a successful invest-to-grow strategy is a good relationship with local regulators. SCANA definitely has that, as do most power companies operating in the Southeast US.

Other regions, such as New York and parts of New England, by contrast, should be viewed with caution, as utility-bashing remains in vogue with certain politicians. Federal Energy Regulatory Commission (FERC) policy on new power transmission lines is another cause for concern, as newly appointed commissioners with consumer advocate backgrounds debate whether current returns are too high.

Regulation is a major concern for seekers of utility invest-to-grow stories. But for those who search carefully there are still plenty of companies yielding 5 percent or more and featuring dividend growth that’s held up in even the worst environments, including the 2008-09 recession.

Canada and Australia are both thought of as natural resource stories primarily. And in fact for US investors all dividend-paying stocks in these countries are in one very real respect: They pay dividends and are priced in currencies that typically move up and down with natural resource prices, especially oil.

There are myriad companies large and small that produce natural resources in these countries. For invest-to-grow seekers, however, the highest-percentage bets are companies that provide infrastructure services to these producers, under long-term contracts that ensure steadily rising revenue, earnings and dividends.

Canadian pipeline companies are a good example. And the opportunities are immense, ranging from light oil and natural gas liquids (NGL) used in industry to potential exports of tar sands output and natural gas. We’ve made a heavy bet on these in Canadian Edge and haven’t been disappointed, as companies such as Pembina Pipeline Corp (TSX: PPL, NYSE: PBA) have soared even as they’ve dished out a rising stream of dividends.

As with the US pipeline stocks, some have a problem with price, as some investors have followed the upside momentum in. But if you have the patience to wait for the right entry point, you’ll be in a money machine that in fact is also a hedge against possible future weakness in the US dollar.

The same is true for Australian pipeline companies, which are a focus of Australian Edge. But there are also immense opportunities in companies with a piece of the country’s offshore natural gas reserves, which are set to be chilled into liquefied natural gas for shipments to energy-starved Asian markets.

When the giant projects now in development were initially conceived, China as expected to be the key to demand. But with the tragic tsunami/earthquake striking Japan that year, that country has over night become a compelling potential market.

Provincial authorities aren’t allowing nuclear plants to reopen after they’re shut for refueling. That’s taken what was well more than half of Japanese power production capacity out of action, and only liquefied natural gas (LNG) can bridge the difference.

Australia is much less well known than Canada to US investors and their brokers. As a result, it’s still largely an “undiscovered country,” sometimes more difficult to get into but also a much cheaper buy–particularly for patient invest-to-grow seekers.

As my colleague and co-MLP Profits editor Elliott Gue has written lately in his PF Weekly and elsewhere, there’s a better than average chance of a market correction in mid-2012. This year’s timetable is a little behind last year’s, which began with the “Black Swan” events of spring and accelerated with the sovereign debt concerns in Europe and the US. But if and when it does occur, even the best stocks will pull back.

That’s a very good reason not to chase today’s high flyers. But whatever happens it will be only a temporary setback for these kinds of stocks, which are set to grow as the underlying companies continue to invest in strong niches. That’s why buying them and holding is such a solid strategy for all seasons.

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  1. avatar
    Roger Ilsley Reply April 21, 2012 at 7:15 PM EDT

    How do I access the Australian Edge web site?
    Canadian Edge comes up fine