Investing Daily

Income investing is, at its core, a long-term enterprise. For one thing, you’ve got to stick around long enough to collect your distributions.

Bonds, of course, accrue interest as long as you own them, so there’s no risk of selling out before or after the actual disbursement date. But you don’t accrue unless you own, making trading pretty much self-defeating—unless of course you’re a big player solely betting on interest-rate swings.

Frequent buying and selling of dividend-paying investments can also jack up your tax bill. The preferential tax rates for qualified dividends are slated to sunset after 2010 and could be repealed or curtailed before then. But for the time being, traders pay full, ordinary income rates on dividends they receive. Those who hold the statutory 90 days before and after pay a maximum rate of 15 percent, less than that for lower tax-rate investors.

Interesting, there are strong indications that buy-and-holders of dividends may still be tax advantaged well after 2010. Republican presidential candidate John McCain has maintained all along that he’ll act to make the preferential rate permanent if he’s elected.

Of course, he may be limited in what he can do, given that the odds strongly favor widened Democratic majorities in both the House of Representatives and the Senate. But Democratic presidential candidate Barack Obama has recently made noises indicating he’ll maintain preferential rates on dividends, though picking the maximum rate up to 20 percent. That’s a pretty good sign they’ll be some give-and-take on this issue and that long-term dividend investors may continue to be advantaged well past this presidential election cycle.

There’s an even more important reason why trading dividend stocks is a loser’s game: You miss out on the steady capital appreciation that a growing dividend can provide. A growing dividend is a strong sign of a company becoming more valuable. Companies that increase dividends tend to have rising share prices, but you only cash in if you buy and hold.

But buying and holding doesn’t come without challenges. The basic two for income investors are credit risk and inflation risk.

Over the past year or so, credit risk has been by far the more important. We’ve seen numerous companies that once paid big distributions collapse into wreck and ruin, as their weakening businesses have been unable to maintain those big payouts.

The casualties have been greatest in the financial services industry, particularly anything involved with the mortgage industry. But the list has grown to include sectors across the board. Exotic investments created to dodge taxes have been among the worst hit, including the rapidly shrinking group of income deposit securities (IDS), which combine equity and a junk bond to create a single high-yielding security.

Also issued as income participating securities (IPS) in Canada, these were in large part created to compete with the rising popularity of Canadian income trusts. But unlike today’s trusts—which have largely adjusted as businesses to prospective 2011 taxation—many of these have been exposed as shaky, unsustainable businesses. As a result, they’ve been dissolved one by one. And even some of those backed by strong businesses, such as Atlantic Power Corp, have announced plans to restructure as ordinary, high-dividend-paying equities.

The portfolios in my advisory services Canadian Edge and Utility Forecaster haven’t been loser-free either. Centered on sustainable companies with demonstrated wherewithal to continue paying distributions, we’ve largely avoided the devastating dividend cuts and total meltdowns.

As I’ve pointed out here, however, even that’s been no guarantee against stock market losses. And while energy producers, energy infrastructure and utility holdings have actually done well since credit risk turned up sharply in mid-2007, other sectors—including, surprisingly, US water utilities—have suffered, sometimes greatly.

Sooner or later, credit risk—or risk to the ability to pay current dividends—will cease being the paramount danger in this market. For now, however, it’s absolutely critical to keep watching the earnings numbers for every company you own to assess how well it’s weathering this environment of tight credit and slowing North American economic growth. And if a company fails to measure up, that will be the time to sell, no matter how far its share price has already plunged.

Conversely, if a company continues to post the right numbers, the best course is still to grit up and hang on, even if its share price has already taken a tumble. History shows that companies that weather down cycles as businesses will eventually recover in the share market, provided they keep up their good work.

That’s the lesson provided by the torrid performance of Canadian oil and gas producer trusts this year. Last year, you could have cut the investor pessimism on this group with a very large knife. Not only were they under the cloud of prospective 2011 taxation, but the Canadian government had imposed limits on how many new shares they could issue, cutting off the lifeblood of many trusts, particularly the smaller ones.

Tighter credit conditions were another punch in the gut, restricting their ability to issue debt. And last year’s plunge in natural gas prices and surge in the Canadian dollar (which cut the value of oil sales priced in US dollars) reduced internal cash flows as well. The result was an unprecedented wave of distribution cuts that hit all but the very strongest trusts and even some near bankruptcies.

As of mid-June 2008, however, the situation has completely reversed. Many individual trusts are up 50 percent and more this year. And the broad-based S&P/Toronto Stock Exchange Capped Income Trust Index has basically returned to its mid-2006 peak. That’s despite lingering uncertainty on the trust tax issue and continually tight credit conditions throughout North America.

The reason for the turnaround: Good businesses have shone through. Trusts that weathered the rough times and continued growing as businesses have shot to higher highs, even as the US economy and stock market have floundered. Granted, oil and gas producer trusts have led the way and have benefited from the upward explosion in energy prices.

The point, however, is the improving health and growth of oil and gas trusts—thanks to strong operations and higher energy prices—has asserted itself in their share prices. The lesson is, as long as a trust, corporation, limited partnership or whatever has a thriving underlying business, its shares or units will eventually recover whatever losses they suffer now in the stock market.

The numbers are where it’s at. And as long as we focus on them, we as investors will weather whatever storms lie ahead.

The Other Risk

Staying with great businesses is also the best way to weather the other great risk to income investments: inflation.

We haven’t had a whole lot to worry about on this score for some years. This decade, we saw spikes in the benchmark 10-year Treasury note yield in five successive years: 2003, 2004, 2005, 2006 and 2007. Each time, income investments across the board sold off. But each time, the spike in rates combined with rising energy prices (see Utility & Income, June 13, 2008, “What’s Hurting”) to cool off the economy. The result was that interest rates backed off and income investments recovered.

In 2007, a T-note rate spike to 5.3 percent set off a selling panic for income investments across the board. Unfortunately, that jump in rates also coincided with a virtual collapse of the US financial system. The corresponding colossal increase in credit risk took down income investments, even though inflation risk basically vanished overnight and interest rates plunged.

Here in mid-2008, the consequences of rising interest rates and inflation are far from the mind of the average American, who’s considerably more concerned with rising prices for food and fuel and plunging real estate values. Arguably, however, these risks are more acute than they’ve been in some years.

First is the action in the 10-year Treasury note yield itself. After hitting a generational low of around 3.3 percent in mid-March, the benchmark rate began an uptrend that carried it toward 4.3 percent, before settling back in the 4.2 percent area over the past week.

That’s a very dramatic move by any standard. And unfortunately, unlike the rate spikes of 2003, 2004, 2005 and 2006, it hasn’t been accompanied by any meaningful rebound in economic growth. In fact, we’ve seen precisely the opposite: Unemployment has risen, the housing market has continued to plummet, and myriad other indicators of spending and output have slipped.

The turmoil in the housing market has now begun to hit even seemingly “safe” areas of the mortgage market, with defaults rising at a record pace even in regions once considered recession resistant. Washington DC and environs, for example, has traditionally been very steady in all economic climates.

Housing prices in the region’s inner core of the District, Alexandria, Va., and Arlington, Va., have continued to rise at a modest pace. But the exurban areas that were the hottest just a few months ago are now seeing prices plunge at a dramatic rate.

Other areas of the country, meanwhile, are faring far worse. The result is regional banks that had generally navigated the meltdown are now feeling the bite. This week, Fifth Third Bancorp shares suffered a 27 percent one-day decline, as the bank slashed its dividend by two-thirds and announced a $1 billion convertible preferred stock offering and noncore asset sales designed to raise a total of $2 billion.

These aren’t typical conditions for a rise in interest rates. But rates nonetheless are rising. And the higher they go, the greater the pressure will be on borrowers from businesses to consumers and the greater the risk of more writedowns and defaults for the lenders themselves.

Rising rates in the past have meant slowing economic growth and easing inflation pressures. The difference this time is inflation pressures are coming from other places, namely the dramatic rise in food and energy prices.

As I’ve written here several times in recent weeks, raw materials inflation is being largely driven by global demand. In times past, a slowing US economy has been enough to curtail global demand, bringing down prices for food and energy.

That’s obviously not the case any longer. There’s mounting evidence that Americans are starting to conserve by curtailing driving habits and slowly but surely switching to more fuel-efficient cars. Their moves, however, are a drop in the bucket compared to the continued surging demand in developing nations.

Worse, the greater the share of raw materials consumed in nations such as China, the less impact US market action will have on global prices. We’ve already seen emerging Asia take the lead in several key commodities, notably copper and steel. And with the average American using 14 times as much oil as the average Chinese, it’s only a matter of time before they catch up and pass us in that vital commodity as well.

To date, inflation in raw materials prices is far more dramatic that that of so-called “core” inflation. This week, for example, inflation rates were announced for the month of May in the Producer Price Index (PPI). The PPI itself rose a whopping 1.4 percent or an astronomical annualized rate of 16.8 percent. That was seven times higher than the rate for April and even far above the consensus forecast of 1 percent. The core rate excluding food and energy, however, was up just 0.2 percent, right in line with forecasts and half that of the prior month.

That’s cold comfort for consumers paying more than $4 a gallon at the pump, with expectations of $5 or higher during the peak summer driving season. But it does seem to indicate that those alarming increases in the basics still aren’t really filtering through to everything else. Core consumer price inflation—again excluding food and energy—is up just 2.3 percent over the past 12 months, right in line with the past couple years.

One reason is US wages haven’t started climbing faster. That means millions of consumers are falling further behind in their ability to service mortgages and even take care of the basics. And that’s having a contractionary impact on the economy, rather than an overall inflationary one.

The Federal Reserve and other central banks around the world are already alarmed that the world may be on the brink of an inflationary spiral not unlike the 1970s. Consumer price inflation in Britain, for example, is up to 3.3 percent. Meanwhile, in contrast to the US, Eurozone wages are starting to pick up, leading to worries of the dreaded second-round impacts on inflation or rising oil prices.

Finally, inflation in the developing world is already at alarming levels. China—now the world’s primary growth engine—is running at 7.7 percent inflation, a factor that has the government working feverishly to squeeze inefficiencies out of its economy. Meanwhile, inflation has already reached double digits in oil-rich Saudi Arabia.

To some extent, the central banks’ hands are tied here. Their primary remedy for inflation is still to tighten credit. But aggressively doing so now, with the US financial system this weak and the consumer so strapped, runs the risk of plunging the economy much deeper into recession. That, in turn, could force the Fed and other central banks to wind up cutting rates far deeper than expected, which would presumably further ignite inflation.

These are without doubt very dangerous times. Thus far, the Fed has chosen to speak loudly about fighting inflation but in reality to do relatively little. The central bank has pretty definitively stated its recent run of rate cuts is now over. And its statements this week at least briefly created expectations for a total 75-basis-point increase in the fed funds rate by the end of the year.

The reality, however, is there’s not much it can do at this point to quickly choke off inflation, short of risking far worse. That means the most likely outcome is continued rising inflation, at least until the economy shows some semblance of getting back on its feet or (less likely in my view) something happens to bring down prices of food and energy dramatically.

The Narrow Way

The point for income investors is we’re going to have to start looking at the inflation risk of what we own, just as we now look at credit risk. The good news isn’t all income investments are equally vulnerable to higher interest rates and inflation. The bad news is some are, including some of the better-performing sectors in this credit crunch.

My philosophy of income investing is that diversification is paramount. If you’re going to buy and hold, you’re going to have to weather the ups and downs of the market.

Holding only first-rate businesses does protect your dividend streams. And over time, it ensures you’ll also get steady price appreciation. But as the market shows us, individual sectors do get whacked occasionally, including the stronger companies. And if you’re overexposed in one or two, you’re at risk to going deep in the red from time to time.

Investors who went heavy into strong Canadian income trusts before October 2006 and held on to now have made back their losses and more. They did, however, have to live though roughly a year and half of being under water. Many were OK with that, given the big dividends trusts paid. But for more than a few, the required patience was just too much. As a result, they sold before the rebound and took the loss.

Diversifying between individual sectors certainly doesn’t guarantee some of your holdings won’t get hit from time to time. In fact, it practically guarantees you’ll have some holdings in the very worst-performing sectors at any given time. For example, I’ve maintained exposure to financials over the past year and have been hit with losses.

Only very rarely, however, will some sectors not outperform, even in the weakest markets. That’s the role that first-rate utilities and energy stocks—particularly Canadian income trusts—have played for me this year. The result is overall solid performance, despite a handful of big losers.

If you have a very long time horizon with your investments—i.e., you don’t have to tap into them for some years—you can afford to be up or down at a given time, even well up or down. If one is pulling money out, however, you can’t afford to be in that position. Diversification and focusing on quality is the best possible way to protect against ever having to be.

In an environment of creeping interest rates and high credit risk, nothing should be taken for granted. We’re coming to the end of the second quarter, and earnings season will soon be upon us, with the bulk of results coming in late July and early August. I’ll be scrutinizing every pick in our portfolios to ensure they’re measuring up to the challenges. Meanwhile, here’s a brief look at the risks to every income sector.

Bonds—Longer maturities and lower credit quality mean greater risk. I prefer to minimize duration by keeping maturities on bonds to five to seven years (or less) and by sticking to midgrade securities. The best of these are utilities in a comeback mode. Their credit quality continues to improve as they cut debt and operating risk, which cuts credit risk and offsets the risk of rising interest rates. I also like open-end, low expense funds with solid credit quality and low duration, like the Vanguard funds. Closed-end bond funds pay bigger yields because they use leverage, but investors should be careful not to hold anything trading at a premium to net asset value (NAV). Rising rates would hurt both NAV and turn the premium to a discount, a double whammy.

Preferred Stocks—These would also be hit by a rise in interest rates. But investors can again reduce risk by sticking to midgrade credits with improving business fundamentals, just as with bonds. Several of the closed-end funds trade at discounts to NAV and are attractive for those willing to live with the volatility. Convertible preferreds are best, provided the company is in good shape. My favorite remains AES Corp Preferred C, yielding nearly 7 percent and tied to the growth of one of the world’s leading renewable energy providers.

Utilities—As I’ve written for years in Utility Forecaster (the July issue will be available Saturday at www.utilityforecaster.com), this isn’t a uniform group. Some are capable of strong growth, as they expand their asset bases and capitalize on rising wholesale electricity prices. Others are cursed by Robin Hood regulators and won’t be able to recover rising costs. The good news is the investing public still hasn’t recognized the difference, so the good sell as cheaply as the bad and ugly.

REITs—Real estate remains burdened by the weak US economy, but apartment owners are still selling at high yields and sizeable discounts to their more commercial brethren. Canadian REITs are also very cheap, as well as tax advantaged to their US rivals.

Canadian income trusts—The oil and gas trusts are among the least rate-sensitive, income-paying investments around. They’ve also been selling energy at well below current spot prices, which locks in strong cash flow gains for the rest of the year, even if oil and gas prices do back off. A drop in energy prices would no doubt hit share prices, and investors should be cautious about new purchases for that reason. But risks to distributions are low at this point, and potential for increases is high. As for nonenergy-producing trusts, they’re cheap, but make sure you know the business before buying.

US limited partnerships—There’s no doubt these are cheap now, but focusing on good businesses is a definite must. For every undervalued powerhouse like Enterprise Products Partners, there’s a disaster waiting to happen. And with the good selling cheaply, too, there’s no excuse not to shop for quality. I like energy infrastructure best of this group.

Communications—This is another very cheap sector that continues to prove it’s recession resistant. The key is to stick with the larger companies because this is a game for scale and scope.

Super Oils—These aren’t cheap by any stretch. But they’re one of the very few investments that will keep up with energy-led inflation and hold their own in the face of recession. They’d likely benefit from a drop in energy prices, as it would give them opportunity to buy reserves and their refining businesses’ margins would improve.

Vital resources—The yields aren’t huge. But adding some gold, copper or other natural resource plays to your portfolio is the best possible inflation insurance around. And as long as China stays strong, they’ll weather the recession pressures as well.

Financials—Sooner or later, this is going to be the best stock sector around. The problem is there could also be a lot more bloodshed ahead, as the mortgage market weakens, credit remains tight and inflation ticks up. Now’s the time to look for the survivors, but no one should hold without expecting downside, possibly a lot of it.

Speaking Engagements

“The coldest winter I ever spent was a summer in San Francisco,” a saying that’s almost a San Francisco cliche, turns out to be an invention of unknown origin, the coolest thing Mark Twain never said.

The natural setting is, however, among the most exciting in the US. Venture west for the San Francisco Money Show Aug. 7-10, 2008, and conduct your own field study.

Neil George, Elliott Gue and I will discuss infrastructure, partnerships, utilities, resources and energy, and tell you what to buy and what to sell in 2008.

Click here or call 800-970-4355 and refer to priority code 011362 to attend as our guest.

I also have a special invitation for readers to join me and my colleagues Elliott Gue, Gregg Early and Neil George aboard an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

For more information, please call 800-832-2330.