Income Investing for a Lean World

Jim Jubak Founder and Editor, JubakPicks.com

With low returns likely for years ahead, dividends become critical. Here's a new spin on my dividend portfolio, along with 3 new plays, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

Wouldn't you know it?

Just when dividend investing is becoming more important—the key stock market strategy for the current market environment, in my opinion—it's also getting to be more difficult to execute.

That's because shifting tax rates and special dividends in December 2012 have distorted the reported yield on many stocks.

I think there's only one real choice: Investors have to pull up their socks and work even harder at their dividend investing strategy. That's why with today's column, I'm revamping the format of the Dividend Income portfolio I've run on the Jubak's Pick website (and its precursor on MSN Money and MoneyShow.com) since October 2009.

The changes aren't to the basic strategy. That's worked well, I think, and I'll give you some numbers later on, so you can judge for yourself and think about putting my approach to work.

The changes are instead designed to do two things:

To let you and me track the performance of the portfolio more comprehensively, and more easily compare it with the performance turned in by other strategies.

To generate a bigger and more-frequent roster of dividend picks so that readers, especially readers who suddenly have a need to put more money to work in a dividend strategy, have more dividend choices to consider.

In this column, I'm first going to give you a brief explanation of why I think dividend investing is so important right now. I'm even going to argue that dividend investing might be the single best strategy for this market environment. (And that's an important argument, in my opinion, since I think this market environment is going to persist for years.)

I'll then lay out the changes in how I'm going to track this portfolio going forward and give you some numbers so you can judge the performance of this portfolio since 2009, and particularly in 2012.

Finally, I'm going to give you a pick to replace one stock in the current portfolio that has been a disappointment, as well as two new picks-that's three picks in all-as part of an expanded dividend portfolio.

Why Dividends are Critical

So why is dividend investing so important right now?

For the last nine months or more, I've been writing about what I've called the "new paranormal" market. If you've missed the foundation of this argument, see my post from March 2012, Call it the new paranormal market. My argument is that we've entered a period of relatively low returns.

Bill Gross, the bond guru at Pimco, calls the current environment the "new normal." He believes that we'll be lucky to see average annual returns of 5% a year during this period, which could stretch out for a decade. In my model for the "paranormal market," I've added a wrinkle to Gross' model: Not only will average annual returns be low by the standards of the great bull market that governed the 1980s and 1990s, but markets will also be extraordinarily volatile.

So, yes, you might see an average annual return of 5%, but that average will include years of 10% or 15% drops in addition to substantial rallies, and the period will include years like 2011, when the market will produce half a dozen swings of 7% or more in a month, as it did that August. The challenge will be to stay in through the volatility. You need to avoid buying high in moments of market optimism and selling low when everything seems to be headed for ruin-or better yet, find a way to sell more often at market highs and buy more often at market lows.

Why Things Really are Different

Why do I believe that there's any validity to either Gross' "new normal" or my "new paranormal" market?

I'm skeptical of attempts to argue for long-term market trends while we're in the midst of the action. What seems like a trend can easily turn out to be just a part of a longer data series pointing in a very different direction. So I'm reluctant to say that just because average returns have been so "modest" and so volatile lately, they must continue that way for some future period. Consider the cumulative return on the Standard & Poor's 500 Index (SPX), which is 13.4% for 2012, 27.9% for the last three years-and -2.87% for the past five years.

What I find convincing about the "new normal" and the "new paranormal" models is the match between the market performance data and the underlying fundamentals of the global financial system. In the last decade or more, we've seen long-term trends-the integration of more countries into the global economy, the rise of new economic powers, big changes in the location of global cash balances and in the direction of global cash flows (as emerging economies emerged and developed economies aged and slowed)-that have challenged that system.

And while the global financial system has survived, by and large, the cost has been huge actions and reactions by the world's central banks that have sent waves of cash sloshing across the world. That has led to massive market bubbles created by the overshoot of central bank policies (cheap money and the technology boom and bust, cheap money and the real estate boom and bust, cheap money and the global financial crisis).

The period has combined falling real returns, as globalization has increased competitive pressures on bottom lines and as aging populations have stressed global retirement systems, with rising volatility, as ever-expanding central bank balance sheets have led to cycles of booms and crashes. The strongest argument for a period of "new normal" or "new paranormal" returns: The trends that have pushed down returns on capital (globalization and aging) continue to work-and central banks now face the challenge of supporting the global economy with new cash infusions even as they confront huge balances that require them to exit these markets.

I'd love to see any logic that holds that this is a recipe for steady positive returns.

Why is dividend investing so important in this environment? I've laid out the reasons elsewhere, but let me restate them here. Volatility will create repeated opportunities to capture yields of 5%-the "new normal" and "new paranormal" target rate of return-or more as stock prices fall in the newest panic. By using that 5% dividend yield as a target for buys (and sells), dividend investors will avoid the worst of buying high (yields won't justify the buy) and selling low (yields will argue that this is a time to buy). And unlike bond payouts, which are fixed, stock dividends can rise with time, giving investors some protection against inflation.

The challenge in dividend investing during this period comes from using dividend yield as a guide to buying and selling without becoming totally and exclusively focused on yield. As I argued in my last update to this portfolio on July 3, what continues to matter most is total return. A 5% yield can get wiped out very easily by a relatively small drop in share price. (For more on that argument, see this post at JubakPicks.com.)

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Focus on Total Return

The way I have been running my Dividend Income Portfolio and tracking its performance, I'm chagrined to admit, did emphasize yield and income from dividends over total return. The stated goal of the portfolio was to beat the yield on the 10-year Treasury with less risk. And each time I reported on the portfolio's performance, I emphasized how much cash the portfolio threw off-and assumed that investors in the portfolio would withdraw that cash rather than reinvest it.

All this had a tendency to de-emphasize total return.

Going forward, I'm going to try to fix that. I will continue to report on the cash thrown off by the portfolio, since I recognize that many investors are looking for ways to increase their current cash incomes. But I'm also going to report the total return on the portfolio-so you can compare its performance with other alternatives-and assume that investors will reinvest the cash from these dividend stocks back into other dividend stocks. That will give the portfolio-and investors who follow it-the advantage of compounding over time, one of the biggest strengths in any dividend income strategy.

How to make the transition? I could go back to October 2009, the last time I did a major revision of this portfolio, and assume that I reinvested all the dividend cash flow from each of those years into other dividend stocks. That would be especially rewarding if I could put the money each year into the dividend stocks that I now know-with 20/20 hindsight-have done best since 2009 or 2010 or whatever.

That does strike me as cheating, though, for the obvious reasons.

How I'm Retooling

Instead, I'm going to assume that I've been sitting on the cash generated by the portfolio since October 2009-let's say I was paralyzed by fear of the market-but that I've now been convinced by my own arguments in favor of pursuing a dividend income strategy to put that cash to work. That gives me $29,477 in dividends received since October 2009 to put to work in new dividend picks that I will add to the portfolio today.

Where does that $29,477 number come from? It's the total of dividends collected by the picks in the portfolio from October 2009 through December 2012 on what was an original $100,000 investment. That comes to a 29.5% payout on that initial investment over a period of 39 months. That's a compound annual growth rate of 8.27%.

And since we care about total return, how about capital gains or losses from the portfolio? The total equity price value of the portfolio came to $119,958 on Dec. 31, 2012. That's a gain of $19,958 over 39 months on that initial $100,000 investment, for a compound annual growth rate of 5.76%.

The total return on the portfolio for that period comes to $49,435, for a compound annual growth rate of 13.2%.

How does that compare with the total return on the S&P 500 over those 39 months? For that period, $100,000 invested in the S&P 500 would have grown to $141,468, with price appreciation and dividends included. That's a total compounded annual rate of return of 11.26%.

I would point out that these performance numbers for the S&P 500 do have the benefit of real compounding, unlike my Dividend Income Portfolio, since each year's gains or losses on the S&P stocks work off of the gains and losses from the previous year. That's part of the reporting handicap my revision of the Dividend Income Portfolio is designed to close.

But even so, an annual advantage to the Dividend Income Portfolio of almost 2 percentage points isn't something I'd turn down in this or any other market.

And Now the Moves

Going forward, I'm going to drop one disappointment from the current portfolio:

Brazilian utility CPFL Energia (CPL) has been clobbered by regulatory changes in the country's utility sector. The stock is down 16.05% since I added it to the portfolio on Sept. 20, 2011. Just as important, the company has cut its dividend payout this year.

I'm also going to add three positions to the portfolio-one to replace CPFL Energia and two others to soak up the cash sitting in the portfolio from past dividend flows. I'll have more on these three buys when I post each one to the portfolio over the next day or two.

I'm going to add Targa Resources Partners (NGLS). The master limited partnership, a member of my Jubak's Picks portfolio, pays a 6.81% dividend. Targa has recently acquired its first big foothold in the Bakken Formation in North Dakota. The pipeline operator recently raised its target for 2013 adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) by 10% to 15% and kept its projections for distribution growth for 2013 over 2012 at 10% to 12%.

I'm also going to add take advantage of depressed oil prices to add shares of ConocoPhillips (COP). The company has one of the strongest portfolios in the liquid-rich Eagle Ford, Permian Basin, and Bakken boom regions. The reserve replacement ratio looks to be greater than 100%, thanks to a $15 billion capital-spending budget. The shares yield 4.51%.

Finally, I'm going to add shares of Intel (INTC), now yielding 4.1%. I'm pretty sure most of you will hate this pick. The stock is down 12.4% in the past 12 months on well-justified fears of the continued slowdown in the PC market. PCs continue to lose share to tablets and smartphones, where Intel has a less-than-imposing presence. We are seeing the end of the "Wintel" Intel/Microsoft (MSFT) duopoly that has dominated desktop computing. (Microsoft publishes MSN Money.) But you can already see the next transition at Intel taking place with its own small- and lower-power chips clawing for share in the smartphone and tablet market, and the company gradually joining the ranks of the few remaining global foundries that make chips for other chip companies. Intel's foundry business is currently very small, with only three customers as of December. But I think that will change in 2013 and that will once again start to transform the way investors think of Intel.

I have the cash in this portfolio to add another pick or two, but I'm going to wait until after the great debt ceiling battle is over and it's clearer to me how the market is going to break in the first half of 2013. Even with dividend stocks-or maybe especially with dividend stocks-it's good to look for bargains.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund owned shares of Johnson Controls as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund's portfolio here.