Why the Dividend Trade Isn’t a Bubble

04/02/2012 6:30 am EST

Focus: INCOME

Kevin Mahn

Managing Director and Chief Investment Officer, Hennion & Walsh

The current quest for yield does not meet the definition of a classic bubble, according to Kevin Mahn. He tells MoneyShow.com about some sectors where he sees continued strength for dividend-paying equities.

Kate Stalter: Today’s Daily Guru guest is Kevin Mahn. He’s president and CIO of Hennion & Walsh Asset Management.

Kevin, I understand that you continue to be bullish about the dividend trade this year. I’m hearing from analysts it could be a bubble that could have passed, but you don’t agree with that. Can you tell us about that?

Kevin Mahn: Yeah, I think what we’re finding now is any time that we see an asset class or a sector that’s run up in value, people tend to believe that it’s the next bubble. And I think bubble may have been an appropriate term for the mortgages in the subprime market, but trying to extend that analogy to gold or to dividend-paying stocks is a stretch from my perspective.

Let’s just look at dividend-paying stocks and how they perform going all the way back to 1972. What you can see is that in bull markets or bear markets, dividend-paying stocks actually provide a great deal of value in all type of market environments. Consider that close to 50% of a stock’s total return historically comes from its dividend.

So the question then becomes, Kate, how do we find good stocks that pay stable dividends, that are well positioned to not only pay that dividend, but also to outperform their peers? And that’s what I’m so excited about, and that’s what I remain bullish about in 2012.

Kate Stalter: Well, let’s go back to the question that you asked then—whether it was hypothetical or not—what should investors be doing to identify those stocks?

Kevin Mahn: Well, I think there are a few things they should look at. Don’t just necessarily look at the current indicated yield of a given stock.

Let’s look more historically. Let’s look at their one-, three-, and five-year dividend growth rates. Have they been growing their dividend, or in fact have they been cutting their dividend?

It’s very important to understand that longer-term trend. Everything that we look at is, if there’s free cash flow on their balance sheets. If in fact there is, then I suggest that:

  • they’re operating their business well
  • if they have excess cash on their balance sheets, well, they may be increasing their dividend at some point in the future.

Finally, let’s look at the total return history of that stock or that company relative to other of their peers in their sector. So, if you can find a good company that has a five-year dividend growth rate with a positive free cash flow balance, that’s outperforming its peers in their sector over the last one and three and five years, I think that’s an investment worthy of further consideration.

Kate Stalter: Any example, just in the past quarter or even past year or so, that would have met those criteria?

Kevin Mahn: Well, if you looked at the last year, you’d be looking at more the utility companies. Some of the conservative, more defensive sectors, like utilities, like health care, and like consumer staples.

Now, as we go into 2012 and we’re starting to see some more growth coming out of the economy, areas such as telecommunications are starting to jump up. Not yet financial, not yet technology, but I would say more the consumer discretionary and telecommunications.

And there’s still value in utilities, there’s still value in healthcare, and there’s still value in consumer staples, as well, despite everyone starting to flee those sectors now and trying to jump on the next bull market.

Kate Stalter: I want to switch gears a little bit and talk about another area that I understand that you like right now, which is closed-end funds. Explain how those can be advantageous to dividend investors, and how to identify one that’s performing well.

Kevin Mahn: Sure. Closed-end funds obviously often get a very bad connotation from the financial community, primarily because of what happened in 2008 and 2009, and also because by the very mechanism of how closed-end funds work.

They often trade far away from their net asset value, which as you know, an open-end mutual fund cannot do, or an exchange traded fund, so they can trade at a premium or a discount to their NAV. Historically, closed-end funds have traded at discounts to their NAV.

So, one of the things that we like about closed-end funds, and we use them in our SmartTrust Unit Investment Trust business, is their ability to provide for a high level of income. In an environment where ten-year Treasuries are yielding just over 2%, investors and advisors are looking for more creative ways to get yield.

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Now, with that said, you have to understand how those closed-end funds achieve that yield, and it’s often by using leverage. And leverage, as we know, can be a very dangerous term. But if you understand the types of leverage that the closed-end fund is employing, and you understand why they’re using it in such a low-interest-rate environment, it obviously makes sense now to utilize leverage. Well, then you use a professional to pick the right closed-end fund for you to get that level of income.

Going back to your initial premise of your question—how do you find the right closed-end fund? Well, there are some characteristics that we look at here, that we think are very important and most advisors overlook.

First of all, just because a closed-end fund is trading at a discount to its NAV doesn’t mean at some point in time in the future it’s ever going to be trading at or near its NAV. There’s no law, there’s no rule written in stone, that says a closed-end fund ever has to trade at its NAV.

So don’t buy a closed-end fund just because it’s trading at a discount. Look at that discount relative to where it’s traded over the last 52 weeks. That might suggest if there’s value there.

Secondly, look at the distributions that they have at present, but also look to make sure they’re earning more than they’re currently distributing. Because if in fact they’re distributing more than they’re earning, you can expect at some point in time down the road that perhaps there might be a distribution or a dividend cut.

Lastly, there’s a term called UNII, or Undistributed Net Investment Income, that’s available for each closed-end fund. Essentially, Kate, that’s a cash buffer that’s available for each closed-end fund. If that’s a positive balance, that’s a positive to us, because that suggest down the road that they could dip into that surplus to withstand any potential dividend cuts.

So, look at where it’s trading relative to its NAV vs. where it’s traded historically. Make sure they’re earning more than they’re currently distributing, and look for those funds that have a positive UNII balance.

Kate Stalter: Once again, just to follow up, any examples that people might want to take a look at right now, in their research?

Kevin Mahn: As opposed to giving individual ticker symbols or securities, I think a good area to start is to look at how those two things are very different:

Look at covered call closed-end funds. They have a very high level of current income associated with them, but if you look at the details, they’re not currently earning their distribution, and a lot of them have negative UNII balances.

On the flipside, if you look at municipal closed-end funds, you’ll find that a lot of them are still trading at or near their NAV and achieving a good sustainable distribution. So that’s an area that we like right now and that seems attractive in the closed-end fund space.

Kate Stalter: One last topic I wanted to cover with you today, Kevin, and that would be the idea of active management of a portfolio of passive securities. I understand that’s an area that you like right now. Can you tell us about that?

Kevin Mahn: Absolutely. That’s basically what I’ve built my career upon, because I believe the S&P studies would suggest that 70% of all actively managed mutual funds don’t regularly beat their benchmark over one, three, and five years.

So, how can we as portfolio managers or we as financial advisors provide value to our clients? Well we can do that by building an asset-allocation strategy commensurate with our clients’ goals and objectives, their investment timeframe, and their risk tolerance.

Once we have that in place, we can then go out and look at passive securities for most asset classes, whether they’re exchange traded funds or exchange traded notes, or perhaps the indexed mutual funds to allow us to have very transparent access to those asset classes and sectors that we pick, and not have to worry about a given money manager trying to underperform their benchmark or take on too much risk to try and beat their benchmark.

Once we have our asset allocation straight, in place, let’s look for passive ways to achieve and access those asset classes.

Kate Stalter: Is this something where individual investors can replicate this strategy on their own, or it is something they really need to work with an advisor on?

Kevin Mahn: I think they really need to work with a professional advisor. I mean, the technology that we have in place to build out an asset-allocation strategy is pretty robust, and it also relies upon our experience to build our assumptions about where we believe the economy and the markets are going forward.

Then finally, using the right criteria. We have 30 points of criteria that we use to select an appropriate mutual fund or exchange traded fund for each asset class or sector.

So, the best thing an individual investor could do is find an advisor that they trust, and sit down with him, and be very open and transparent on what their goals are and what their tolerance for risk is and then work together to build a portfolio.

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