Dividends Are Only Part of the Story

02/19/2013 5:25 am EST

Focus: INCOME

Roger Conrad

Founder and Chief Editor, Capitalist Times

Don't just chase high dividends, says Roger Conrad. Investors need to be very cautious when choosing among companies with high yields.

Nancy Zambell: My guest today is Roger Conrad, and he is the editor of Utility Forecaster, Canadian Edge, and many other publications too numerous to count. Roger, thanks for joining me.

Roger Conrad: Thanks, Nancy.

Nancy Zambell: I've noticed that the utilities have been rallying quite a bit. You wrote about that recently in one of your newsletters, as well as about master limited partnerships.

Roger Conrad: At the end of last year, there was a lot of worry about the dividend tax rate and the fiscal cliff, and we saw a lot of profit-taking across the board, and underperformance.

There was worry that the top rate might go to 39% or even 40%-well over 40% for higher income brackets. There was something of a worry that a higher rate would set off a real selling wave, so a lot of investors tried to get out ahead of that.

As a result, we had some fairly dramatic underperformance at the end of the year. That included the master limited partnerships, which were never targeted.

But I think a lot of people were concerned that because of the accumulated capital gains on MLPs that they would be paying a pretty high tax rate. So, what we saw this year, I think, is in some ways a reversal of that, because we did have an eleventh-hour deal on the deficit.

Nancy Zambell: Right.

Roger Conrad: 15% to 20% tax rates were not nearly as much as a lot of people had feared, and I think part of that (rally) is the reaction to that. I do think that people need to be fairly discriminating toward their dividend-paying stocks as we go in. So don't be completely taken in by this big rally that we've had.

Nancy Zambell: So no more "just throw at the dart board," right?

Roger Conrad: Yes, I think that what we're seeing here. And one of the things that a lot of people haven't really been talking about is what impact austerity will have on the economy.

We've certainly seen in Europe a lot of very turbulent activity-credit markets, and companies unable to borrow, earnings dropping, and dividends being cut. And of course, a lot of those economies are still running very, very slowly as they try to get their deficits under control.

While the action here hasn't been nearly as dramatic-with the Social Security tax and some of the spending cuts and the raising of rates-there is some austerity coming down the pike. And the economy hasn't been growing that fast.

In the last two or three years, we've seen fairly positive action for dividend-paying stocks across the board, but some of them are stumbling because of economic trends. And the more exposed companies have been-to commodity prices, or to something else that's economically sensitive-the more vulnerable they've been to this type of action.

Even as dividend-paying stocks as a whole have been going up, some individual companies have more or less crashed and burned. Investors today follow momentum, probably about as much as I've ever seen. When something's rising, everybody wants to own it. So you see them casting valuations aside and bidding things up.

But it works the other way, too. When you do have a company that stumbles, it can take a bite out of your portfolio.

Nancy Zambell: Sure. Now we're in the midst of earnings season, and they are sort of mixed with the dividend-paying companies.

Roger Conrad: That's correct, and it's really part and parcel of the broader economic context. One area that I think has kind of snuck up on people-myself included-has been the rise of price differentials in oil across North America.

There's a global price, Brent crude, which has been trading at a fairly substantial premium to West Texas Intermediate crude, considered the benchmark for the United States. The reason is inadequate pipeline capacity to bring oil from the Oklahoma hub down to Gulf Coast refineries, where it can be exported.

And that's where you have the arbitrage in pricing. You've had inadequate capacity there. But if you look around where we're seeing a lot of the new oil being produced-the Bakken region, Canada, western Texas-you don't have those pipelines that you've historically had.

You have a lot of oil coming out. It's a huge boom. I think it's going to continue for a long time to come. But right now companies are shipping it any way they can. Some are doing it by rail, which has become a really big business. But the bottom line is, the pipeline capacity is not there.

So you have high prices, oil companies producing oil and paying dividends, but they're selling their product for $30, even $40, less than benchmark prices. So that puts pressure on dividends.

It's one of those issues that we're really watching, because if cash flow really does drop off for some of these companies, the dividends are one lever that management pulls. And even though you can have a company that's still pretty solid, it's paying you less, and more than likely the share price is going to come down as well if there's a cut.

NEXT: A Dividend Pick to Watch

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Nancy Zambell: Roger, how likely do you think there will be cuts?

Roger Conrad: We've already seen some. And we've seen some damage done. If you do own stocks that yield 8%, 9%, or 10%, you want to make sure that those dividends are sustainable. Earnings season gives us a prime opportunity to do that.

We spend a lot of time looking at factors such as what sort of coverage they have, but also what sort of debt is being taken on, revenue trends. Are profit margins pretty stable, is the core business healthy, or are some of these companies heading for cuts?

We saw a big phone company, CenturyLink (CTL), announce they were doing a capital change. What that basically meant was they were cutting their dividend fairly substantially, and they said they'll be applying the money to buying back stock. There has been a pretty radical reaction in the stock on that news.

I think that this is going to obviously scare people. What you want to do is to protect yourself against this type of thing. CenturyLink is still a viable company, even though it has disappointed people.

But you really want to make sure that you're diversified and balanced. A lot of people tend to latch on to individual companies as favorites, and they never want to sell them. They just want to keep buying them all the way up when the prices are rising. CenturyLink is a cautionary tale.

You don't want to be too exposed to companies. If they do really take off and something gets out of balance with the rest of your holdings, you want to pare it back. You want to have as many different companies paying dividends for you as you can possibly keep up with. That's really the key to this type of environment, where disaster can strike in many different places.

Nancy Zambell: That's good advice at any time. Now, out of your universe of companies, do you have one that's a favorite right now?

Roger Conrad: I do favor the strategy of owning a lot of different things, as opposed to one or two. I think if someone was really looking for one stock-and again, take this with a grain of salt-but Energy Transfer Partners (ETP) is one that's really captured my attention.

They're a master limited partnership. They yield right now about 7.5%, and I think they're on the verge of having a nice boost in the share price this year as they return to raising distributions again.

They've been doing a lot of different acquisitions, so they're now a major oil and gas pipeline company. I think there are a couple more deals left to do, but I think this is going to be a nice one going forward.

Nancy Zambell: Good. We'll just tell our investors to make sure they just add that to their already diversified portfolio, right?

Roger Conrad: Absolutely. I do think it's going to be a nice year for dividend-paying stocks. But again, there are going to be some stumbles, and sometimes they're going to occur in places where you don't expect them.

Nancy Zambell: Very good. Thank you so much, Roger, for joining me. I appreciate all of your good recommendations.

Roger Conrad: Thank you for having me.

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