High Yield Is Great...But Look Beyond the Rate

04/02/2013 9:00 am EST

Focus: STOCKS

Neil George

Editor-in-Chief, Income Publication and Products, Agora Financial

Neil George of By George knows a thing or two about income, and here he reviews a few companies whose strong finances and market potential support their hefty dividends.

Nancy Zambell: My guest today is Neil George, the editor of the popular By George column on LibertyInvestor.com. Welcome, Neil, and thanks for joining me.

Neil George: Thanks for having me, Nancy.

Nancy Zambell: You're welcome. I'd love to talk to you today about income. There are a lot of stocks right now paying some pretty good dividends. The yields seem to be actually going up. What's your take on this?

Neil George: Well, Nancy, I think you're right. There in an increasing demand for income, and it's not just for retirees that have to depend upon it.

It's also desired by those people who are trying to build a retirement fund. And it's even people in the early stages of their portfolio development who are recognizing that just going along with what I call "the hold and hope"-buying the general market, hoping something gets better-has not proven to be a good, consistent strategy, versus getting paid, getting paid regularly, and getting paid well.

Even if you're not taking that cash, you can build it up, and over time, stacking up those dividend checks is a better, more secure way of building one's portfolio.

Nancy Zambell: Cash in hand, right?

Neil George: Absolutely, but there are also a growing number of different types of securities that are trying to court these sorts of dividends. That can lead to a lot of pitfalls in which companies that might not have the cash flows to defend or to supply the dividends are using them as an opportunity simply to raise capital from the unsuspecting.

The other part is that a lot of formerly good dividend stocks have been bid up in price, and therefore the effective yields that they are offering have been coming down. A company that might have been paying a 5%, 6%, 7%, 8% or more now might be paying a 3% or 4% dividend, which is not much more than the S&P.

You really have to spend a lot more time and do a lot more homework to find good quality companies that are paying more realistic and higher dividends.

Nancy Zambell: So, basically, investors should not just be chasing yield. There are an awful lot of REITs and other types of companies out there that are paying 17% or 18%, but those are not always a great idea.

Neil George: No, they're not. I think the key is that you really need to start by not just looking at only the dividend. You really want to get to know the business you're buying, so that you can anticipate and know what the threats are going to be for that company, and therefore for their dividend.

Ask yourself, what is going to go wrong? What's going to impact the sales in a negative way? What's going to cause their assets to go down in value? And look at the past, when that company faced that challenge, and see how it impacted the dividend and the company's performance.

The second part, Nancy-which I think is even more crucial, given the credit crisis that we've just gone through in the last few years-is looking at the finance side. The balance sheet.

Where is your company getting its funding from? Who is providing the loans? If they have bonds outstanding, when are they coming due? What's the game plan, and how attractive is that company to lend money to?

I don't know if you recall, but I used to be in the banking business. And we always tell people, if you won't lend money to your company, you have no reason buying its stock.

I think if you do the discipline that I do for my subscribers, I think you'll end up with fewer surprises and with less of what I call front-page risk. You don't want to open The Wall Street Journal and see your company on the front page for something bad happening.

Nancy Zambell: Exactly! Let's talk about some companies. Are there any particular sectors that are your favorites right now, Neil?

Neil George: There are three things, Nancy, that I think are interesting and well-defended by their fundamentals. They are not just paying well, but their businesses are expanding, and they're also getting more attention in the marketplace. So it's a good combination, right now.

Trend No. 1 is college dorms. There has been a huge surge in the number of high-school graduates heading to colleges. And, at the same time, there is a shortage of dorm space throughout the nation.

Some major schools like Arizona State University have deficits amounting to nearly 60,000 dorms that they need-right at this moment. You literally can take any state in the country and find both private and public universities that have dorm shortages. And the trend is not only about shortages, but also students want to have more quality housing.

The other part is that so many schools have been looking at their costs and tuition, and students are now balking at paying too much and racking up debt. The idea is that they have to be cautious on what they spend their money on, and building or expanding dorms can be very expensive in the near term.

The solution has been for companies to work with the university to build, manage, and restore dorms, giving students places to live on campus or nearby-quality housing at a better price and better-managed, and without capital investments from the university.

Nancy Zambell: Are they set up as a joint ownership with the university, Neil?

Neil George: There are various structures and a variety of companies out there. The one in particular that has done well, and has recently expanded in a dramatic fashion by taking over one of its peers, is Campus Crest Community (CTG).

It's structured as a REIT and pays about 5% and change as far as a dividend yield. It's not that high, but it's a lot higher than a lot of other REITs. More importantly, if you look at the growth rate of their revenues and the quality of their assets on that balance sheet, it's a very sustained dividend and a very good growth story over time.

And there is one other way to play this, if you want to give up some of the growth, but get a yield into that 7% range. You can look at their Campus Crest Preferred (CTGA) shares.

Again, you're going to be buying something that's going to be more stable in price. You're not going to get growth, but you're going to get a lot more current income, and that's a good way to go.

The second trend is the mortgage market. There are some major developments that are very positive for this segment. One is that the mortgage industry has gotten much more secure-delinquencies are down, defaults are down.

Also, the underlying performance of mortgage securities-particularly with US government-guaranteed assets in the mortgage sector-has been extremely good. They offer good yield and some good price movement.

The second major development with this story is that the Federal Reserve-through its Open Market Committee, as well as from its lending-has been buying $40 billion-plus per month of mortgages and mortgage securities, so they've been creating a huge demand and providing a floor for this particular market.

In addition, they've been lending against mortgage securities that are held by banks. It's providing almost a put for the major investors in this segment.

Nancy Zambell: And it doesn't look like that's going to end anytime soon, either.

Neil George: No...in fact, in the recent Open Market Committee meetings, it has been pretty clear that this should continue at a minimum for the next few years, before they might even start to slow. Therefore, it's a good trend that we're working with right now.

One of the ways to invest is in the real estate investment trusts that only buy good-quality mortgage securities, and therefore act like banks. One REIT that's run well-even through the pitfalls in 2008 and 2009-is MFA Financial (MFA). It pays a fairly good dividend, which has been coming down a bit in yield because the price has been doing well.

But like Campus Crest, they also have another alternative on the fixed-income side-a senior note that trades like a preferred stock, under the symbol MFO. The yield is in the upper 7% range. Therefore, you can have some more growth and a little less yield on the common shares, or you can get more price stability and higher yield by looking at their senior note or preferreds.

The last trend, Nancy, is that we are looking at companies in the nut-and-bolt businesses-companies that manufacture and deal with very specific, needed services, and that generate a lot of cash flow. These are the types of businesses that Warren Buffett, in the early days of Berkshire Hathaway (BRK.A) loved to buy.

These are companies that manufacture things like safes for banks or gun safes-which are now more in demand with some of the gun safety concerns we have in this country.

One company has a collection of these sorts of firms, and pays close to a 9% dividend yield. And most of that is sheltered from income tax, since it's structured as a limited liability company. Therefore, you effectively get depreciation, which offsets some of your dividends, so your dividend is actually tax-advantaged.

The company is Compass Holdings (CODI). They meet my credentials, with their structure of owning several businesses inside the holding company, paying an ample dividend-which is well-defended by the business-and having a fairly well-controlled debt structure.

Nancy Zambell: Do you think, Neil, that these companies would be good long-term holds for investors?

Neil George: That's an excellent question, Nancy, because people say, "I want to buy and own," and I say that's great. I like to buy and own as well, but you don't want to hold and hope.

For each one of these-as well as anything else in my portfolio-every month when I get my brokerage statements, or when I go through my portfolios, I look at each individual issue and I ask, would I buy it all over again?

If I can't say I'd buy it all over again, then it's time to sell. Using that discipline, you can end up owning something forever, but you also avoid holding something that you're going to regret owning forever.

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