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My dividend stock portfolio: income and less risk too
10/09/2009 8:30 am EST
By the end of this post, you’ll know
- why I think a dividend income stock portfolio is something all income investors need to consider as part of their total income portfolio
- how the portfolio I launched in the winter of 2005 has performed
- and what 10 dividend stocks I’m recommending now.
This is an even tougher environment for income investors than in December 2005 when I began this portfolio of ten high-dividend stocks.
Interest rates in general are lower. The 3-month Treasury bill yields just 0.07% currently. The yield on a two-year Treasury note is less than 1% at 0.9%. And if you’re willing to lock up your money in a 10-year Treasury you get paid just 3.26%.
Risk is higher. Thanks to the big rally in junk and other distressed bonds in the corporate market are trading at higher prices, which means you get less yield and more risk. For example, when I bought the senior notes of home builder D.R. Horton (DHI) back in late 2008, I paid $9,035 for a bond with a $10,000 par value and got, instead of the 7.875% interest rate coupon, a yield of 8.69%. On October 6, that bond has rallied and now it would cost me $10,425 to buy that $10,000 par value note and, because of the rally, I’d collect a yield of just 7.68%. And if I bought today and held to maturity in 2011 I’d be looking at a $425 loss on each bond with that $10,000 par value.
And we’re a lot closer to the turn in the interest cycle. I don’t expect the Federal Reserve to start raising rates in 2009 and 2010 is, in my opinion, an outside chance. But 2011? For sure, unless the economy slips back into a double-dip recession. Remember that rising interest rates drive down the prices of any existing fixed income vehicles such as a bond.
Investing in dividend paying stocks is one way to either get completely around these problems or to at least reduce them.
First, while stocks have rallied 60% or so from the March 9, 2009 bottom, many are still trading substantially below their 2007 highs. That’s not surprising since even after this huge rally as of October 6 the Standard & Poor’s 500 Stock Index was still 33% below its October 9, 2007 high of 1565. That means a stock such as Chevron (CVX), which on October 6 traded 18% below its October 9, 2007 price, pays a dividend yield of 3.9%. That substantially higher than the yield on a 10-year Treasury at 3.26%
Second, risk in the stock market isn’t by any means absent but I’d argue that an investor in dividend stocks is getting paid more for that risk than an investor in high-yield bonds is right now. PepsiCo (PEP), for example, is still 11% below its October 9 price. It has raised its quarterly dividend to 45 cents a share from 37.5 cents during that roughly two-year period. And if you’re willing to hold for something like the three years that will expire before the D.R. Horton note matures, I think you stand a very good chance of seeing you capital appreciate. At least the investor who holds to maturity isn’t locked in to the 4.25% haircut that holding D.R. Horton to maturity guarantees.
And third, dividend stocks offer you some protection—in many economies and markets a great deal—against rising interest rates. If interest rates are going up because the economy is in full recovery and is growing strongly enough for the Federal Reserve to try to claw back some of its interest rate cuts, companies are likely to be showing climbing earnings. So they’ll have the money to raise dividend payouts. Rising earnings should also be pushing up stock prices. The combination gives you a good chance to stay ahead of rising interest rates.
Now that all that’s said and done, how did the portfolio do?
I made the first investment in this portfolio on December 6, 2005. I didn’t get up to a full 10 stocks until April 8, 2008. I built the portfolio starting with a hypothetical $100,000 and put $10,000 into each of the 10 stocks I picked.
As of October 6, 2009 that $100,000 in capital was worth $98,891 for a loss of capital of 1.1%.
During that same period the 10 stocks in this portfolio produced $18,166 in dividends. (No dividends were reinvested but instead accumulated as cash.) That’s an 18% return on that initial $100,000 invested.
The total, looking at both the capital loss and the dividends, is a total portfolio of $117.007. That’s roughly a 17% total return over what is a period of 46 months.
For a little context, the return on the Standard & Poor’s 500 stock index during this period from December 6, 2005 to October 6, 2009 was a loss of 17%.
If I turn that $18,166 in dividends into a simple annual rate of return (as opposed to a compounded rate of return since I didn’t reinvest my dividends) that comes to a yield of roughly 4.53%.
Better than a poke in the eye with a sharp stick, but I think I can do better. In fact, you don’t have to take the portfolio too far apart to see some of the problems.
Here’s a list of the 10 stocks in the final portfolio with gains and losses with and without dividends.
|E.I. du Pont||DD||12/9/2008|
|Penn Virginia Resource||PVR||12/6/2005|
You can see that part of the problem is that I took a beating in three stocks: Natural Resource Partners (NRP) down 64% before dividends, Penn Virginia Resource Partners (PVR) down 35% before dividends, and US Bancorp (USB) down 33% before dividends.
In one of these cases, that of Penn Virginia Resource Partners, the dividend was ample enough to make up for much of the loss. But the capital loss in the other two overwhelmed any dividends collected. And in the case of US Bancorp, the company cut its dividend to just 5 cents a share as a result of the financial crisis.
The lesson I take away from this is that sector selection matters, especially when some sectors such as banking (US Bancorp) and coal mining (Natural Resource Partners and Penn Virginia) are collapsing. A hefty dividend isn’t enough to prevent major capital damage when a sector takes that kind of punishment.
The other lesson that I take away from this is that a dividend income portfolio needs more frequent care and feeding that I gave this one. I should have replaced these three positions far earlier in the crisis. Going forward I’m going to tend this garden more carefully.
What else am I going to do going forward?
First, replace US Bancorp. I think this is a bank stock that will recover and I’m keeping an eye on its potential for capital gains. But it clearly no longer makes the cut as an income stock. Not with a quarterly dividend of 5 cents a share.
Second, I’m going to better diversify this portfolio. It’s very heavy on energy and on master limited partnerships. The combination has done rather well by this portfolio, but I think I can add some safety here by moving a bit of money outside the energy sector.
In addition, the tax treatment of master limited portfolios doesn’t make loading up on that vehicle ideal for tax-deferred portfolios such as an IRA. If you wind up with more than $1,000 in annual income from a master limited partnership if triggers a different kind of tax treatment. In most cases that treatment isn’t either onerous or costly but I’d like to give you more alternatives.
So today I’m selling US Bancorp out of this portfolio and replacing it with Verizon (VZ), which currently pays a yield of 6.34%. (I’ll give you the complete logic on that buy in a blog post later today.)
I’m going to take the proceeds from selling US Bancorp plus sufficient cash from the portfolio’s dividends to put $10,000, an equal position, into Verizon.
Right now it doesn’t make any sense to sell either of the coal master limited partnerships in the portfolio since the coal sector is one of the hottest in recent market sessions.
In the future I’m going to deal with the cash from dividends that builds up in this portfolio by rebalancing all the positions at the end of each year so that I will have 10 equal positions of a larger size.
I’m going to track with portfolio in the same way that I do my other two portfolios, the Jubak’s Picks and the Jubak Picks 50. Beginning next week—as soon as we can get it up--at the top of the home page of my JubakPicks.com blog http://jubakpicks.com/ you’ll find a link to a portfolio page that gives current gains and loss percentages plus a short-description of why I originally bought the stock and any recent updates.
I think those changes will assure that this portfolio gets the same attention as the other ones I run.
Full disclosure: Jim Jubak owns or controls shares in the following companies mentioned in this column: Enbridge Energy Partners, Natural Resource Partners, Oneok, and Rayonier.
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