If you want to earn more dividend income, you'll have to put up with more volatility--what you want to avoid is a permanent impairment of capital

07/03/2012 8:30 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

“What do you mean, get paid while you wait? A stock with a 4% dividend that falls 25% in price is still a losing proposition,” read an email I got recently in response to a post where I added Ensco (ESV) to my watch list http://jubakpicks.com/tag/ensco/

And that is, of course, absolutely right. A 4% dividend gets wiped out pretty quickly when a stock tumbles in price.

Ideally, you’d like to buy dividend stocks that never go down in price and that don’t share in market volatility—except to the upside.

Unfortunately, in my experience, “ideally” doesn’t exist. Dividend stocks may go down less than the average stock—after all they have that dividend yield to support their price—in a down market but they do go down nonetheless. Dividend stocks do turn in bad quarters and when they do they go down in price. Even stocks with long uninterrupted histories of never cutting dividends and, of raising them every quarter, fall in price.

And if you’re going to wait until you’ve found a dividend stock that never goes down before adding one to your portfolio, you’re never going to buy a dividend stock. For that matter, you’ll never buy a bond either—since bond prices fluctuate with interest rates, inflation, fear, and the credit ratings of the issuer.

What we hope for from a bond is that despite the fluctuations in the price of the bond, it will 1) pay the interest promised to buyers and on time, and 2) when it comes time for the bond to mature pay off 100% of its promised maturity value.

Now dividend stocks are riskier than bonds. They don’t have any maturity date and they don’t carry any promise that you’ll get back what you paid on a non-existent maturity date. By buying a dividend stock, you’re signing up for more volatility than you’d get with a bond. Hopefully, you’ll also get a higher return from that dividend stock than you’d get from a less risky bond. But you certainly aren’t looking for an investment without any volatility.

Indeed what you’re looking for is a stock that pays its promised dividend on time, and that raises its dividend over time, and where the stock price doesn’t show a permanent impairment of capital.

What? What’s “permanent impairment of capital?” It’s what you want to avoid in a dividend stock (and indeed in any income vehicle.) You don’t mind if a stock gyrates in value while you hold it as long as it doesn’t go down and stay down When you need to sell it, you want it to be worth as much or more than you paid for it so that the yield you earned by owning it isn’t wiped out by a drop in your capital.

Let me show you what I mean by looking at my Dividend Income portfolio on Jubak’s Picks http://jubakpicks.com/ .

Of the 10 stocks in that portfolio, six wouldn’t cause any dividend income investor any second thoughts: In the time since I last reviewed this portfolio on May 6, 2011 (or from when I bought them if I purchased the shares during one of my periodic updates), all six of these stocks climbed in price.

Some of the gains were pleasingly hefty. Magellan Midstream Partners (MMP) was up 25.8% from May 6, 2011 through June 29, 2012. ONEOK Partners (OKS) was up 31.8%. AmBev (ABV) was up 21.5%.

Some were more modest, although in this market I’ll take modest. General Electric (GE) climbed by 11.5% from my February 3, 2012 purchase through June 29, 2012. CPFL Energia (CPL) was up 5.1% from my September 20, 2011 purchase through June 29 2012. Penn Virginia Resource Partners (PVR) eked out a 0.9% gain from May 6, 2011 through June 29, 2011.

In all six of these cases, then, a dividend investor wouldn’t have had to worry about any decline in share price detracting from the yield on the stock. (Just the opposite in fact with the gain from price appreciation adding to the income from the dividend.)

Deciding whether stocks in this group were a good or bad income investment during the period is straightforward. You don’t have to subtract any losses to your capital from the income. The 4.7% yield on ONEOK Partners, the 4.8% yield on Magellan Midstream, the 8.5% yield on Penn Virginia, and the 6.6% yield on CPFL Energia makes them straight forward good income investments.

In the case of General Electric, with its 3.3% yield on June 29, and AmBev, with its 3.8% projected yield (since the company only pays a dividend once a year the trailing 12-month dividend yield can be deceptive), the analysis is equally straightforward. Is the current yield—and the prospects for increases in company dividends, high enough to make this a good income investment? In the case of General Electric, which is about to start getting dividends from its financial unit again, I’d say the answer is yes. In the case of AmBev, I’d say the answer is no and I’m dropping the stock from this portfolio with this post and replacing it with another higher yielding stock.

In the case of the other four stocks in the portfolio, I’m showing losses, and in two cases sizeable losses, that make it important to bring “the permanent impairment of capital” into my thinking. Shares of Westpac Banking (WBC) were down 1.3% from my February 3, 2012 purchase date through June 29, 2012. Kinder Morgan Partners (KMP) was down 7.1% from May 6, 2011 to June 29, 2012. Total (TOT) was down 17.8% and Banco Santander (SAN) was down 39.1% in that same May 6, 2011 to June 29, 2012 period.

Although you might shrug off the 1.3% loss on Westpac in light of its 7.7% current yield, the losses on the other stocks are big enough to wipe out all the dividends these stocks paid and more. When you’re looking at drops in price like this, the current 6.1% yield on Kinder Morgan the 6.4% on Total, and the 17.6% on Banco Santander aren’t especially impressive.

It is correct to say that those losses won’t be realized until you sell and that in the mean time you’re collecting real dividends. (Well, mostly “real.” Banco Santander is paying in scrip so instead of cash you get more shares.) But that isn’t an excuse for thinking those losses aren’t real. Your portfolio is poorer today than it was a year or so ago to the tune of that 39% drop in Banco Santander and that 18% drop in Total.

The big question that an income investor faces with underwater positions like these is are the losses permanent? (Or of such long duration that they might as well be permanent.) What do you have to look FORWARD to with these stocks?

If Banco Santander is going to come back to anything like the $10.20 a share that I bought it more on May 20, 2010, then it’s a great dividend income investment on the basis of its current 17.6% yield (and you ought to be buying more at the current price) and it's a very attractive total return investment as well. If the trend in the stock is still down, the extraordinarily high yield doesn’t matter. A drop of another dollar of so per share would wipe out your yield and you should sell. (This is especially true for Banco Santander because the bank has been paying much of its dividend in scrip. If the bank’s shares fall, the value of the dividend paid in stock will too.)

So the analysis of whether to buy/sell/hold of these underwater income stocks comes down to your decision on how permanent the current impairment of capital is. I certainly wouldn’t recommend selling Westpac right now because I think the shares will make back the current miniscule loss when the Australian market isn’t so worried about a slowdown in China. I wouldn’t sell Kinder Morgan either since I think the loss on the stock is a temporary reflection of slower growth in the U.S. economy. Total’s shares are down more in the last year (17.2%) than those of ExxonMobil (XOM) or Chevron (CVX), which show 7.8% and 6% gains, respectively, but the loss isn’t out of line with the losses on smaller oil company stocks. Shares of Apache (APA), for example, are down 28.3% in the last year. I expect the price of Total shares to come back when oil prices and demand do—in 2013, I estimate—and in the meantime I’m willing to get paid 6.4% while I wait.

Banco Santander is, I readily admit, the tough one in this group. My expectations are that the bank will come out of the current Spanish debt crisis with a bigger market share in its home market of Spain and with much of its global banking kingdom largely intact. I haven’t materially changed my take on the bank since my post on April 13 http://jubakpicks.com/2012/04/13/update-banco-santander-std-weighing-global-promise-against-spanish-threat/ and I think that the decision of the recently concluded European summit to allow direct capital injections into struggling Spanish banks (a group that doesn’t include Santander) lessens the risk that Spain’s weak banks will drag down the Spanish government and that it will in turn drag down Spain’s stronger banks. But anyone holding this stock should recognize that you don’t get paid 17.6% even in scrip unless you take on a lot of risk. At this point I’d keep it in the portfolio

Your permanent impairment of capital analysis shouldn’t be limited to just your underwater positions. You should also try to project the possibility that any stock now above water will join the underwater part of your portfolio in the unpleasantly near future. The one stock in the positive section of the portfolio that worries me on this basis is Penn Virginia. The company’s coal comes from the relatively high-cost Eastern United States and while I understand the company’s diversification into natural gas collection and pipeline systems, if I wanted to own more of this kind of asset, I look to increase my investment in ONEOK or Magellan or Western Gas Partners (WES.) I’m selling Penn Virginia Resource Partners from this portfolio with this post.

Which leaves me with two slots to fill. One goes to Western Gas Partners. The stock is currently a member of my Jubak’s Picks portfolio, but I think it’s a better fit with this income portfolio given its 4.2% yield. The shares have recently pulled back on http://jubakpicks.com/ on news that the company was going to sell 5 million new units. The other slot goes to SeaDrill (SDRL), another stock that I’m moving over from Jubak’s Picks. The stock was down 7.5% from May 1 through June 29 and it now pays a 9.2% yield.

I’ll have detailed write-ups of these drops and adds in the next day or so as I add them to the portfolio.

During its lifetime since I re-launched this portfolio on October 6, 2009, an investor in this portfolio has traded yield for capital appreciation. From May 6, 2011 through June 29, 2012 the yield on the portfolio’s initial $100,000 in capital was 6.23%. During that same period the yield on the Standard & Poor’s 500 stock index was just about 2%. The dividend yield on the S&P 500 from October 6, 2009 to June 2012 was 1.97% a year. The dividend on the portfolio averaged an annual 5.7%. In calculating the value of the portfolio I assume all dividends from the portfolio are distributed to the owner of the portfolio as income and that no dividends are reinvested. The value of the portfolio—the value of the 10 stocks in the portfolio plus the cash balance, if any, from buys and sells--has climbed to $120,642 from the original $100,000 in October 6, 2009, for a gain of 21%. During that same period the Standard & Poor’s index has gained 29%.

So far, then, that’s the trade off—about 3.8 percentage points higher annual yield versus a slower increase in the value of the portfolio of a total of about 8 percentage points from October 6, 2009 to June 29, 2012. My hope is that the current impairment in the value of stocks such as Banco Santander and Total won’t be permanent. That would clearly change the parameters of the trade off.

I’ll revisit this portfolio on its three-year anniversary in October 2012.

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 http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Banco Santander, Magellan Midstream Partners, SeaDrill, and Westpac Banking as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market- beating Jubak's Picks portfolio, the writer of the Jubak's Picks blog and the senior markets editor at MoneyShow.com. Click here to find Jubak's most recent articles, blog posts and stock picks. Get a free 60-day trial subscription to his premium investment letter JAM by using this code: MSN60 when you register here. [http://jubakam.com/wp-login.php?action=register
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