Dividend Stocks That Beat the Market
10/09/2009 9:18 am EST
Low interest rates are making life difficult for investors who need a steady income stream. But that is now, and investing—like farming—is all about anticipating the next season.
Today I'm relaunching my portfolio of dividend stocks for income investors. By the end of this column, you'll know:
- Why I think all income investors need to consider a dividend stock portfolio as part of their total income portfolios
- How the portfolio I launched in December 2005 has performed
- The ten dividend stocks I'm recommending now
Income investors today face an even tougher environment than when I began my portfolio of high-dividend stocks nearly four years ago.
Interest rates, in general, are lower. The three-month Treasury bill yields just 0.09%. The yield on a two-year Treasury note is 0.87%. And if you're willing to lock up your money in a ten-year Treasury, you get paid just 3.21%.
Risk is higher. Because of the big rally in junk and other distressed bonds, corporate issues are trading at higher prices, which means you get less yield and more risk. For example, when I bought senior notes of homebuilder D.R. Horton in late 2008, I paid $9,035 for a bond with a $10,000 par value and got, instead of the 7.875% coupon interest rate, a yield of 8.69%. As of October 6, that bond has rallied, and it now 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 get back $425 less than I invested.
And we're a lot closer to the turn in the interest cycle. I don't expect the Federal Reserve to start raising rates in 2009, and 2010 is an outside chance. But 2011? For sure, unless the economy slips into a double-dip recession. Remember that rising interest rates drive down the prices of existing fixed-income vehicles, such as bonds.
Investing in dividend-paying stocks is one way to either get around or minimize these problems, for three reasons:
- Though stocks have rallied 60% or so from the bottom on March 9, many are still trading substantially below their 2007 highs. That's not surprising, because even after this huge rally, as of October 6, the Standard & Poor's 500 Index ($INX) was still 33% below its high of 1,565, reached two years ago. That means a stock such as Chevron (NYSE: CVX), which on Thursday afternoon traded 17% below its October 9, 2007, price, pays a dividend yield of 3.86%. That's substantially higher than the 3.21% yield on a ten-year Treasury.
- 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, for example, is still 12% below its October 9, 2007, price. It has raised its quarterly dividend to 45 cents a share from 37.5 cents during that two-year period. And if you're willing to hold PepsiCo's stock for something like the three years that will pass before the D.R. Horton note matures, you stand a very good chance of seeing your capital appreciate. At the very least, the investor who holds the stock isn't locked in to the 4.25% haircut that holding the D.R. Horton bond to maturity guarantees.
- Dividend stocks offer you some protection 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' earnings are likely to be climbing. So they'll have the money to raise dividend payouts. Rising earnings should also push 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 ten stocks until April 8, 2008. I built the portfolio starting with a hypothetical $100,000 and put $10,000 into each of the ten 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 ten 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 investment.
Looking at both the capital loss and the dividends, the total value of the portfolio of $117,007. That's roughly a 17% total return over 46 months.|pagebreak|
For a little context, the return on the S&P 500 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, because I didn't reinvest my dividends) that comes to a yield of roughly 4.53%.
That's 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 look too closely to see some of the problems.
Here's a list of the ten stocks in the final portfolio:
You can see that part of the problem is that I took a beating in three stocks: Natural Resource Partners, down 64% before dividends; Penn Virginia Resource Partners, down 35% before dividends; and US Bancorp, down 33% before dividends.
In Penn Virginia's case, 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 a nickel a share as a result of the financial crisis.
One 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.
Another lesson is that a dividend income portfolio needs more frequent care and feeding than 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. This is a bank stock that will recover, and I'm keeping an eye on its potential for capital gains. It clearly no longer makes the cut as an income stock. Not with a quarterly dividend of five cents per share.
Second, I'm going to better diversify this portfolio. It's heavy on energy and on master limited partnerships. The combination has done rather well, but I can add some safety here by moving a bit of money outside the energy sector.
In addition, the tax treatment of master limited partnerships doesn't make loading up on that vehicle ideal for tax-deferred portfolios such as individual retirement accounts. If you wind up with more than $1,000 in annual income from a master limited partnership, it triggers a different kind of tax treatment. In most cases that treatment is neither onerous nor 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 Communications (NYSE: VZ), which currently pays a yield of 6.47%. (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, because the coal sector has been 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 ten equal positions of a larger size.
I'm going to track this portfolio in the same way that I do my other two portfolios, the Jubak's Picks and the Jubak Picks 50. Beginning next week, atop the home page of my Jubak Picks blog, you'll find a link to a portfolio page that gives current gains and loss percentages plus a short explanation of why I originally bought the stock and any recent updates.
Those changes will ensure that this portfolio gets the same attention as the others I run.
At the time of publication, Jim owned or controlled shares of the following companies mentioned in this column: Enbridge Energy Partners, Natural Resource Partners, Oneok Partners, and Rayonier.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.