With the recent market run-up, dividend-paying stocks have become more attractive. There are numerous reasons to love dividend stocks. The most obvious one is that you get a source of income regardless of the "animal spirits," helping provide a bit of a cushion in a down market. Historically, dividend-paying stocks have tended to outperform the broader market, as well.
Then there are less obvious reasons: a dividend payment is a form of insurance against fraud. It's difficult to pay investors a large cash flow stream if such a stream does not exist. The larger the dividend, the more difficult it becomes for a company to fudge its numbers.
For all the reasons I mentioned above, and many more, I always prefer dividend-paying stocks over non-dividend paying counterparts, when all other things are equal. Meanwhile, the market has gotten a bit hot recently, which makes me more concerned about those "animal spirits." In a little over three months, the S&P 500 (NYSEARCA:SPY) index is up 10%. Even more dramatic is the bigger, 4-year picture, where the S&P is up 96.7% over that time frame.
The chart below attempts to put this all in perspective. The current trailing quarterly return (10%) is amongst the top 15% of quarterly returns since 1950. Meanwhile, the 4-year trailing return is amongst the 7% of 4-year returns since 1954. All of this is to say, we've had quite a good run recently.
I can't say whether the market is "overvalued" or not, but it certainly doesn't look cheap any more. With many macro issues looming in the background, the market also may be a bit vulnerable. For these reasons, I prefer to play things a bit cautiously right now, with an increasing focus on high-quality dividend paying stocks.
Here are three of my favorite dividend payers.
1. One Liberty Properties (NYSE:OLP), 6.4% yield
One Liberty has been my favorite property REIT for the past two years and it retains that distinction today. I've written about OLP before in 2011. I liked it then because it was a well-run office REIT, with above average historical returns, a strong management team, high inside ownership, and it was priced very attractively compared to other office REITs.
That article was written back in August 2011 when OLP sold for under $14 and had a dividend payout in the 9% - 10% range. Unfortunately, you can't buy it for that cheap now, as it retails for a shade under $22, with a 6.4% yield. Even if it's no longer "dirt cheap," though, it's still one of the most attractive property REITs you can find.
There's been some research that shows that smaller REITs offer higher yields than larger counterparts. There's not really much of an economic justification for this discrepancy. Rather, it's merely a case of mutual funds, ETFs, and other large funds pouring into the well-known names and ignoring the smaller ones; so much for the "efficient market."
You can see these valuation discrepancies by taking a quick glance at the yields on the larger REITs. Right now, Simon Property Group (NYSE:SPG), Vornado (NYSE:VNO), and General Growth Properties (NYSE:GGP) offer yields of 2.9%, 3.5%, and 2.4% respectively. Larger office REITs such as Douglas Emmett (NYSE:DEI) and Boston Properties (NYSE:BXP) don't fare much better, offering yields of 2.9% and 2.6%, respectively.
Those are dismal yields, and it shows how much "dumb money" is out there. When you consider that REITs pay out about 90% of their income that makes this all the more perplexing. One Liberty, on the other hand, is a best-of-class operator and with a dividend yield of 6.4%, it's still one of the most attractively priced REITs out there. Combine an attractive price with a strong management team with lots of inside ownership, and you begin to see why it's my favorite REIT.
2. SandRidge Permian Trust (NYSE:PER), 16.5% yield
I've become very intrigued by some of the oil and gas trusts over the past few months and SandRidge Permian Trust is the one I've grown most comfortable with. PER produces oil, natural gas, and natural gas liquids (NGLs), but the mix is decidedly skewed towards oil, with oil accounting for about 87% of PER's output. Rather than provide my own synopsis, I'd recommend reading Elliot Gue's article on PER from January, "SandRidge Permian Trust: What Every Investor Needs to Know."
While the dividend yield is listed at 16.5%, I would ignore that figure. PER's output is expected to peak around 2014 / 2015. After that, the dividends will likely be in a perpetual decline. For this reason, you shouldn't expect any price appreciation. All the same, this can still be attractive for the right payout.
We can look at Elliot Gue's numbers to get a better idea of where this should be valued. When it sold for $17, Elliot came up with an IRR of about 8.25%. The stock now sells for $14.20. That at least implies that the current IRR is over 10%.
I decided to do a scenario analysis on PER with three different cases. With a conservative scenario, I came up with an estimate of an 8.9% IRR, based on today's stock price of $14.20. With a more moderate scenario, I came up with an IRR of 12.8%. In a slightly more aggressive scenario, I come up with an IRR around 14.1%.
When I use the $17 stock price (that Elliot used) for my valuations, the IRRs fall to 5.3%, 9.0%, and 10.2% respectively, suggesting that Elliot's valuation is slightly more conservative than my "moderate scenario." While I don't have his exact figures, that might put his IRR somewhere around the 11% - 12% range at the current price.
Of course, there are a few big "ifs" in there. What happens if oil prices decline as a result of a downturn in China, or a major recession in the US? What happens if the trust has less oil than expected? These trusts certainly pose their share of risks. Still, PER is attractively priced for what it is. With an expected IRR in the 10% - 14% range, I consider it an above-average income investment.
3. Compass Diversified Holdings (NYSE:CODI), 9.1% yield
The best way to describe Compass is that it's a private equity fund that's not actually a "private equity fund." Unlike a traditional PE fund, it does not have a fixed time period for investment. Since it's publicly traded, you can also exit at any time you like.
These differences give Compass some distinct advantages over the traditional PE model. For one, it doesn't have to constantly raise capital. It also can invest for longer time frames; most PE funds have a limited term of 10 years, forcing them to sell off most investments after 3-5 years even if the market has turned sour. For these reasons, I see Compass as having incentives that are more aligned with its investors than a traditional PE fund.
Compass's business model is attractive, but what I really love about it is its unique strategy, strong selection of portfolio companies, consistent improvements in cash flows, and the massive amount of insider buying initiated by executives and officers of the company. Compass's strategy revolves around purchasing companies with brand equity (i.e. intangible assets) and improving operations. Its portfolio of companies includes Camelbak, Liberty Safe, and ERGOBaby. Cash flows improved 12.6% YOY and distributions have been increased consistently.
I wrote about Compass in January 2012 for those interested in a more in-depth analysis. It's a tricky firm to value, in some ways, but even going by very conservative growth assumptions, I thought it was worth $11 - $15 back then. Remember, Compass is essentially the equivalent of a growth private equity fund, so we should not expect "very conservative growth" if management does its job. Indeed, I've been encouraged by the progress in CODI's portfolio companies.
While Compass costs a bit more now (around $15.75 as I write this), I still view this as a very solid company that has a lot of potential for growth. Collecting a 9.1% dividend from a "growth company" is a pretty unique deal in the public markets. This has been amongst my top two holdings for the past year and I plan to keep it right at the top.
There are risks for all three of these high-dividend payers, so I think it's worth addressing those. Of the stocks mentioned, OLP is the lowest-risk of the three. The odds of a crash in the office RE space seem small. If we were to enter recession, OLP's price would likely decline, but the cash flows and dividend (which are vastly more important) still might hold up relatively well. All the same, I don't view OLP as "underpriced" so much as I view most other REITs as "overpriced," so it's possible that a broader market correction in REITs could hit OLP, as well.
CODI has somewhat higher risks than OLP. While its brands are solid, a recession could impact some of its portfolio companies significantly, as they have significant exposure to many consumer goods, as well as furniture manufacturing. CODI is also somewhat aggressive in its distributions, so it's probable that the dividend payments would get cut in a recession scenario.
PER is the highest-risk of the three. Oil and gas trusts can have significant risks, with a re-evaluation of reserves being the largest one. With PER, I'm less concerned about that, and more concerned with the possibility that oil prices could decline back to around $70 - $90 / barrel. That would certainly result in a lower IRR. For instance, if expected distributions were to fall about 22% due to lower oil prices, I estimate that PER's IRR in my "moderate scenario" would fall from 12.8% down to 8.6%. That's a sizable haircut, but not disastrous.
We are in a very tricky market right now. We've had a bit of a run-up, stocks are looking increasingly expensive, and macro risks appear to be on the rise. This doesn't mean that the market is going to crash in the next few months, but it certainly means that one should be a bit more cautious right now. Large dividend-producing stocks aren't immune from the impact of a market downturn, but at least they do provide some cushion on the way down.
One Liberty, Compass Holdings, and SandRidge Permian Trust are three solid long-term income investments and amongst my favorites right now. They are not without risks, but I view them all as either "fairly valued" or somewhat attractively priced given the risk and reward potential.
Disclosure: I am long CODI, OLP, PER. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.