2 DRIP Candidates

 |  Includes: APO, KCAP
by: Northrop Puckett

I consider one of the best long-term investment strategies with equities -- maybe the best -- to be buying a high dividend stock with a strong business model and strong financials, and then enrolling it in a DRIP (dividend reinvestment plan). It is a play on compounding interest.

With retirement money I don't generally want low probability investments. I want high probability investments. Specifically, I want high probability realized returns.

A problem with value investing -- choosing an undervalued stock with the anticipation that other investors will realize its value -- is that it can take months or years for others to see the same value in it that you see. In that scenario, probability is pretty good, but there is the chance that before others realize that it has underlying value, a change could occur at the company.

The problem with choosing a growth company for a long-term investment is that there is a moderate (or high) probability that it may not live up to growth expectations.

But if your strategy is to choose a solid company that is paying relatively high dividends, you receive a tangible benefit four times per year. The probability that you see returns on the investment are very high, especially if the company has a long track record of paying ever-increasing dividends. You are constantly extracting value from your investment.

I am sure that some of you are saying, "choosing undervalued stocks worked for Benjamin Graham and Warren Buffett." That may be true, but Mr. Buffett has employed a strategy that mimics a large dividend reinvestment plan. His whole strategy now is not necessarily one of buying undervalued stocks, but rather of using dividends from existing holdings to buy more dividend-paying companies, and then using that ever-growing dividend cash to purchase more and more companies, which add to the cash hoard with their dividends. It is a pretty beautiful cycle.

But without arguing over whether this strategy is "the best" for a long-term investment portfolio, let's just take the time in this article to go over two strong investment companies that I consider to be good candidates, along with some strategies to increase returns and limit drawdowns in the position.

Kohlberg Capital Corporation

Kohlberg Capital Corporation (NASDAQ:KCAP) (hereafter "Kohlberg") is a publicly traded private-equity firm that focuses on buyouts, investments, and debt purchases of mid-market companies (frequently private ones). The mid-market firms that it deals with would be considered small to mid-cap companies if you were to compare them to public companies.

The company is currently paying a strong dividend because its business is booming. The current dividend yield is 10.95%. It has a PEG of .82 and a forward P/E of 9.39, both indicating a low valuation relative to future earnings growth expectations. The company has less leverage -- a debt-to-equity ratio of .49 -- than the next stock mentioned.

Earnings growth this year is expected to be 187%, and quarter-over-quarter earnings are up 876%. Quarter-over-quarter sales are up 59%.

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Kohlberg is expected to release its financial results for the fourth quarter and year ended December 31, 2012 on Friday, March 15, 2013 after the close of the markets.

Apollo Global Management

Apollo Global Management (NYSE:APO) is similar to Kohlberg, making investments in debt instruments, distressed assets, fixed income securities, and restructurings to name a few. Apollo also has significant real estate investment portfolios. The investments are more focused on North America and Europe than Kohlberg, and are not stated to be on mid-market firms that Kohlberg focuses on.

Apollo serves pensions, endowments and institutions, so it's definitely "smart money" when it comes to investments. The benefit of it being a publicly traded company is that you don't have to be a millionaire to place your money with it.

Apollo has beaten earnings expectations four quarters in a row. Because of the increase in earnings, it boosted its dividend significantly. You can expect the dividends in this (and in Kohlberg) to fluctuate between booms and recessions over the life of your investment, but with boom-time dividends like its current 17% yield, it makes for a good DRIP candidate in my opinion.

The benefit of these alternative investment stocks is also that they do provide you with exposure to strategies that are hard to find or non-existent in other stocks, such as restructurings leading to second IPOs.

While the stock has increased a lot since December due to earnings, its metrics are still very reasonable. It sports a forward P/E of 7.92 and a PEG of .72. These indicate that analysts have high expectations for earnings growth in coming years. The fact that it has a return on equity of 37% shows how well it uses the money it has.

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In both of these stocks, you are primarily investing in the skill of its investment managers and their ability to find financing to make deals/investments.

The one issue to watch with these companies into the future is the cost of borrowing money. Right now it is cheap, and they can borrow cheaply to execute their investment strategies, but if interest rates do eventually go up dramatically these companies could be hurt. If a long-term change to interests did appear likely, I would look to remove these from my retirement account (and potentially restructure the retirement account as well).

The DRIP Benefit

The drawback from a DRIP is that you don't get to choose new stocks that you want to invest dividend cash in. That is about the only bad thing. The positives are better left to the chart below. As you can see, stock appreciation in large-cap stocks vastly underperformed position appreciation when reinvesting the dividends.

Covered Calls, Collars and Selling Naked Puts

Other things that you can do to increase returns on a dividend-paying portfolio, include the following:

1) Selling calls in stock that you own proportional shares in is called writing covered calls. This strategy is considered safe since the calls that you are selling are covered by the stock that you own. This provides income if the stock does not move much and caps your gain depending on how far out the call is.

2) Collars incorporate the covered call strategy. But instead of pocketing the income from the sold call(s), you would use that money to purchase downside protection. This essentially allows for small gains and losses, and prevents large gains and large drawdowns. This strategy can be good if used on a stock paying a large dividend yield. Below is a chart showing returns using active and passive collars versus just holding the stock outright over 10 years. The difference speaks for itself.

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3) Finally, while considered by many people to be risky, selling puts on a stock is, in my opinion, a reasonable way to add to returns if the puts are far enough out of the money -- close to 2 standard deviations for example. A 2 standard deviation move by definition only occurs 5% of the time, so if you are selling monthly puts at that distance, you can generally expect it to be tested once every eight years. Then assuming the worst -- that the stock you own has a catastrophic drop either due to its own issues or due to a market crash -- you are obligated to buy that stock lower or buy back the puts for a loss. If the company is sound, this purchase at a low price isn't the worst thing in the world, as long as you can afford it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Disclaimer: We do not know your personal financial situation, so the information contained in this article represents an opinion, and should not be construed as personalized investment advice. Past performance is no guarantee of future results. Do your own research on individual issues.