In recent days, I have written about the benefits of creating a dividend-based strategy that focuses on creating some kind of income infrastructure first as a way to get regular infusions of cash into your checking account to make investments elsewhere. If you can get to a point where you have $500-$1,500 being generated in income every month, your life starts to open up because you have created a system that allows you to always have money coming in to invest. If you try to build your base income infrastructure using common stocks, there are five places where it traditionally makes sense to search:
1. Big Telecom. AT&T (NYSE:T) is probably the classic stock in this regard. For investors that pay a rational price, the expectation for this company is that you receive a 5-6% starting dividend that will grow by about 4-6% each year. This company compensates for what it lacks in growth by providing investors with stability. Having an investment that returns 1.25% of your principal every three months can provide the kind of income base that allows you to make other investments.
2. Big Tobacco. Reynolds American (NYSE:RAI), Altria (NYSE:MO), and Lorillard (NYSE:LO) currently yield over 5% as of the time I'm writing this (although Altria's share price is flirting with the mark that takes it below 5%). Both Reynolds and Altria are currently trading at valuations above their historical averages (although the spinoffs of Kraft (KRFT), Philip Morris International (NYSE:PM), and Mondelez (NASDAQ:MDLZ) complicate most long-term comparisons involving Altria). If you believe the menthol risk is overblown, Lorillard could prove to be a compelling investment at current prices.
What has made tobacco stand out as an income investment historically is the fact that Big Tobacco has offered investors both a high current dividend yield and a high dividend growth rate, a trend that has continued to the present day. Of course, the political risk of this investment is enormous. The government seems to find new ways to regulate and restrict tobacco consumption every year. Annually, the domestic tobacco industry is experiencing volume declines of about 3% each year. Because of these facts, I would not make any predictions about Big Tobacco's dividend viability more than six or seven years into the future. There is a strong "monitoring" element inherent in adding this kind of income stock to your portfolio.
3. Real Estate Investments. This is an area of the investing landscape that seems to have become particularly overvalued due to the record-low interest rates in the United States. It is hard to find a high-quality REIT investment that is trading at a margin of safety below its ten-year P/FFO ratio.
Personally, I couldn't bring myself to pay $50 per share to acquire an ownership stake in Realty Income (NYSE:O) right now. However, as an incoming generating business, the company is excellent. Realty Income is on the very short list of companies that both (1) raise the dividend annually in a reliable manner, and (2) pay out a dividend monthly. In many ways, this makes Realty Income a dream stock for an income investor. Right now, the starting dividend yield for investors is just shy of 5%. If you only want a safe dividend, it could make sense to buy Realty Income at current prices. However, I'm not buying shares because I believe there will be some reversion to the mean with its P/FFO ratio in the future, and on that basis, it seems that there is a high likelihood of a future 15-25% correction for this stock in the coming years if interest rates rise.
4. Oil Supermajors. BP (NYSE:BP), Total SA (NYSE:TOT), Royal Dutch Shell (NYSE:RDS.B), and to a lesser extent, ConocoPhillips (NYSE:COP) seem to be great stocks for investors that want to receive high current income at decent valuations that also allow for some meaningful capital appreciation along the way. Of course, there are reasons why these stocks are trading at good valuations now. If you buy Total SA, you have to deal with the French government's seemingly insatiable appetite to tax the oil giant.
If you buy Royal Dutch Shell, you have to deal with the fact that the company will cut its dividend if the price of oil falls sharply. If we enter a world of $50 per barrel oil, Shell's dividend will go down before Exxon (NYSE:XOM) or Chevron (NYSE:CVX) cut their dividends. When oil prices cratered during the financial crisis, Royal Dutch Shell held its dividend steady at $3.36 per share all three years. The company's last dividend cut was from the 2005-2006 period.
Royal Dutch Shell only qualifies as dividend growth if you think in terms of, "Over most five year rolling periods, the dividend will rise by a meaningful amount." If you need guaranteed annual raises, I would not recommend Royal Dutch Shell to you. However, if you like a company with a phenomenally diversified (and substantial asset base) that will always return a chunk of profits to owners, then I would recommend Shell to you. The important thing with Shell is that you recognize ahead of time that earnings (and potentially dividends) will be volatile on the long-term march upward, and you should make a decision ahead of time whether your temperament and strategy could make peace with that.
And lastly, there is BP. That's the company where I have been putting my money because I believe that the company's earnings are currently artificially low (BP has 15 new large projects that will be starting in the coming 8-24 months) and set to reach the $6-$7 per share mark in the next five or so years, provided there is no sharp decline in oil prices. This conclusion leads me to believe that the company will have the room to offer investors both high future dividend growth and significant capital appreciation if you look out five years.
However, I'll be the first to say that this investment is not for everyone. The company recently divested $38 billion in assets. That's a lot of money any way you slice it. Likewise, some investors may want to stay away from a company with a significant litigation risk. For every investor that sees this as an analogous opportunity to buying Exxon during the Valdez overhang, you can find another investor that sees long-term earnings impairment as a result of the asset sales. I believe my thesis on BP will be correct provided that oil remains above $80 per barrel long-term and that the company's new project launches get BP's reserve replacement rate back above 100% from the current 80% range. But we shall see.
As you may have already noticed, this is not exactly the golden age of high current income investing with high-quality dividend stocks. Companies that "don't have much wrong with them" like Realty Income and AT&T are trading at premium valuations. Big Tobacco investments are not exactly trading at firesale prices, and they come with the risk of future tax raises and regulations (as well as the fact that long-term volume shipments in the domestic tobacco industry are declining). At the present prices, I prefer using big oil companies to serve as "dividend machines" that can provide regular infusions of cash to invest elsewhere. But if you are looking to find the places where the "dividend machines" hang out, those four sectors are good places to regularly monitor for good deals.
Disclosure: I am long BP, COP, XOM. 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.