Seeking Alpha
Hedge fund analyst, newsletter provider, research analyst, portfolio strategy
Profile| Send Message| ()  

Benjamin Graham gave us many great teachings and contributed more than anybody to the world of financial analysis. But one obscure idea buried deep in his writings has become particularly in vogue, even if investors aren't totally aware of it.

It was Graham's idea of holding dividend stocks as a substitute or complement to any other stream of income. In that instance, similar to that of an apartment landlord, one cares far less about the price of the underlying asset, which can fluctuate wildly, than one does about the stream of income that the asset generates. After all, aren't we supposed to go into these stocks as a long-term venture? Why should we get bent out of shape (or especially excited) about what happens month to month, or even year to year?

It's a very intriguing concept, and if properly applied, can help steer certain types of investors towards victory. But there are some under-appreciated risks we need to measure first.

First of all, the streams of income that stocks are generating right now are pretty depressing.

S&P Dividend Yield:

(click to enlarge)

These are still dark days for dividend investors, but judging by the popularity of the strategy and the traffic that this sort of thing gets at places like Seeking Alpha, one would think this was a golden era for income stocks.

Everybody's desperate for a yield substitute, of course. We have the Federal Reserve to thank (or blame) for this. They've forced down yields on Treasuries via Q-Infinity, and since most bonds trade at a spread, yields on pretty much every other type of paper has fallen dramatically as well. This is awesome if you're a big company that can issue debt at microscopic rates or are an individual with good credit who's shopping for a historically-cheap mortgage. But if you're a saver, retiree, or pension fund, then life sucks.

This wasn't an unintended consequence. The Fed has been fairly explicit about its direct goal of using QE to prop up risk assets, and, via the wealth effect, hope to create some sort of real economic impact and a few jobs along the way. We can debate the efficacy of that another day. But they've known all along that a certain large swath of investors would have no choice but turn to equities to replace the yield they lost in the bond market.

The idea of "equities as fixed income" is simultaneously exciting and terrifying to me.

It's exciting in the sense that Graham wrote about. Sure, these stocks are just another asset that pay out cash and over the long run we shouldn't really worry so much about the value of our principal, provided it's a good business, of course. It's a neat way to look at stocks.

But I am absolutely terrified about the potential large-scale misunderstanding of how dividends work and the psychological consequences of what happens if something goes wrong here.

See, dividends are discretionary.

Let me repeat.

DIVIDENDS ARE DISCRETIONARY.

This is absolutely crucial to understand if you're using stocks as a yield substitute.

Companies don't have to pay dividends. They don't have to raise them. They don't have to maintain them.

Unlike a bond, there is no legal requirement to pay.

So it's all well and good to park $100k in a single stock to collect that juicy 5% yield (funny how a 5% yield these days qualifies as "juicy"). You can go ahead and happily collect your $5,000/year of income and worry about your $100k later or not at all. But if that company starts to really struggle and find itself on shaky financial footing, they might need those dollars they're paying out as dividends. Companies can get shut outside very quickly. Nobody wants to offer assistance to a wounded wildebeest; the vultures just wait for it to die and then take as much as they can from the carcass. That's where things like legal rights within the capital structure get really important and why using stocks as a substitute for bonds is not something investors should wander into without a proper understanding of how it works out on the savannah.

Look, if you're turning to equities as a replacement for fixed income, you have my blessing. I've been writing about dividend stocks since 2009. I love boring ol' dividend stocks as much as you do. Just make sure you understand a few things. If you're getting into these things for the yield, employ these basic defenses to keep you and your herd safe.

Three Ways to Manage Yield Risk

1. Diversify - The obvious answer is to diversify your dividend portfolio. Don't go all in with a single name. The great news is that we have super-efficient ETFs to help us out here. So if you just want to own something like the (DVY) or (SDY), that's great. Those yield 3.3% and 2.7% respectively. You get instant, low-cost exposure to a basket of stuff and that's how you manage the risk that any one company cuts its dividend and leaves you in a situation where now, all of a sudden, you care a whole lot about your principal value.

2. Don't chase yield - I almost feel like this is a proxy for picking the companies with the lowest risk of dividend cuts. There's a very strong, basic correlation between yield and companies that cut their dividends. Stocks yield 8% for a reason and usually that reason is because the market is skeptical the dividend is sustainable.

3. Low risk of cutting - If you do want to inch a little further up the individual equity yield curve, then make sure you spend more time assessing whether or not it's a dividend at risk. Start looking at metrics like the payout ratio and look at the company's history too. Is this a company who has cut their dividend before? Do they have a track record of raising it and will their future earnings continue to stay robust enough to support it?

There should be zero debate about the fact that one of the biggest drivers of the bottom line for S&P style companies during the recovery has been increased efficiency. Companies have cut costs wherever they could. They've consolidated staff, turned to more technology-based solutions, and eliminated whatever unnecessary expenses that they can. This has boosted net earnings per share. The problem is that cuts like this, by definition, are finite. At some point, there will be linkage between the top line and the bottom line again.

And the potentially scary thing about that inflection point, is what happens in another broad-based or industry-specific economic slowdown? Dividends aren't guaranteed to get cut in that instance, but depending on the severity of the slowdown and the options available to the company in question, they may have no choice.

The good news is that the number of companies increasing their dividends in 2013 will probably clock in at a similar rate to 2012.

(click to enlarge)

The bad news is that the number of S&P companies cutting their dividends this year is already at the highest rate since 2009, and by year-end, non S&P companies will almost certainly feature the highest rate of dividend cuts since 2009.

(click to enlarge)

We can have a discussion about whether this is indicative of a future economic slowdown at another time. Regardless of which side investors select in that debate, they still need to pay more attention to the risk of dividend cuts than ever.

This is a risk right now.

Sometimes companies cut dividends simply because they feel like their long-term earnings power has been compromised. It doesn't take a crisis or a really messy year. Sometimes they cut on a preventative basis.

Knowing that...

Let's Go Fishing

If you do a search for higher yield companies with low payout ratios, the list is dominated by energy & telecom companies. The reason for this is because these are two industries that are really profitable industries right now. These are good businesses. But the problem is that the future gets progressively less exciting the further out you look. Because of the nature of these industries, there's a natural skepticism associated with the ability for dividends to be sustained, or at the very least to continue rising.

In practice, these are also two industries that seem to feature the most frequent cuts.

Consider some of the following high-profile cuts this year:

  • CenturyLink (CTL)
  • Exelon (EXC)
  • Newmont Mining (NEM)
  • Cliffs Natural Resources (CLF)
  • Telecom Italia (TI)
  • Vale (VALE)

All of those companies except Newmont feature high payout ratios or infinite payout ratios since they're losing money. They were all featuring high payout ratios before the cuts, too. I wouldn't have touched these stocks before this year and I wouldn't touch them now. (In Newmont's case, it's industry specific. I'm bearish on gold.)

Here are three interesting companies that turned up on the screen:

Garmin (GRMN) - I know. I hate the core business too. But they aren't on the verge of BlackBerry-style irrelevance just yet. They do all sorts of other stuff like airplane and maritime navigation systems and they've been playing around with interesting new tech like pet location devices. Garmin gives you a 5% yield with a 64% payout ratio right. At the very least, the dividend is probably safe for a little while.

Plus, the stock is by no means expensive with a 10x cash-adjusted PE and 2x book value. They don't have any (LT) debt, either. Zero. So it's not like the creditors will come knocking and steal your dividends. Plus they're in the middle of a big buyback, too. I guess with Garmin, it really is a case of people hating the GPS business that much. Hated businesses can still be good sources of cash flow, you know.

Corrections Corporation of America (CXW) - I'd actually never heard of this $4 billion company either. They own and operate privatized correctional facilities and detention centers. I can see some potential concern about a company like this relating to slower government spending. But they've managed to grow the top line in the mid-single digits and going forward, there's no reason why a business like this shouldn't grow by at least the population rate.

There's a bit of debt on the balance sheet, but a 0.61x debt/equity ratio isn't something to run screaming from. The great news is that this business generates boatloads of cash, just as you'd expect a business like this might. It trades at under 5x cash flow! And with a 5.5% yield on a 19% payout ratio, you're probably pretty safe. It's a great chart, too, and the stock is locked in a solid up trend. I guess the business is just too small for most income investors to really care. If you want to lock in that 5.5% yield and know what you're doing in the options space, go ahead and put on a collar.

AT&T (T) - Yes, it's a telecom name and yes, the payout ratio is around 100% right now, but that's on depressed earnings because of a special loss last year. AT&T should earn $2.51 this year, which represents a totally-sensible ~50% payout ratio. Plus, they're one of S&P's so-called "dividend aristocrats." Those are the companies that have had 25 consecutive years or more of increased dividends. I'm not sure there's a bigger status symbol in the world of traditional institutional investing than that.

T used to yield up close to 7%, but today it's down around 4.8%. That's still pretty attractive, and if investors are going to make a big bet on one big single dividend stock, AT&T is a name to consider. Again, apply a collar if you just want to lock that yield in or are too concerned about a falling price. Otherwise, I have a hard time coming up with a bigger, safer, higher-yielding stock than T. Buy it with confidence on a pullback into the low 30's.

In Search of Income

It's a lot tougher than it used to be to pick up some yield. We all know this, of course, but I'm not sure we're all psychologically wired to succeed at the endeavor. It takes work, and there might not be a niche in the market that requires more of the 10 Qualities for Successful Investing than in the income space right now. We are tested daily on all fronts, and only those with cardinal virtues such as patience, fortitude, objectivity, and self-understanding will succeed. Before you venture out into the land of dividend stocks, make sure your core qualities are up to snuff.

Right now everybody is talking about using equities as a substitute for fixed income, but not everyone appreciates the risks. Dividends are continuing to be flattened across the board as yield-starved institutions bid up the price of the underlying stocks. In the meantime, earnings margins may be teetering on a tenuous equilibrium. Finding the right yield opportunities requires a different approach now.

Source: The Most Important Thing To Know If You're Using Stocks As Fixed Income

Additional disclosure: For additional disclosure, see here:cornicecapital.com/AlpineAdvisor/legal-notice/