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Once again, it is time for a mid-year update of our diversified dividend portfolio, comprised of the best dividend stocks from our SA articles. We also will rebalance the portfolio with some additions and deletions.

During the past year this portfolio has provided a 7.7% yield on original investment and additional capital gains of 28%. With the current disdain of dividend stocks, these are well off their highs, and only 7% of the price gain has occurred in 2013, about half of the 14% appreciation of the S&P 500. Before launching into our individual update of the portfolio stocks, we should comment on the current negative perception of dividend investing.

Current Market for Dividend Stocks

Recently we received calls from investors who had heard on CSPN that they had to sell their dividend stocks. Apparently, what they gleaned from the talking heads is that expected rises in bond interest rates would automatically make dividend stocks fall in price. While there is definitely a relationship between dividend yields and bond yields, the simple notion that dividends are bad goes against all that I learned in 40 years of investing. I think that our media-led society has a tendency to react to sound bites and over-hype from the "experts," rather than consider all the economic factors.

When there are a large group of investors over-reacting, stock opportunities surface. Call me a contrarian, but I think the pull back in dividend payers is overdone, and we would be buyers of stocks in companies with sound operations and big payouts. If a company has growth prospects, the dividend is not the only thing supporting the stock. Unlike bonds with fixed payouts, companies can grow their stocks' dividend yields by increasing earnings and free cash flow. When dividend stocks are beaten down and under-loved, capital appreciation prospects improve.

Portfolio Report and Update

STOCKSECTORJuly '12CURRENTGAINDIV %
Telular Corp.Wireless Tech.$9.37$12.6135%3.80%
HCI GroupInsurance$18.09$34.8493%2.80%
Ares CapitalBus. Dev. Finance$16.15$17.639%8.70%
BlackRock Health Sciences TrustHealthcare$27.99$32.8517%7.40%
GAMCO Natural Resource FundPrecious Metals & Petroleum$14.80$11.19-24%4.00%
RAIT Financial ReitReal Estate$4.79$7.5958%6.80%
Legacy Reserves LPOil & Gas$25.60$27.016%8.50%
AVERAGE CAPITAL GAIN 28%
AVERAGE DIVIDEND PAYOUT 6.00%

Telular (WRLS) was bought out and taken private for $12.61. We hated to lose this one, and the buyout price seemed low to us, but we will take our 35% profit and move on. We are looking for a replacement in the wireless technology/consumer sector that WRLS provided.

Our replacement for WRLS is Cypress Semiconductor Corporation (CY). Perhaps CY is best known for its touch-screen technology that is common in Samsung products, as well as others. However, CY has a culture of innovation, and it has recently won several industry awards for technological breakthroughs. Earnings announced Thursday indicate that CY has gotten past the slow-down in the cell phone market, and is expecting renewed strength in the near term. CY pays a 3.8% dividend and has cash flow to cover double that payout, despite spending nearly $50MM on R&D each quarter and paying down debt. WRLS was a technology company with exposure to consumer spending, and CY fills that role well in our diversified portfolio.

We also need to decide what to do with HCI Group (HCI), formerly Homeowners Choice, a Florida property insurance provider. HCI has nearly tripled since we introduced it to readers in February 2012, and the dividend yield has subsequently dropped below 3%. Earnings have grown with the stock price, and fundamentals still look reasonable for HCI. It has been a roller-coaster ride, and the volatility is difficult for some income investors. In all fairness, HCI has benefited from a lack of serious hurricanes in the past two years, and its reinsurance as a percentage of premiums is less than most Florida property insurers, which adds some risk in the event of catastrophic storms. It recently increased the reinsurance coverage, which will take an additional 10% bite out of premiums. We have lightened our holdings in HCI, as is normal when we get triple-digit gains. We are still holding some for diversification sake in our portfolio. We do think that dividend increases are in the future for HCI, as its payout is less than 35% of net income. We think some dividend investors may prefer to look for a less volatile investment and a return of more than 3%.

A suitable alternate is Universal Insurance Holdings (UVE). UVE is a competitor of HCI, has similar growth in premiums and offers a 4.1% yield. Although UVE has also doubled in share price in the past year, it has better price-to-book and price-to-sales ratios than HCI. The knock we have had on UVE in the past is that management had invested company funds heavily in precious metal miners, and the market losses continued to negatively impact earnings. For instance, in the quarter ending March 31, the EPS was $ .29, but it would have been double that if it were not for trading losses. We were pleased to see that in the first quarter management exited the precious metal exposure and converted funds to more conservative investments. We think this will enable UVE to exceed current earnings expectations for 2013.

Ares Capital (ARCC), a business development company, is selling off its highs. This is a case where the rise in interest rates may not be as bad as some experts believe. For instance, ARCC has variable rates on 75% of the loans it provides to small and medium size enterprises, while it has about 85% of its own borrowed money at low fixed rates. It also has been focusing "on floating rate, shorter duration senior debt investments, and defensively positioned companies..." according to the last conference call. ARCC has positioned itself for a rising interest rate environment, and we continue to think that this is one of the better options in the BDC sector.

BlackRock Health Sciences Trust (BME) is a closed-end fund that invests in a variety of small and large companies in the healthcare industry. It has increased its Net Asset Value by being invested in a very hot industry, and it enhances its income by selling call options on its holdings. This is a well-managed fund, and its high dividend yield includes a year-end bonus payout that it has issued in the past few years. Unlike many closed-end funds, the distributions from BME are not "return of capital," but all profit from investing activities. Any investment in this sector is subject to volatility, but this fund is the best one we know for both diversification and income. We consider it a long-term buy, despite its gains in our portfolio.

GAMCO Natural Resource Fund (GNT) has been our only loser. It is also a closed-end fund heavily invested in commodities stocks and especially precious metal miners, which have been hammered for two years. Like BME, this fund writes options to enhance income, but due to the poor market for its holdings, it has lost value, and 75% of the distribution is "return of capital." That means that its real income yield is now about 4% maximum. We think that any long-term, diversified portfolio should have at least some exposure to gold-related stocks, despite their current level of unpopularity. Unfortunately, the issue we see with the gold price being below production cost for many miners is that funds like GNT that invest in a broad group will get hit with failure of some of its holdings. We will drop GNT from our portfolio.

We think that a safer investment may be in a single low-cost producer with a sustainable dividend. We propose substituting Alamos Gold (AGI) for GNT in the portfolio. AGI has a small 1.5% dividend that is not as high as some miners for now, but we think that it has the best chance of sustaining and increasing that payout and holding its price for the long haul. AGI has very low sustaining "all-in" costs, under $900 an ounce, and no debt service. The payout is only 27% of already slashed earnings estimates so there is room to grow. AGI may get a big bounce if the gold market recuperates, which it will surely do in time. Other comments on miners and gold can be found in our article, Finally, A Reason to Buy Gold Miners.

For speculators that like a larger yield and are willing to take more risk, Barrick Gold (ABX) yields 5.40%. ABX has low sustaining costs, but some analysts expect a dividend cut due to the big write down of its Chilean operation. The current payout represents only about a third of reduced earnings estimates, so the cut is no sure thing. The capital appreciation potential of this stock may make up for any dividend reduction. The silver lining is that any writedown will help cash flow by providing favorable tax treatment for several years. This one is strictly for intrepid investors.

RAIT Financial Trust (RAS) has held up better than most REITs in the war on dividend stocks, and there are reasons for that. The diversified property owner and manager is selling at a discount to book value and a P/E less than 6 times 2013 analysts' earnings estimates, which have been bumped up recently. The company does have a high debt load, as most REITs do, and is actually a turnaround company. Nonetheless, RAS has increased its dividend five times in the last six quarters, so the turnaround looks complete.

Legacy Reserves LP (LGCY) is a master limited partnership that engages in the acquisition and development of oil and natural gas properties primarily located in the Permian Basin, Mid-Continent, and Rocky Mountain regions of the United States. In the month since the "Bernanke scare" about rising interest rates, the West Texas Intermediate oil price has increased more than 12%. We do not think that the interest rate scare should trump the obvious increase in revenues and cash flow available to upstream developers such as LGCY with better oil pricing. It appears that this is a case of throwing the baby out with the bath water, as pipeline MLPs are less likely to benefit from the oil price increase than LGCY. The recent purchase of additional Permian Basin properties appears to be a timely move, although the dilution of added units has kept the price of LGCY subdued. With an 8.5% yield that is 80% of 2012 cash flow, there is not much room for error in the operations. However, with higher prices and the added production from acquisitions, this ratio should improve.

Alternates:

Following is a table including alternates that we have either recommended in the past or are watching closely. If we do not reinvest dividends, we accumulate funds that occasionally allow us to add a stock for diversification. These are some that look like possible candidates that readers may want to consider if they are uncomfortable with the ones above. These are generally larger companies; therefore, some people consider them less risky and more stable than our smaller dividend payers.

ALTERNATES:SectorJan-13CURRENTGAINDIV %
CompresscoOil Services$ 17.50$ 21.6023%8.30%
WhitestoneREIT$ 13.50$ 16.3521%7.00%
ExelonUtilityna$ 31.83na4.00%
Barrick GoldGold Miningna$ 15.74na5.40%
CypressTechnologyna$ 12.46na3.80%
Universal Insur.Insurancena$ 8.25na4.10%
Alamos GoldGold Miningna$ 13.08na1.50%

Compressco (GSJK) is a past recommendation that is an MLP that provides services to enhance production in oil and gas wells. It may be better than LGCY for investors seeking less exposure to the volatility of oil prices.

Whitestone (WSR) is a REIT that invests in strip retail centers in diverse neighborhoods. It is a little less leveraged than RAS, and the benefits of the housing boom are probably only starting to be reflected in its revenue, growing about 30% per year.

Exelon (EXC) is an old friend. I bought one share of Philadelphia Electric (its predecessor) in 1982 in a secondary offering... it was all I could afford with my young family growing. In those days, the issuer paid the broker fee, and I added to it commission-free through the dividend reinvestment and stock purchase plan when I got small salary bumps. I used it like a savings account, and eventually I sold all my shares and gave my daughter an Ivy League education. I think I gained about 15 times what I had invested. Despite the experience, I do not like utilities as the over-regulation stunts their growth. I think this one is probably undervalued now, so there is also a chance for capital gains. Besides a good dividend for its group, EXC is a relatively clean producer of electricity, and it is likely to survive Obama initiatives to clean the air better than most utilities.

With the recent rise in the stock market in general, the second half of 2013 may see much sideways market action. Dividend paying stocks with growth prospects help patient investors sleep at night when the market cools.

Source: Refreshing Our Best-Of-The-Best Dividend Portfolio

Additional disclosure: We do not know the circumstances, risk tolerance or investment objectives of our readers. There is no guarantee that any investment mentioned in this article will be profitable or appropriate for readers.