5 Forecasts For Income Investors

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 |  Includes: BPL, EPB, LINE, OILT
by: Roger S. Conrad

Wall Street's January ritual is to roll out new investment strategies. This year, fund manager Bill Gross has proclaimed the end of a 30-year bull market for bonds. So it's no great surprise income advisors further down the food chain are pushing investors to adjust portfolios for higher interest rates.

To be sure, Mr. Gross' fixed income offerings have bled red ink in the face of rising US Treasury bond yields. But not all income investors are suffering.

The Alerian MLP Index, Dow Jones Utility Average and S&P 500 Telecommunication Services Index all posted double-digit gains in 2013.

(click to enlarge)Click to enlarge
Source: Bloomberg

In any given year, some dividend-paying stocks outperform, while others lag. Our biggest winners in 2013 were out-of-favor resource companies such as Freeport McMoRan Copper & Gold (NYSE: FCX). Our laggards were conservative fare investors had previously favored.

That tendency of sector performance to reverse from year to year-always contrary to prevailing market sentiment-is one big reason we don't mind holding leaders and laggards at the same time. More important, however, healthy and growing companies raise dividends over time, regardless of sector.

This strategy builds wealth over the long haul, regardless of prevailing market winds.

Diversification and balance remain essential as we begin 2014. Here are five forecasts to consider.

1. Dividend growth will drive returns, but only when companies beat expectations.

Dividend growth is the best antidote to the two primary dangers in income investing: Inflation and credit risk. A rising income stream backed by a healthy, growing business holds its purchasing power over time, even if the value of money itself declines sharply.

Equally, there's no better sign a dividend is safe than an increase. And rising dividends drive stock prices higher over time.

That being said, investors have flocked to dividend-paying stocks since this bull market began in March 2009. High-profile stocks with records of strong growth now carry high expectations. And if a company boosts its payout less than expected, the stock will sell off.

Once high-flying El Paso Energy Partners LP (NYSE: EPB) dropped almost 20 percent within a few days in early December. The partnership announced a distribution growth target of 2 percent for 2014,--well below a previously stated goal of 5 percent to 6 percent.

Distribution growth alone will not push share prices higher in 2014. Rather, companies have to surprise to the upside. And that's become exceedingly difficult for many market darlings.

High-quality, high-growth companies are still portfolio bedrock. In fact, despite delivering a total return of 69.6 percent in 2013, Oil Tanking Partners LP (NYSE: OILT) is still a good candidate for more upside, as new storage projects accelerate the master limited partnership's (NYSE:MLP) distribution growth.

The ability to deliver a positive surprise, however, is much greater with companies whose dividend growth has lagged.

There's always the risk that the weak earnings behind stalled dividends won't strengthen. But as we saw with the 67 percent return delivered by Buckeye Partners LP (NYSE: BPL) last year, there's nothing like a return to dividend growth to spur capital appreciation.

And if the US economy continues to strengthen, other stocks could follow Buckeye Partners LP in 2014.

Learn more about our favorite energy-related MLPs in 3 Master Limited Partnerships to Buy Now.

2. It will be a tough year to make money in bonds.

I give no credence whatsoever to the oft-repeated prediction that we've entered a 30-year bear market for bonds. But there's little doubt it will be difficult to make money in fixed income in 2014.

Ironically, US Treasury securities may be the safest corner of the bond market. Last year's 72 percent rise in the 10-year yield was the biggest in decades. The 10-year yield is now four times that of equivalent Japanese government bonds, despite a 19 percent decline in the yen-US dollar exchange rate in 2014.

That fact alone may lure global investors to Treasury securities this year, particularly if inflation fails to clear the Federal Reserve's 2 percent threshold for a tighter monetary policy. But it's indisputable that Treasury paper is already pricing in a lot of tapering that has yet to occur.

In contrast, corporate bond yields are still near generation lows. The yield premium gap between high- and low-quality bonds is similarly narrow. And Detroit's bankruptcy and Puerto Rico's weakening finances have dramatically increased credit risk in the municipal bond market.

Bonds still have a place in a diversified income portfolio. But the risk of rising corporate bond yields and/or municipal defaults argue for a strategy focused on short maturities and high credit quality. That was at least a breakeven approach last year. Shooting for yield, in contrast, was a loser and is likely to be once again in 2014.

3. Stocks priced in currencies outside the US dollar will rebound from a weak 2013.

Despite the incessant bickering in Washington, DC, the US dollar reasserted itself as the world's reserve currency last year. The greenback rang up gains against almost every major rival except the euro and rose 28.3 percent against gold.

The once-promising bitcoin has recently seen wild swings in value and now faces a crackdown in China and other Asian nations. And the Australian dollar-US dollar exchange rate has plunged by almost 20 percent, fully reversing an uptrend that began four years ago.

As a result, many high-quality stocks on foreign shores are again cheap. And the rock-bottom expectations they carry won't be hard to beat in 2014.

Many investors will be tempted to use the new year to unload any stocks that lost ground in 2013. And international stocks could slip a bit further in the early months of 2014, especially if the strengthening US economy drives the dollar higher

One thing is certain: Our US dollar can buy more of first-rate companies overseas than it's been able to in quite a while. And history has repeatedly demonstrated that these instances are the time for patient investors to strike.

4. Short interest in high-yielding stocks will remain elevated, increasing the potential for short squeezes.

The fearful consensus' conviction that dividend-paying stocks must follow the bond market is as strong as ever. That alone has triggered unprecedented short volume in high-yield stocks, where trading has historically been quite sleepy.

Short sellers borrow stock from their brokers, with the idea of buying the shares back at a lower price. They make money when stock prices fall and are responsible for paying dividends as long as they hold positions. Most also use a degree of leverage to magnify potential gains.

Short selling is particularly elevated in stocks whose dividends are considered at risk. More than a few have weakened, rewarding those who shorted early. But with so much piling on, the opportunity now is on the long side.

Investors who buy Linn Energy LLC (NSDQ: LINE), for example, can capture a distribution yield of more than 9 percent. And if the energy producer's unit price rises further because of solid fourth-quarter results or a distribution increase, they may benefit from a short squeeze.

That's what happens when short sellers try to close positions at the same time to cut losses. In Linn Energy's case, short volume equals about 5 percent of units in circulation, or 7.1 days of average trading volume.

That's a lot of potential buy orders that could come on the market at the same time. The result would be a quantum leap in Linn Energy's unit price in a very short period of time. Look for more such opportunities next year, particularly if the US economy surprises to the upside. (See Our Economic Outlook for 2014.)

5. Returns from dividend-paying stocks in 2014 will be as poorly correlated with interest rates as they've been the past 21 years.

Dividend-paying stocks behave like other stocks. They perform better when the economy is healthy, and suffer their worst losses when it craters as in 2008.

Interest rates can be an important factor, but only insofar as they affect companies' ability to grow. A direct correlation between interest rates and performance of dividend paying stocks is non-existent. (See Myth-Busting: Rising Interest Rates and Dividend-Paying Stocks.)

  • Exhibit A: The yield on the 10-year Treasury note rose by more than 70 percent in both 2009 and 2013. However, dividend-paying stock indexes across the board finished both years on higher ground.
  • Exhibit B: Since 1992, dividend-paying stocks finished universally lower only in 2008. That was a year of falling interest rates, with the yield on the 10-year Treasury note plunging by more than 44 percent.

That's why I'm focused on my companies' growth first and foremost as I execute my income investing strategy. Here's to a super 2014!

Disclosure: I am long OILT, FCX, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.