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Portfolio strategy, dividend investing, REITs, value
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Summary

  • Income strategy continues to be a controversial topic.
  • Dividend "zealots" are in actuality investors with a clearly defined goal.
  • Don't necessarily be swayed by "bubble" commentary.
  • Approach income investing with a balanced perspective.
  • 5 income securities to buy and 5 not to buy.

Portfolio strategy exchanges, just like political or religious discussions, can turn into touchy squabbles in a hurry. While constructive critiques and "mine is better than yours" arguments can serve informational purpose in the investing realm, they nonetheless can turn deleterious when belligerence overrides enlightenment. Such seems to be the case when various income strategies are challenged.

While growth investors seem to have a fairly focused goal - grow capital by generally any means possible, the income investing milieu tends to be a bit more choppy, with a host of security types, yield points, and perceived risk involved. Further, given the relative lack of free yield available today, investors are utilizing more aggressive methods to achieve nominal yield points than they have historically. Thus, given the nature of the income beast and the current ZIRP environment, there is going to be a plethora of opinions on what types of securities should or should not be utilized in both retirement and non-retirement income portfolios.

Are You A Dividend Zealot?

I tend to chuckle when dividend advocates, more specifically dividend growth investors, are accused of being zealots, fanatics, or are told that they are investing the wrong way. While DGI may not represent the most sensible path for all, it is certainly a solution with significant allure for a passive investor with a predilection for a growing income stream and agnosticism to capital fluctuation.

Late last year, Larry Swedroe, who has spent a great deal of time picking on dividend investors, wrote an article titled "Misguided Interest In Dividend Paying Stocks." In the article, Mr. Swedroe referred to total return as "the right approach." While I actually tend to agree with his contention that total returns are more predicated on a slurry of fundamental data and not forecasted by dividend behavior, I believe his commentary discounts the fact that some investors have goals beyond capital growth or total return.

Therefore, when he states, "there doesn't appear to be any advantages to a strategy of investing in dividend-paying stocks," I think he misses the point of what a dividend payment represents and why some investors are highly attuned to receiving them.

Now before I'm flamed for asserting that dividend growth does not necessarily represent a cogent total return philosophy, I'll state that I consider dividend growth a narrowly-defined and perhaps "backdoor" method of capturing total return. Since earnings beget dividends, and dividend payments are arbitrarily controlled by a corporate board of directors, it seems to me that the variable which begets another variable is a more important item in the analysis pool. But that's just my opinion! That being said, I think dividend policy/history does seem to have variable impact on price, but in general, it would seem to be variably subservient to other factors.

Further, I am very agnostic to the question of whether dividend payers are "better" than non-payers to own over the long haul. While some are inclined to refer to academia studies and papers - and I find those reports interesting for some light bedtime reading - I continue to opine that investment success is relative to specific securities picked, as opposed to any one strategy or type of security that might predominate a portfolio. One can certainly cherry-pick data points and sources that can bolster a contention one way or the other.

See It From Both Sides

The prejudice for or against dividend stocks or what they represent is certainly not the only bias that exists in income land. Some commentators apply broad brush negativity to bonds, mREITs, as well as other elevated yield fare, usually without much in the way of explanation other than that there is "risk" involved. Although use of the word seems to have quieted down for the near term, there was a point where it seemed like every asset in creation was enveloped in a bubble, whatever that may mean.

Having a balanced perspective can get you past the polarity that tends to exist in asset class discussion. Bonds may not represent a great total return idea today, and may pose opportunity cost in a rising rate environment, but compared to cash, the yields are good and the capital risk, in general, still low. Mortgage REITs may have a convoluted structure that lends to volatile income streams and market pricing, but guess what, Annaly (NYSE:NLY) and American Capital (NASDAQ:AGNC) got way below book value and have rallied 10% near term. Bonds and mortgage REITs won't offer the perception of value for everyone, but if you take the time to understand both sides of any given story, you'll be in a better position to make the best income-related decision for your overall portfolio and income needs situation.

Option-income closed-end funds (CEFs) are generally written off immediately by many income investors, because they possess yields of roughly 10 percent, which infers "risk." However, their diversified portfolios and the tax-deferred income that is generally thrown off makes them a solid consideration for many portfolios, yet, there is tremendous bias against them. Why? Because investors are constantly pressured into believing that higher yield necessarily engenders higher risk, which does not always have to be the case. I would opine that "income alpha" can be achieved by not allowing prevalent types of bias to get in the way of thoughtful consideration of the universe of income strategy and/or vehicles.

Strategy Session

If there's one piece of advice I would offer to income investing neophytes or those who are in the process of transitioning over to one, it's to investigate each and every general strategy type, as well as every kind of income security you can before committing capital. Though capital and income dependability risks will vary from sector to sector and security to security, the self-directed investor should always be aware of what's out there.

Two general caveats that I would point out are that the equity market has basically doubled from the financial crisis lows of 2009, and that interest rates, while well off their lows of last year, certainly have more room to run to the upside than the downside. Ergo, dividend equity earnings multiples are higher today than five years ago, and the bond market could possess much more general downside risk than upside potential at current levels. Take those admonitions in any way you see fit.

Having said that, following is a diverse list of income securities that I currently own and would consider at current prices:

  • Prudential Global Short Duration High Yield Bond (NYSE:GHY) - Trading at a 7% discount to NAV and possessing 30% leverage, this fund yields 8.5%, while investing nearly 90% of assets in B/BB paper. Fund duration is a very low 2.5 years.
  • American Realty Capital Properties (NASDAQ:ARCP) - A real estate investment trust (REIT) yielding 7.2% investing in primarily triple net, standalone commercial properties.
  • ConocoPhillips (NYSE:COP) - The world's largest independent energy exploration and production company. Yielding around 4%, COP trades at about 11X this year's earnings expectations.
  • Prospect Capital (NASDAQ:PSEC) - A business development company (BDC) investing in a portfolio of 130 middle market companies either directly or through private equity. The stock yields around 12% currently, and trades at a slight premium to last stated net asset value. The dividend was slightly uncovered by NII recently.
  • Cisco Systems (NASDAQ:CSCO) - Pre-eminent networking company. Though the company's growth pattern is erratic, it yields 3.5%, trades at a cheap valuation, and continues to be a cash cow, aggressively returning that cash to investors.

Here is a list that I also own, but would not buy at current prices, as I see corporate valuations as high relative to forward growth prospects:

  • Johnson & Johnson (NYSE:JNJ)
  • Colgate (NYSE:CL)
  • Disney (NYSE:DIS)
  • Costco (NASDAQ:COST)
  • Diageo (NYSE:DEO)

Summary

Everyone has their own idea of what's right and what's wrong when it comes to income investing. Of course, what might be right for them, might not be right for you. Though there is usually some pro and some con to every kind of investment or strategy, income or not, don't let yourself get fooled into believing that something is better than it really is, or is as necessarily bad as someone makes it out to be.

Disclosure: I am long COP, DIS, PSEC, ARCP, GHY, CSCO, JNJ, CL, DEO. 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: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.

Source: Don't Let Income Strategy Bias Intimidate You