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We established the assumptions for the economic environment and examined the baseline dividend-growth model in Part 1. The conclusion is that we are not on a course of high growth and good economic times. As well, the total yield, dividend growth model, may not provide the returns that we seek. Now we will examine high-current-yield, and how this can be managed to be less risky than generally perceived. The next step is to explore how yield and market capitalization should fit into your high-yield investment model.

Yield

You should take prudent risks with your stock investment portfolio in order to generate above-average current yield from long-life investment assets. Overweight current-yield in order to get paid on your investment, upfront. Given the market uncertainty, improve the probability of a positive return by receiving high dividends. Supplement the high-current-yield on investments with a modest allocation to dividend-growth securities which have geographically-diversified income streams and assets. As a Canadian, my local currency investments are over-represented in my portfolio, and you should adjust to meet your personal and currency diversification needs.

If you are seeking a high yield on investment, I propose that we use a hurdle of at least 5% AFTER TAXES to pay for the volatility risks. Then you will need to look to the mid and small capitalization stocks, The Dividend Champions, Aristocrats, and other dividend-growth categories that do not have many securities providing a current yield in excess of 5% -- even if your tax rate is 0%.

There are many Seeking Alpha contributors whose articles and comments provide an excellent framework to include yield as part of your portfolio return. Many reasons have been identified – dividend-payers have lower volatility; better price performance; are better managed for long-term growth; and have built-in inflation protection – to name a few of the major benefits. One comment that I particularly liked as it has the additional goal of compensating for bond holdings, from Richjoy403:

Fortunately, I don't need the high yield stocks for income, but I find them useful to both offset my present modest allocation to bonds (given present rates and trends), and because they tend to dampen portfolio volatility.”

Excellent advice is offered by many SA authors, but regardless of the analysis, the current 3% yield on Johnson & Johnson (NYSE:JNJ), Pepsi (NYSE:PEP), Coca-Cola (NYSE:KO), and other blue chip, dividend-growth stocks will not reach a 5% after-tax yield for many years. These securities are also subject to the same price-decline risks as the rest of the market. I propose that your yield should pay you to take the risks of participating in a volatile market.

The bottom line is that you will need to consider your investment goals, and be an active manager of your portfolio in order to attain your target yield. What should you be thinking about to plan your financial future? I propose that you need to defensively posture your portfolio to create a very-high yield and mitigate risks through global diversification.

One risk is dividend cuts from high-yielding companies. One can mitigate the risk through research – examining pay-out ratios, cash-flows, and other financial factors. That said, dividend reductions may be unavoidable, and can occur because of economic and/or market conditions – witness how the decline in natural gas prices impaired the dividends of certain natural gas exploration and production companies. As long as each security represents a very small portion of your total portfolio, the overall impact would not be material.

There is one other important point about high-yield securities, which is particularly important in a low-growth environment. Your expected return is based on yield only; market-share / sales growth is not a prerequisite to your investment. As long as the company maintains (rather than grows) its revenue and manages its cost structure and payout ratio, there is no need for growth. If I can receive a 7% yield in a 1% inflation environment for 5 years, and get my money back at the end, then I am a winner (by 6% per year, compounded). It does not matter to me if the share price and top-line sales have not increased – the only goal is high-yield on investment. The main assumption is that you can recover your invested capital across your entire portfolio – your invested portfolio value is returned at the time the securities are sold (share price winners and losers net-out).

One last clarification is about taxation. Our hurdle should be after-tax yield – not stated yield. Although this is an individual financial attribute based on one’s personal marginal tax rate, there are certain generalizations that we can make. Investments in limited partnerships or other non-corporate structures may not provide you with the return that you anticipate. MLPs (Master Limited Partnership) are typically taxed at your personal marginal rate, which is usually far more than dividend taxation. Although a partnership may have a stated yield of 7%, you may only keep 5%, depending upon your marginal rate and taxation jurisdiction. Perhaps you would be better off with the same pre-tax yield from a corporation / dividend? This also proposes that one must be strategic about what classes of assets are kept in tax-sheltered accounts. REITs and CEFs (Closed-End Funds) with managed distributions often provide the yield as a return of capital, which has a taxation deferral benefit, but raises security-valuation concerns. I have modeled various Canadian investments and tax rates -- Canadian readers can read one of my blogs Minimizing Income Taxes on Your Investments to help choose your form of investment income to minimize income taxes. Perhaps one of our colleagues can identify a similar article for U.S. and other readers?

Market Capitalization and Asset Allocation

Market capitalization and certain other balance sheet and income statement metrics will help us assess the risk of our investments. Market cap and debt levels are not the only measures, but are reasonable indicators of risk of both mitigating capital losses and dividend reductions. Certain companies provide their investors return in the form of capital growth, and others provide it in the form of dividends (or a combination of both). The mega-capitalization dividend-paying companies rarely have high yields (with the exception of business models, such as MLPs, BDCs, and mREITs, which are designed for high distributions). Therefore, one needs to look at smaller capitalization companies.

Conveniently, Jeff Paul recently analyzed dividend-growth stocks, with a focus on small caps, and reached an interesting conclusion:

I proceeded to sort the DCC universe by market cap and highlighted the top 25% ... The U.K. research found that stocks in the Top 25% based on market cap underperformed the other 75%... The study found that higher yield stocks had higher total returns over the long run.

Based on historical results, the DCC-SmallCap-HiYield portfolio had the highest yield of all the groups, which surprised me. I expected small caps to invest more and payout less, though I did filter to take the highest yielders from each sector. This group also had the highest payout ratio, and lower dividend and EPS growth rates. Given that the yield is 50% higher than the top 25% group’s yield, the lower dividend growth rate may not be a huge short-term issue to income investors, as it would take some time for the top 25% group’s yield to catch up (at 5 percentage points difference per year, around 10 years).

With this in mind, you are now in the business of looking for smaller-cap target investments, while closely managing portfolio risk. Investment advisors and gurus come up with metrics that you hold 10 – 12 equity positions. I do not want to start a debate on this topic, but will share an observation. Jim Cramer’s recent program proposed that you hold only 10 equity positions, but his charity site currently has 34 open positions (okay, this portfolio is also a "little bigger" than mine). Typically, the advisor selects very-large-cap stocks or funds to represent the entire industry or geography, and then follows it closely, as each pick is 8% - 10% of the equity portfolio. This tends to result in a low-risk, moderate-yield outcome. I propose that you do NOT pursue this approach. A high-yield, moderate risk strategy demands a much broader spectrum of stocks in your target portfolio.

I suggest that you start with a base of dividend-paying blue chip stocks. Certain global banks, telcos, consumer products, pharmaceutical, and utilities, pay generous dividends for relatively low risks. These should form 33% - 40% of your portfolio. To start, you need to actively manage this defensive position – exchange your lower-yielding dividend aristocrats for those with a richer yield.

To achieve the higher total portfolio yield, you generally need to move to smaller-cap stocks - although preferred shares, Master Limited Partnerships (MLPs), Closed-End Funds (CEFs), Mortgage REITS (mREITs), REITs, Business Development companies (BDCs), and other specialized investment vehicles may help achieve this goal. As your risk would be magnified – one management misjudgement or legislative change can erase a small company – you should diversify into many more than 10 small / mid-cap stocks. The number is a personal preference, but depending upon the size of your investment portfolio, this may be in the range of 30 to 60 additional, mid and small cap equities (and if you do not employ a discount broker, then the first step is to move to one in order to reduce your transaction costs). Each mid / small-cap security should represent an average of 1% – 2% of your portfolio.

They should collectively provide current yields at least 3% above your core, large-cap holdings. In other words, 60% of your portfolio should lift your current dividend yield by 3% from the large-cap base. For example, if you have a $100k portfolio, and $33k is invested in 3% yield dividend-growth stocks (providing $1k income in the 1st year), then you need the other $67k of your portfolio to provide a current yield of 7.5% (and generate a yield of $5k/year) to achieve an overall portfolio yield of 6%.

This is not to propose that you should desperately buy all of the securities with high yields. In fact, there are far more candidates in the global market than you can use to build a reasonable portfolio. The goal is to buy high-yielding stocks in less-volatile industries. Take your return as dividends exclusively, and do not count on any return from capital growth. Think of your overall portfolio as a single certificate of deposit. This approach should change the distribution and number of securities in your portfolio.

Click to enlarge

Asset Allocation Pie Chart

The impact is that:

1. You cannot hold too many, low-yield dividend-growth stocks if your goal is to attain high-current yield. You will need to reallocate to higher-yielding blue chip securities. For example, If your portfolio is over-represented with lower-yield dividend-growth stocks, and you want part of your portfolio to have this characteristic, then you may want to sell PEP, KO, or JNJ, (current yield of around 3%) and buy AT&T (NYSE:T) (a dividend-growth stock which yields 6%) or Bristol Myers Squibb (NYSE:BMY) (yields about 5%). Again, the goal is to keep these lower-yield large caps to 1/3 of your portfolio, but raise the yield of this dividend-growth allocation.

2. You may need to invest in generally higher-risk and higher-yield securities. In other words, you may choose to sell your lower-yielding dividend champions – which are largely mega-cap, dividend-growth stocks -- in order to buy more small/mid-cap, higher yield-on-investment stocks. You may have historically attained a high total return on the dividend champions, but that is a different strategy. If you choose a high current yield on investment, then you cannot afford to over-represent these low-current-yield securities.

3. In order to manage the risk of owning the smaller companies, your investment size and target industries must be carefully selected. For example, buying a small utility with a regular income stream (and assets such as dams, pipelines, and wires) has a different risk profile than buying a technology start-up, where the balance sheet consists of goodwill and intellectual capital.

4. Smaller capitalizations do present greater risk of insolvency, and this is the reason to invest in “bite-sized” chunks. Investing 10% of your portfolio in AT&T, with its $172B market capitalization, has a different risk profile than investing in Atlantic Power (NYSE:AT), with under $1B market cap. This is why one should spread the investment risk across more securities.

By holding many securities, a 3-bagger will not have a huge impact on your portfolio, but neither will a dividend cut or bankruptcy. The point of holding a large and diversified portfolio is to mitigate the downside, while enjoying the higher yield.

Although I am not seeking capital gains, this strategy can also be an enabler for total returns. Not only is your yield magnified, but it is easier for mid and small cap companies to grow. Your move down the capitalization “food chain” may enhance your return through growth. That said, the low-capitalization stocks are typically more volatile, so this is not a “sleep well at night” strategy.

To summarize, in Part 1 we identified the likely future investment environment, and that dividend-growth stocks provide a moderate yield, and rely on capital appreciation for a substantial portion of the total return. This article (Part 2) proposes that we seek a higher, tax-adjusted dividend yield, by moving down the “food chain” to lower capitalization stocks with higher yields. In order to mitigate risks, each holding should be substantially smaller than the “sleep well at night” positions, but we should also retain 1/3 of our holdings in the higher-yield end of the dividend-growth space. In Part 3, we will examine how global and industry diversification can promote higher yields and reduce risk, but portfolio management will require more effort.

Source: Positioning Your Equity Portfolio For High Yield With Moderate Risk, Part II