This will probably be the most controversial part of the strategy, and was the most difficult one to write. Part 4 provided a group of investments to achieve our current high yield-on-investment with moderate risk strategy. Given limited capital, we need to decide which investments will best meet our goals. This requires that we deliberately exclude other investments from our portfolio. In this last part of the strategy discussion, I will identify investment types which may not achieve this goal.
Many investment alternatives do not meet my investment criteria, although they may meet yours. I am not proposing that you sell everything that you own; rather, I am sharing ideas of what you could consider as being outside a current high-yield, moderate risk and defensive portfolio. That said, I do own a few securities that fall into these categories for various reasons, so these limitations and/or exclusions are not iron clad:
1. Retail, technology, manufacturing, media, defence, business and retail services, and other (admittedly these may be growth) sectors do not figure in my strategy, so are under- or not represented in my portfolio. These are generally inessentials, and I am trading off capital growth for steady and high dividends; I also cannot seem to find many securities that meet my yield hurdle and other requirements in these industries. My apologies to those who hold Wal-Mart (NYSE:WMT), Microsoft (NASDAQ:MSFT), GE (NYSE:GE), Disney (NYSE:DIS), Raytheon (NYSE:RTN), Fedex (NYSE:FDX) and other big-name dividend payers/growers in these sectors, but the current yield is insufficient to include. Of course, if you had acquired these at low prices, and enjoy a high yield on investment, then perhaps these should remain within your portfolio.
2. Divest securities which pay low dividends or do not pay dividends – preferably for a gain – and which do not have a strategic purpose in your portfolio. A 2% dividend, even growing at a high 10% annual rate will take a generation to match the present-value of an annual dividend yield of 6% - check my earlier article for the mathematics and graphs. Most of the past decade’s big technology winners and losers fall into the low-to-no yield category, including Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Research in Motion (RIMM), Hewlett Packard (NYSE:HPQ), and others. Apple may have been (and perhaps will continue to be) a brilliant company - technologically disruptive, and a high-growth stock. About 85% of the 41 analysts covering Apple on AOL.com rate Apple as a “Strong Buy”. For a high-yield dividend investor, the 0% yield makes it a sell! This is not a question of a right or wrong rating; rather, it is a choice of strategy.
3. Do not invest in heavily-indebted companies, unless the nature of the industry is to extensively employ debt. I agree that there is “good debt” – often leasing companies, REITs, pipelines, shipping, and other asset-based companies have a higher degree of financing than would be found on the balance sheets of other industries, but do your homework. The companies that align their debt with their income streams can provide better results than those with no debt. High-debt companies may find it difficult to continue their high dividends in times of increasing interest rates. There are several ratios which can help investors assess the level of debt in target investment, and each industry has different norms. Compare important ratios, such as debt-to-equity and interest coverage for comparable companies, in order to understand this risk.
4. Exchange Traded Funds (ETFs) may be a buy-high, sell-low investment category, unless managed carefully. The nature of most ETFs is to be fully invested. They may be forced to buy more securities within their asset class when the market rises, and when investors liquidate, may be obligated to sell their investments at lows. If you feel strongly that ETFs complement your high-yield strategy, invest carefully in this segment; determine an exit point; and ensure that yield compensates you for the risks.
5. Be cautious when investing in securities domiciled in the PIIGS (Portugal, Ireland, Italy, Greece, and Spain). For example, the domestic Spanish telecom business of Telefonica (NYSE:TEF) may shrink with continued high (20%+ official) unemployment in Spain, despite its growing developing country exposure. Based upon earlier comments, I understand that many high-yield investors perceive that Telefonica (TEF) has an excellent risk/return investment candidate. I may someday jump in, but the yield will need to be very tempting – north of 15% for me, as I believe that they are heading towards debt issues and a dividend cut – also do not forget that Spain’s withholding tax is 35%, so my target 15% yield is really 10% after taxes – I suggest that we should be well-compensated for the additional sovereign (and capital-loss) risks. Other PIIGS also have securities trading with attractive yields. Although there may be some very good candidate investments, which include high-yielding shipping companies located in Greece, I propose that you seek (shipping and other) investment alternatives in safer domiciles, such as US, Norway, Bermuda.
6. Limit direct investment in developing countries. Outside of the developed countries, corruption is rampant, economically destructive, and impairs proper business governance (read: financial reporting). The information sources are not reliable. For example, many SA authors have reported that the dividends for emerging-market companies are grossly over-stated in North American financial sources. Muddy Waters LLC makes a business of identifying shorts based upon “fictitious” (they use the more politically correct term “opaque”) balance sheets and income statements. Transparency International has a colour-coordinated map which describes this perception of corruption, so you would compound your business risk through direct investment. Achieve this diversification goal by investing in global companies which are represented in these markets, or funds which have a broad regional base. Frankly, I do not believe that many developing countries have sufficiently mature governance structures or reliable operational and financial reporting; the language, governmental, and unfamiliar cultural and legislative barriers, also concern me. It seems unwise to compound economic and business risks with all of these additional unknowns.
7. “Why not buy a bond if you want a static yield?” is an excellent question that was asked by a tragicslip in his comment on a previous Seeking Alpha article. If you believe that we will experience inflation, then stocks should preserve your capital better than bonds, and our assumption is that the bond market is heading down, as interest rates will rise (over a 5 – 10 year time horizon). What will happen to the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) and other bond funds should we experience a 5%+ interest rate hike? That said, interest-rate sensitive securities – specifically high-yielding common stocks – will also head south; my belief is that bonds have a lot further to fall.
8. US Royalty Trusts and any other investment vehicle which extinguish the asset with their distributions qualify for a “sell” rating. The high yield is tempting, but you are simply getting back your own money. Lacking a means to reinvest and build their business, all of them will (eventually) reach a zero-value. I would like to get my money back from my investments, so this is a non-starter. Let’s look at an example. Back in January, 2011, there were fantastic articles about the value of BP Prudhoe Bay Royalty Trust (NYSE:BPT) - BP Prudhoe Bay Royalty Trust: The Most Overvalued Trust of All, BP Prudhoe Bay Royalty Trust: Most Overvalued or Most Misunderstood? (Part I), and (Part 2). The two authors did brilliant work examining the return and assumptions around this royalty trust, and the many comments from eaders added to our understanding. Regardless of the financial models and exact calculations, the conclusions were consistent – this royalty trust was overvalued relative to the expected return over its lifetime. If this would be common shares, with the ability to invest and build the business (and sustain the payout), perhaps it would be an attractive investment; however, with the depleting asset, the yield is only the return OF (not return ON) your invested capital, with the hope of timing the market for the right exit point before the asset value equals zero.
9. Securities and other investments that do not provide an easy exit strategy; do not permit you to recover your investment; or lock-in investors for a very-long term at current (low) rates, should be avoided. Non-publicly-traded securities can be difficult to liquidate and recover your investment. Insurance annuities consume your capital, and may be impossible to exit – an article which proposes that you create your own annuity - Forget The Insurance Company, Build Your Own Annuity, written by The Financial Lexicon, raises some excellent points in this area, and, again, the comments add to our understanding of this trade-off. Intelligent Speculator has also recently authored articles on this topic. With the current, rock-bottom interest rates, long-term yields from annuities, bonds, and illiquid investments, are correspondingly low – and these are being dragged lower by the Twist program in the USA.
There is one notable consideration from my perspective - if and when interest rates rise, buying a long-term investment at a high yield can be a hugely beneficial. For those Canadian readers in the baby boom generation, mortgage rates in Canada in the mid-1980s ran to about 15%. I know of one investor who bought a 25-year bond with a 13% annual return. Another bought a government strip bond with an imputed rate of return of over 10% annually. Therefore, if and when rates become high, go long; until then, stay away.
10. There are some very clever people in the market who aggressively trade options on their investments. Although I avidly follow their publications and activities, their timelines and objectives differ from mine. To be frank, I also lack the confidence and risk appetite to take big plunges (in other words, they have more guts, experience, and knowledge, with options trading). For me, these are limited to a handful of covered calls and puts. I avidly follow an author that writes well-explained articles on options - Kevin M. O'Brien, and a comment on a recent Seeking Alpha article from fullyinformed also endorses this approach to earning a yield without owning the security:
I take the approach that rather than even owning these stocks I would rather pick some very strong blue chip companies such as Intel or MSFT and sell naked put options on them in a reverse naked put ladder manner in order to gain the income from the premiums while at the same time avoiding the stock... with a little more knowledge an investor can more than double those dividend payments while protecting themselves from stock depreciation. Teddi Knight fullyinformed.com
11. Depending on your risk profile and outlook, you may choose to “double down” and buy on margin. My perspective is that this moves the portfolio from moderate risk to high risk. Given that the approach is to move to smaller-cap stocks (which does magnify the risk), buying on margin will further exaggerate your risks. A more conservative approach is to play the market without debt, so that you can ride-out the troughs. Debt and margin compound your risks in a market which lacks consistent direction. If you feel that you should use financial leverage in your investment portfolio, I would propose that you stick to the North American, larger-cap securities. You should not be averse to holding some cash to wait to see what happens for correction/buying opportunities. If these do not arise, then continue to hold some cash – with zero interest rates, and lots of volatility, there is almost no opportunity cost.
12. Precious metals, shares in precious metals producers, and funds of these commodities, do not typically generate significant yield (without selling options). I identified some yield-oriented alternatives in a previous article, Buying Gold Without Sacrificing Yield. Other authors get excited about gold and silver producers which provide “fat” 1% - 3% dividends; respectfully, these do not meet my criteria for “high yield”. The likely paths include convertible debt, preferred shares, and other yield-oriented hybrid securities. Unfortunately, I found few candidates – regardless of their issuance price, they seem to be selling at high premiums and have imminent redemption dates. Many of the North American listed companies and ADRs (including those with preferred or convertible issues) have most of their operations in Africa, South America, or other developing countries – an example is AngloGold Ashanti Limited (NYSE:AU). In addition to low dividends, there is sovereign risk. I wrote a blog that examined a Canadian gold income fund, but found that the fees were too high. Perhaps someone has high-yield (CEF, convertible debt, or other) recommendations in this precious metals space?
13. I know that this will be an unpopular position, but you may want to cancel your participation in certain Dividend Reinvestment Plans (DRIPs), in order to decide what to invest in, and time the volatile market. I am not proposing that you cancel all DRIPs – some may be for strategic, portfolio building purposes – but it is likely that you can outperform your DRIP, and should certainly make active decisions on when and how to reinvest your income. For a more comprehensive explanation, please refer to: Dividend Reinvestment Plans, Part 2 - The Case Against DRIPs. This is not to propose that DRIPs are not useful for building wealth or for constructively using growing dividends. I am sure that someone can empirically demonstrate that if one invested $1 in Procter & Gamble (NYSE:PG) on October 31, 1837, when it was “born” (source Wikipedia), that it would be worth $1 “zillion” today, if one had reinvested through a DRIP. The point that I am making is that DRIPs are not necessarily part of a high, current yield-on-investment strategy. I use a handful of DRIPs – mainly with Closed-End Funds (CEFs) – to grow certain portfolio positions, but otherwise prefer to accumulate and reinvest my cash dividends.
You will need to make your own luck in the market, for the next few years. There is no clear direction, and the threats/risks appear to outweigh many of the opportunities.
What securities should you hold and buy?
- Buy mainly high-current yield securities.
- Make many small investments in mid and small-cap, moderate-risk/higher-pay-off propositions.
- Earn current, high dividends to pay you a lot, early, and often.
- Geographically diversify into other developed markets.
- Focus on sectors that people “must” use (financial services, utilities, energy, telcos, and food).
- Buy reliable companies. These need not be “the best” in their market segment (which contradicts Warren Buffett’s strategy); rather they should have adequate balance sheets and income statements to support the dividends.
- Do NOT buy investments which do not meet your yield and risk-mitigation criteria. There may be a lot of smart financial analysts out there, but they may not share your strategy.
If you buy solid securities on corrections, such as current-high-yield and dividend-growth stocks, then you should continue to build your defensive portfolio.
In subsequent articles, I plan to identify specific securities to help attain the high-yield goal. There are frequent lists and analyses that relate to mREITs, MLPs, and the other US yield-oriented security-types, and listings of a small set of the same foreign high-yield, mega-cap stocks seem to be the subject of daily articles. I will not focus in the usual areas. Instead, I will explore alternatives in areas such as US small/mid-caps, Canadian REITs, Australian Utilities, and other securities which can be purchased on North American exchanges or Over the Counter (OTC) by US and global investors.
One last point; I appreciate your ideas and constructive feedback in the comments. We regularly see philosophical investing differences and ideas, and I enjoy the learning opportunities from my colleagues. In which geographies and industries are you investing for high dividend yield (my definition: +5% after taxes – and let’s assume a 30% tax rate)? How are you managing your portfolio risk? Why have you chosen these securities and your strategy?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.