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By Mark Bern, CPA CFA

<< Click to view Part 2

In Part 2 of this series I provided a brief summary of Part I, my thoughts on diversifying into investments denominated in other than the US dollar, and four defensive, equity-income offerings. In this article I intend to provide my thoughts about using precious metals and/or commodity-based equities for hedging purposes as well as the next four defensive, equity-income offerings of the series. Part 1 included an overview of what I intended to accomplish with this series, why I decided to write these articles now, and the first four equity-income offerings.

I am not a gold bug, but I wish I could have said I was starting a decade ago. I've never caught the fever for investing a disproportionate amount of my portfolio into something that does not pay interest or dividends. But I do own a relatively small amount of silver in small denominations. I prefer junk silver coins because the silver content is evident and I can buy them for very little or no premium over spot prices. Why do I choose silver over gold? It's a personal preference, because I hold precious metal for two reasons: a hedge against inflation and the very long shot that social unrest and/or another greater financial crisis create a temporary disruption in our traditional economic transactions processing system. I like small denominations because I don't want to ask for change in emergencies for an ounce of gold that may have a value of $2,000 or more. Gold may be a great store of value over time, but it wouldn't work as currency when I want a loaf of bread and some milk. I don't really expect a crisis of that proportion to occur, but if it does, I'll have what I need to get me through a few months.

The other, more practical reason I like silver over gold is two-fold as well: the historical gold/silver ratio is telling me that gold is over-valued relative to silver or that silver is under-valued relative to gold; silver, while still abundant, has a growing number of industrial uses. Silver is not just jewelry. It gets used and discarded more often than gold. Nearly all the gold ever mined is still in existence today. That is not the case for silver; silver is consumed and eventually, as demand continues to grow and supply of easy-to-mine sources dwindles, the price will be forced higher by normal supply/demand relationships.

Some would say that it is nearing that point already, but I'm not buying that story yet. Peak silver, in my opinion, will play out in a fashion similar to peak oil. When it seems that we're going to see demand exceeds supply, miraculously exploration companies locate new reserves that are more costly to recover, but there just the same. There are hard to reach areas of the globe that haven't been explored yet. If the price increases enough and there is evidence that demand will keep continue to increase even with prices at elevated levels, I fully expect that new, more costly silver reserves will be located and mined to meet demand. Gold prices are driven more by psychological concepts. I prefer prices driven by demand.

In the comments for Part II it was suggested that oil might be a better commodity to invest in than precious metals because investors can purchase equity shares in oil companies and earn dividends. Well, I have no problem with that. As a matter of fact I agree with that concept for the inflation side of the equation. But that doesn't address the other, albeit long-shot, possibility that social unrest and/or another greater financial crisis create a temporary disruption to transaction processing. Having some cash on hand might solve that problem and it might not. Plastic cards for credit or debit could be worthless for a time. Withdrawals from the bank or credit union will be impossible.

We were actually very close to such a scenario in 2008, when large electronic runs on money market accounts almost caused a panic. Fortunately the Treasury and Fed officials recognized the potential threat and, within hours, announced an increase in the federally insured maximum balance for each account from $100,000 to $250,000. That move quelled the run. People with more than $100,000 in each account were scrambling to reduce their balances to less than $100,000 fearing more failures when Lehman fell.

My point here is that we came much closer to the edge than the majority of investors realize, and the potential contagion from Europe could be much greater than officials are willing to admit. Thus, we could be closer to the edge than we think we are, and nobody knows for sure. I certainly don't, and I'm pretty sure that those who say they do know are only listening to those sources with which they agree. Isn't that always the case?

I'm not trying to scare anyone here with claims of doom and gloom. I'm actually on the side of the fence that believes that the worst that will happen can be contained and accommodations will be made to keep Europe from falling off the cliff and taking us with it. But I don't want to be caught with my pants down, either. So, all I'm recommending is that investors be prepared for the worst, just in case, with some small portion of their savings.

Now, I'd like to get back to oil versus silver for a moment, because I left something out. I can't spend oil shares. I can't even spend precious metals mining shares. I should be able to spend cash, but I know that sticking it under the mattress will surely loose me money due to inflation. So, I hold a little silver in coins for the very long term with the expectation that eventually future supply/demand imbalances will support sustainable price increases without the fear of inflation and that if inflation does occur I will also have some additional protection. Plus, in a pinch, I can spend the stuff if necessary. Nothing is perfect, but this suits me and it covers all my bases as long as I don't go wild and buy too much. Too much of any single asset increases the overall risk of a portfolio.

My first equity offering is designed to bolster the portfolio income: Annaly Capital (NYSE:NLY), a mortgage REIT that currently touts a dividend yield of 13.9%. I added this company to the list because of the recent announcement by the Federal Reserve that short-term interested rates are likely to remain near 0% through all of 2014. The announcement, of course, is an attempt to drive perceptions and could be changed at any time should inflation rear its ugly head. But with a recession in Europe becoming almost a sure thing and slowing growth on a global scale, even in emerging countries, the likelihood of inflation getting out of hand for the foreseeable future is relatively small.

The wild card, of course, is if the Fed decides that more quantitative easing is necessary or if it decides to help bail out Europe with massive loans. The Fed has overstepped its mandate before, and I believe that current leadership may be willing to do so again if it deems necessary to mitigate another global financial crisis. Again, this is purely speculation on my part, but there is little left that could surprise me anymore. I don't expect much, if any appreciation from NLY, but do expect that even with Operation Twist narrowing margins somewhat the dividends should remain above 10% through 2013 and into 2014. You will find a more detailed report on NLY here.

Year

2006

2007

2008

2009

2010

2011

EPS

$0.76

$1.22

$2.20

$2.73

$2.51

$2.65*

Div. / Share

$0.57

$1.04

$2.08

$2.54

$2.65

$2.44

*Estimated

My second equity offering is TECO Energy (NYSE:TE), a regulated electric utility based in Tampa, Florida that also has a coal mining operation (unregulated). The current dividend yield is 4.8%, well above the average in the electric utility industry and more than doubles the average yield of the S&P 500. TECO has a solid balance sheet and despite the problems in housing around the state the company fared will throughout the recession. The company trades at a bit of a premium to the industry but for good reason. Expectations are for earnings growth to top 10% on average over the next few years due to increases in coal prices, expanded coal production, and increased demand for electricity in an area with a growing population.

The company recently discovered a new deposit of metallurgical coal beneath its existing reserves and intends to produce about 2 million tons a year from the new reserves beginning in 2014. Met coal commands higher prices for its use in making steel. Also a single, large coal contract that has remained underpriced until renegotiated recently will increase the bottom line by about $24 million a year beginning in 2012. The company is poised to grow nearly twice as fast as the average electric utility and I expect higher than average dividend increases as well.

Year

2006

2007

2008

2009

2010

2011

EPS

$1.17

$1.27

$0.77

$1.00

$1.13

$1.30*

Div. / Share

$0.76

$0.78

$0.80

$0.80

$0.82

$0.85

*Estimated

My next offering is Chevron (NYSE:CVX), the fourth largest oil company in the world based upon proven reserves. The current dividend yields 3.0% and the trailing 12-month P/E ratio is 7.9. The company recently reported a positive earnings surprise with EPS rising 74% over 3rd quarter result of 2010 and about 30% higher than street expectations. CVX has increased its dividend every year for 24 consecutive years. Earnings could level off for the next year unless the average price of oil increases from current levels near $100 per barrel. I expect that by 2013 the average price of oil will again reach higher levels with the overall trend remaining intact even though there are likely to be some relatively wide swings. We are that many years away from an average price per barrel closer to $125. Gradual improving global demand for energy will favor this well-managed, quality company with sustainable growth opportunities. Find more detailed reports on CVX, XOM and other oil companies with rising dividends here.

Year

2006

2007

2008

2009

2010

2011

EPS

$7.80

$8.77

$11.67

$5.24

$9.48

$14.40*

Div. / Share

$2.01

$2.26

$2.53

$2.66

$2.84

$3.09

*Estimated

My final equity offering is Walgreen (WAG), the largest drug retail chain in the U.S. by sales and number of stores (CVS has more total revenue, including its PBM business, but less from retail and fewer stores). The loss of its relationship with Express Scripts has done three things: caused management to cut expenses to make up for the lost revenue, is likely to result in higher margins on the remaining sales, and has caused the stock's price to drop nearly 25% providing ample cushion and a good entry point.

The bad news is already in this stock, in my opinion, and the best part is that the profit lost will not be as great as the revenue lost due to very slim margins on the Express Scripts business. Now the company is free to go after corporate clients traditionally served through the former ESRX relationship without having to share the revenue. For many of those prospective clients the loss of access to WAG pharmacies for their employees will not be acceptable. I expect WAG to claw back a portion of the lost business at higher margins.

Also, WAG derives higher margins from generic drug sales than from branded sales. The next two years will see some very prodigious opportunities due to many major branded drugs coming off patent. The effects of the recession on WAG earnings per share were minimal as I would expect since people still need to fill their prescriptions. The dividend currently yields 2.6% and has been increased in every year for 36 consecutive years.

Year

2006

2007

2008

2009

2010

2011

EPS

$1.72

$2.03

$2.17

$2.02

$2.16

$2.64

Div. / Share

$0.27

$0.33

$0.40

$0.48

$0.59

$0.80

Once again, I hope that at least some of the information included in this article has been useful to readers. If you only find one new stock to add to your portfolio that performs well for you over the years then the time spent reading was worthwhile. Please do your own homework on these or any other stocks you read about. Well-informed decisions are generally better decisions. I wish you all successful investing decisions and, as always, look forward to your comments.

>>Click to view Part 4

Disclosure: I am long CVX, NLY, WAG. I expect to add shares of TECO Energy to my portfolio in the next few weeks.

Source: Building A Capital Preservation And Income Portfolio, Part 3