Income investors face two challenges in the current environment -- they need to combine high income with safety. Neither is easy right now. With the Federal Reserve holding short-term rates below 0.5% since 2009, the challenge of finding income has left many investors with more risk than they are comfortable holding. One example of this is master limited partnerships (MLPs), an asset class that promised high income but carried hidden risks. The chart below shows Alerian MLP ETF (NYSE: AMLP), an ETF that tracks an MLP index. These were actually investments in the energy sector rather than fixed income trades and when oil fell, AMLP got crushed.
In this case, chasing a 6% yield resulted in losses that could take years to recover. AMLP fell more than 50% in the energy crash. Investors who bought near the top remain almost 30% below their breakeven price. The price decline has cost investors years' worth of income and they are likely years away from breaking even.
The good news for investors in AMLP is that this is an index ETF and suffered average losses. Some of the worst-hit MLPs may never reach their old highs and many have slashed payouts, reducing income as capital losses mounted.
MLPs are not the only source of pain for income investors. High yield bond funds have also been hit by the decline in oil. Some ETFs tracking junk bonds had significant exposure to the energy sector. Unless investors did extensive research on their fund's holdings, they might not have realized what they owned when they bought what looked like an income investment. Later, when it was too late, they learned it was an energy trade.
Fortunately, it is possible to find high yield investments that have some degree of safety. One way to do this is with large cap stocks. Any stock has risk but stock in a large company has less risk than a smaller company. Large companies have usually demonstrated an ability to survive at least a few ups and downs of the business cycle and while past performance is no guarantee of future performance it is the best information we have to forecast the future. A company that survived the Great Recession, for example, has demonstrated an ability to navigate through adverse economic conditions. These companies should be safer than companies with an unproven track record.
Right now, many large companies offer high yields. But, I'm sure you remember a high yield is only one requirement of an income investor. Safety is the other, and arguably most important, requirement. We can screen stocks for safety by considering their earnings. Some investors will argue the ability to generate earnings is not the best way to measure a company's safety. However, the company will need to make money in order to pay dividends, so earnings do enhance the safety of a company's dividends.
Technically, dividends are paid from cash flow but earnings are still important since companies with losses generally don't pay dividends. Just to be safe, I screened out companies with negative cash flow from operations.
We will limit our search to stocks in the S&P 500 since these are considered to be among the most stable companies. We also require a yield of more than 5%, positive cash flow from operations and a consensus analyst estimate that the company will be profitable in each of the next three years.
It might be surprising but just three stocks met these requirements this week.
CenturyLink Inc. (NYSE: CTL) is in the midst of a transformation from a regional telephone company to a global data carrier. The company operates 55 data centers in North America, Europe and Asia to manage a network consisting of 250,000 miles of fiber optic cable in the U.S. and an additional 300,000 miles serving overseas markets.
The company beat earnings expectations last quarter but the stock sold off, creating a buying opportunity for income investors. CTL now yields about 8%. The high dividend is well-covered by cash flow. In the conference call with analysts after earnings were released, management confirmed it is on track to generate $1.8 to $2 billion in free cash flow this year, about $3.80 a share. This is more than enough to cover the annual dividend of $2.16.
The company is expected to report earnings per share (EPS) of about $2.40 a year in each of the next few years. EPS could increase because of a new government program that subsidizes internet access for poorer households. CTL, as a large provider of that service in rural states, could enjoy an increase in revenue and profits as the program rolls out.
The long-term chart shows CTL is near an important support level. Sell-offs in the past five years have been stopped near $25. A break below this price would be a sell signal and buying at the current price is a low risk trade.
Our next income opportunity carries a yield of 7%. HCP, Inc. (NYSE: HCP) is a real estate investment trust (REIT) focuses on the healthcare. HCP has ownership interests in more than 500 senior housing facilities including independent living facilities, assisted living facilities, memory care facilities, care homes and continuing care retirement communities. It also has interests in approximately 310 post-acute/skilled nursing facilities.
HCP recently announced plans to spin off its skilled nursing and assisted living assets into a newly created REIT. This will leave the original company with high-quality cash flows from private-pay assets that generally aren't dependent on government reimbursement. The properties HCP is retaining in its portfolio have the strongest growth potential. Income investors will benefit directly from HCP's growth since REITs are required under tax rules to pay out substantially all of their earnings to investors.
For now, the stock is likely to trade within a narrow range as investors await additional details on the spin-off. After the details are clear, the stock could rally as investors see the growth potential of HCP.
Another factor that could boost the prices of REITs is Standard & Poor's decision to recognize REITs as their own sector. Previously, REITs were included in the financial sector. On September 1, REITs will receive their own category within S&P's Global Industry Classification Standard (GICS). All stocks are currently assigned to one of 10 sectors under this standard which has been in place since 1999. Some analysts believe this change could force portfolio managers to move up to $100 billion into the REIT sector as they rebalance their portfolios.
Another REIT rounds out our list of safe income stocks. Host Hotels & Resorts, Inc. (NYSE: HST) is yielding 5.3%. Host owns and operates luxury and upper upscale properties in the central business districts of cities and near resort/conference destinations. Host's property portfolio consists of over 100 luxury and upper-upscale hotels containing approximately 57,000 rooms, with the majority located in the United States and with approximately 20 of the properties located outside of the United States, in Australia, Brazil, Canada, Chile, Mexico and New Zealand. Host's properties include hotels under the Ritz-Carlton, Hyatt, Marriott and Starwood brands.
HST has grown revenue steadily at an average rate of 4.3% in the past five years. Earnings have grown an average of 40% a year over that time while cash flow increased an average of 6% a year. The dividend has increased from $0.14 a share in 2011 to $0.80 last year. Another bullish factor from the financial statements is that long-term debt has fallen from $5.8 billion to $4 billion in the past five years.
From a technical perspective, the long-term chart shows this should be a low-risk entry point. HST has found support near $15 since late-2011. For two years prior to that $15 was a resistance level. The longer support or resistance it holds the more important it becomes.
Income investors could benefit from the recent pullbacks in these three stocks to lock in high levels of income that are likely to increase in the future.