The investing strategy "sell in May and go away" is ineffective for dividend investors. Dividend investors need to eat and pay bills 12 months of the year. The "sell in May" strategy is highlighted every year at this time. My year round strategy is to collect dividends and use risk management to minimize losses. This article highlights finding reliable dividends versus investing in less reliable income stocks.
Risk Management and Dividend Stocks
The portfolio core should highlight blue chip stocks with consistent dividend growth. I prefer understandable and basic business models. Pepsico, Inc. (PEP) is a perfect example. The company is a major global beverage and food snack operator. Pepsi, in my portfolio, serves as a fairly conservative and safe stock. I don't worry about Pepsi, Mountain Dew, Doritos not being popular in the next year.
Pepsi's Credit Risk
The majority of Pepsi's long term debt has an interest range under 5%. Management has an ongoing stock buyback plan and annually hikes the dividend. A blue chip holding typically has stock increases and a stock buyback plan. Pepsi has access to inexpensive capital for acquisitions or other business model needs.
General Electric Company (GE) has a business model which required a U.S. Federal Government bailout. General Electric had an excellent credit rating at the time. I do not want to own stocks that need to be bailed out by the Federal Government. Capitalism is built upon investing in strong companies that can endure the tough times. On April 4th, Moody's cut GE's credit rating due to GE Capital's risk profile.
Yield on Cost
The yield on cost increases, on a blue chip with dividends reinvested, over time. This is a basic dividend reinvestment benefit. I am comfortable reinvesting dividends in a select few stocks. If I have doubts about a stock's long term viability, then I will keep the dividends as cash or redeploy the funds. There are certain sectors that excel during specific time frames. Annaly (NLY) is an agency mortgage real estate investment trust (mREIT) that is benefiting due to the low Treasury Bond yields and Government Sponsored Entity (GSE) Mortgage Backed Securities (MBS). When interest rates start to rise, mREITs are not ideal for an income portfolio. They have their place and time, but it is not long term like a Pepsi.
The benefit of reinvesting dividends is annual growth for one's income portfolio.
As an example, I could purchase a Pepsi protective put for $138: PEP Jan 2013 57.500 put. This would provide downside protection to the $57.50 price per share. I prefer to not pay for protection. In this case I would sell a covered call to offset the protective put cost: PEP Jan 2013 70.000 call. In this case, I would receive $141 by selling a $70 strike price call that expires in January 2013. This put and call option is a referred to as a collar option strategy and is fairly easy to implement.
Downside protection can be crucial during economic crisis or a sudden downturn in the overall stock market.
Credit Risk and Preferred Stock
Magnum Hunter Resources Corporation is an independent exploration and production company engaged in the acquisition, development and production of crude, natural gas and natural gas liquids. Key locations are the unconventional shale resource plays Marcellus Shale, Utica Shale, Eagle Ford Shale and Williston Basin/Bakken Shale.
The term "preferred stock" sounds like a certain degree of safety exists. One popular income security is the Magnum Hunter Resources Preferred "C" shares (MHR-PC). This preferred stock pays a monthly dividend. The "C' shares are Magnum Hunter's 10.25% Series C Cumulative Perpetual Preferred Stock ("Series C Preferred Stock"). The April dividend is 21.35 cents per share, based on the $25.00 per share liquidation preference.
Magnum Hunter Resources per the below SEC 10K filings lost $76.66 million in 2011 and has lost money in the two prior years. I don't see any safety net in owning the preferred shares if the business is losing money.
The company has a net loss for the past 3 years. The company is operating in high growth areas for oil production. I hope the company makes a lot of money. Hope is not an investment strategy that I recommend. As an income investor, the preferred shares offer zero comfort to me. Unless I have an arbitrage situation and I am short the Magnum Hunter common shares and long the preferred, the preferred shares have substantial risk. A 10.25% yield is not compelling when dealing with an oil company losing money.
Substitute Oil Position
Baytex Energy Corp. (BTE) offers an annual 5.2% annual dividend. The monthly dividend is 22 cents per share. The yield is paid from net income. Baytex has provided a total annualized 26% return, each year, on average over the past 7 years. The shareholders are institutional based and in strong hands, as shown on page 5.
Baytex's business model is ideal. The company hedges its production and pays out only part of their earnings as dividends. This contrasts to Enerplus (ERF) which pays a higher dividend and is not growing. Enerplus 2011's revenues of $234 million were 25% below the prior year's revenues of $315 million.
Baytex is outperforming Enerplus on investment results despite Enerplus' 12.3% annual dividend yield. I believe Baytex is in a better situation for the future. Baytex appears to be in the sweet spot with increasing cash flow, increasing annual revenues, and increasing net income.
I believe it is crucial to keep income investing simple. Investing in a preferred stock has high risk if the company is losing money. Investing should focus upon easy to understand businesses, Pepsi's food and snack space is easier to understand than GE's conglomerate business model. A retail investor cannot define the GE Capital risk profile at any given time.
I believe in owning outperforming business models. If an investor cannot quality what risk exposure a company possesses, then it's easy to find a company that does offer such benefits. High yield does not correspond with being a better investment. The future is what matters. . Income investors seek dividends and reliable income. If there is known risk to the income stream, then an alternative stock can be found and purchased. Investors have to look at the business model going forward, and not rely upon the past glories of any given company.