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Question of the Week: Desperately Seeking High Yields

|Includes:BLXJF, BRLXF, Qualcomm Inc. (QCOM)

In this space, I answer a frequently asked question. I hope you find this week’s entry helpful.

  • I lost a great deal of money over the past two years and am anxious to recoup by investing in high-yielding stocks. What can you recommend with a yield of at least 15 percent?

First of all, you’ve got to get out of the mindset of trying to recoup what you lost the past two years.

What we went through was a truly historic event, i.e. the worst credit environment and sharpest economic contraction since the Great Depression of the 1930s. Everything lost money except money market accounts and US Treasury bonds, and that’s only because Uncle Sam backed up both with our tax dollars.

Investors who stuck with stocks and fixed-income securities (bonds, convertibles and preferred stocks) backed by strong underlying businesses have made back a surprisingly big chunk of their losses. But chances are even they’re under water. And those who were seduced by junk during the last boom--or who bailed out at the bottom earlier this year--are permanently out.

I know it’s hard to do, particularly if you didn’t hang in there to enjoy this year’s rally. But you’ve really got no alternative but to put the past behind you. That means positioning your remaining funds in the best possible way for the future, not trying to make back what you lost. As someone a lot smarter than me once said, the market doesn’t know or care who you are or what your objectives are.

Point No. 2: When something yields as much as 15 percent, there’s usually a good reason why. Back at the bottom in early March, there were plenty of investments backed by high-quality companies paying out that much. The reason was that investors were deathly afraid of everything except cash and Treasury bonds after what had been an historic decline in the market. Yields were that high because no one wanted to take the risk.

That’s no longer the case today. Rather, anything yielding upward of 15 percent is almost certainly at high risk to a dividend cut. It could prove to be a big winner if the underlying business challenges are resolved, both for yield and capital gains. But it could also lose a lot of money if the dividend is cut, as the stock sells off in response.

Once in a while in this business there’s a seminal moment where the nature of the market becomes clear. Back in the ’90s, the craziness surrounding Qualcomm (NSDQ: QCOM) stock was a red flag that investor appetite for technology stocks had run too far and a crash was imminent.

This decade, it’s been all about yield--a good thing I think because dividends had too long been discounted as a way to build wealth. Over the past couple of years, however, yield investing too has reached an extreme.

Last year, for example, an investor emailed me a list of 12 stocks yielding 20 percent and up. He then proceeded to berate me for running an income portfolio where the average yield was roughly 7 percent. What he failed to realize is that every last one of the stocks on his list had already cut its dividend and was rapidly sliding toward bankruptcy and a total shareholder wipeout.

In contrast, those boring 7 percenters have held their own during one of the worst periods of market history.

I currently recommend a handful of investments with extremely high yields. One of these is Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF), a Canadian trust that derives essentially royalty income from power plants run by its parent Boralex (TSX: BLX). It pays out monthly at an annualized rate of nearly 16 percent, mainly because of one of its biomass power plants has been shuttered due to troubles in the Canadian timber industry that supplies its woodwaste fuel.

If Boralex can resolve the situation, we’re going to have a big dividend and capital gain. If not, the units are likely to sell off, though downside would be protected by the low price of 89 percent of book value.

I’m willing to hold Boralex Power for two reasons. First, I think it has a good chance of beating expectations, mainly getting the woodwaste plant problem resolved.

More important, however, I’m comfortable because it’s just one high-yielding and less secure stock in a portfolio of companies that are primarily lower-yielding but far more reliable and growing.

Even if Boralex Power craps out, my overall portfolio isn’t going to suffer. And if it pays off, it has the potential to strongly boost my returns.

Third quarter earnings, for example, were solid; management affirmed the current distribution after making up a small distributable cash flow shortfall with its ample cash reserves. Cost-cutting and hydro performance almost completely offset the negative cash flow from the biomass operations. Even management, however, acknowledged in its conference call that it needed to resolve the biomass situation to hold the dividend long term.

If you want to go high yield, I can’t urge you enough to construct a similar portfolio. It may sound counter intuitive in today’s yield-crazed environment, but a 7 to 8 percent yield growing 5 percent a year is going to make you a lot more money than a 15 percent yield that’s perpetually at risk and won’t grow at all. That’s because share prices always follow rising yields higher. And if you hold on long enough, your current income will be higher as well.