Why Income Investing Will Be Difficult In 2013 (Part 2): 2 Safe Income Generators To Buy

Includes: F, JNK, WFC
by: Convex Strategies

Part 1 (Stay Away From Fixed Income) can be read here.

It's quite early, but 2013 has so far gone as many analysts expected it would. Rates on longer dated treasuries have started to break some resistance as the fear trade begins to unwind, equities have been the best performing asset class, and the outlook for fixed income has gotten bleaker.

Though Junk bonds (NYSEARCA:JNK) have held up well as the case for jumping into stocks gets more compelling (or at least more difficult to resist), the 10-year note broke the psychologically significant 2% yield mark on Friday, and the yield on the long bond has risen about 16 bps to 3.21%. Even these relatively small moves have wiped out a meaningful portion of the yearly coupon payments - all the more painful when equities are making record highs.

I truly believe that this is a structural change, as opposed to a head-fake. It's easy to make the case that we saw similar market movements in 2011 and 2012, and that ultimately yields kept dropping, so we shouldn't trust this move either. However, if we look at a variety of market indicators (courtesy of Mark Dow - please read his blog, it's excellent), it appears that the unwinding of the so-called fear trade is unwinding. The takeaway, of course, is get the heck out of long-dated fixed income and rebalance your portfolio to enter equities on pullbacks:

  1. Treasury curve: the 2Y10Y spread is on its way to 200 bps, indicating that investors feel much better about the state and growth prospects of the economy.
  2. EUR/USD currency pair: It's astonishing how quick and violent this move was. We have come a long way from last summer when we watched the pair move down to 1.20 as shorts pilled in. When Europe didn't collapse, shorts got fried and those betting on euro/dollar parity were disappointed. Now on its way back to 1.40, it's clear that its really "risk-on" this time.
  3. EUR/CHF: This might be my favorite example. The Swiss franc was bought en masse as a flight to safety trade, but this too has ended. The pair seems to have broken out of its trading range and is now testing 1.25

All of these indicators are telling the same story: the fear trade, one based on a collapsing Europe, no-growth United States, and impending Lehman-like disaster, is being unwound in favor of trades that are more constructive on beta.

I believe this will result in the following:

  • Holders of equities who have been bid up to lofty levels because of the dividend they offer will see negative returns when they account for the equity component. A 3% dividend doesn't do much when the stock drops 5%. A good example of this kind of stock is Procter & Gamble (NYSE:PG).
  • Holders of US Treasuries, specifically those at the longer end of duration, will begin to feel serious pain as 2013 drags on.
  • Owners of junk bond funds may actually see further price appreciation, in the intermediate term at least, as they benefit from the risk trade.

All this being said, there are many investors who are building retirement portfolios or have needs where income producing securities still make sense. For these investors, we need to find securities that will be largely unaffected by a rise in rates. My recommendation is to avoid fixed income entirely unless it's an absolute necessity. For normal yield-seekers, stocks are the way to go.

What investors need to recognize is that these kinds of securities are by nature going to have to be a bit unconventional with respect to what income investors usually own.

Here are two equity recommendations:

Ford Motor (NYSE:F): I truly believe Ford is as solid as any "typical" retirement-like stock. If not for the events of 2008-2009, I think Ford would be receive much more consideration amongst the income investing crowd.

Currently yielding 3.10%, Ford pays out $1.5 billion in annual dividends compared to $5.66 billion in net income, resulting in a payout ratio of only 27%. I recently wrote that F looks likely to make as much as $2.50 by year-end 2016, which would mean annual EPS growth of almost 20%. I think investors in Ford will be rewarded handsomely over the next few years as Ford continues to increase its payout. Ford is a much leaner operation then it was pre-2008, with a strong focus, superb management, and a competitive position in China.

Trading at only 7.5 times forward earnings, income investors are being offered a 3% yield without risking losses on the equity. Dividend growth has the potential to be far stronger than people are realizing; if Ford does $2.50 in EPS by mid-decade it's plausible that it will be paying at least .70 per share, based on today's payout ratio. This would mean a realized yield of over 5% for those who buy the shares today.

Buying a consumer cyclical for a safe, steady income producing portfolio is uncommon, but its image as a dangerous, economically sensitive company is exactly why the shares are so cheap today. The financial crisis was an incredibly rare event, and Ford was able to manage quite well. Today, with a $10 billion net cash position, strong organic growth prospects, and generous industry tailwinds (exceptionally high average car age, consumer income growth, low interest rates) the next decade will treat both Ford and shareholders very well.

Wells Fargo (NYSE:WFC): In the glory days leading up to financial crisis, the big banks were a favorite place for many to find the combination of equity growth, strong dividends, and rapid dividend growth. Today, financials aren't generally considered for their dividend, though a few of them are yielding nearly 3%. Many have taken advantage of some of the financial preferreds, but those opportunities have largely been eaten up.

Wells Fargo may feel like "slow money" to some. The banking industry is facing some challenges going forward in the form of extensive regulations, weak net interest margins, and the loss of some trading operations. That's all unfortunate, but banks also have a US housing sector on the rise, expanding US business, and the strengthening consumer.

In 2007, when the book value per share was $14.45, investors were willing to pay exactly what they're paying today: about $35. Since then, BPS has grown to $27.64, yet investors are still only paying about $35 per share.

Clearly, investors were paying far too much for WFC in 2007, but paying only 10 times earnings for annual book value growth of almost 20% doesn't make a lot of sense. This is an excellent read on what Warren Buffett likely sees in WFC. In sum, Mr. Buffett typically likes to pay as much as 10x pre-tax earnings, which are $27.1 billion in WFC's case. At a $271 billion market cap, shares would be trading at more than $51.

Sometimes things really are this easy. The general sentiment is that the major banks are still at risk of a major macro event, and that there isn't much upside considering weak developed world growth. Additionally, I'd venture to say that people don't want to "like" the banks as they've been credited with almost destroying the global economy. These bearish, volatility-averse viewpoints have resulted in WFC share prices that are well below their intrinsic values. WFC has the best cross-sell in the industry, and their place as the low-cost producer gives them a major competitive advantage.

Over the next five years, book value will continue to grow at a double digit rate, earnings will improve substantially, and investors' yields on cost will reach mouth-watering levels. Currently, WFC yields 2.80% ($1.00 per share annual payment), for a 26% payout ratio. When we consider ultimate earnings power and a higher payout ratio as regulators give the green light, it seems plausible that WFC could be paying at least $2 a share in 2018. At current levels, that's a 5.7% yield.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here