Should You Avoid REITs, MLPs And Utilities In This Market?

by: Rob_Stein

Since the last two weeks of May, there has been a lot of chatter in the financial press about rotating out of dividend paying stocks. For example, in a recent interview Jim Cramer indicated that in the current market he would avoid "higher yielding equities" (specifically utilities, consumer goods, MLPs and REITs), basically throwing cold water on the carefully crafted portfolios of many of us looking for solid companies providing both growth and yield over the long term.

On CNBC he said:

"I'm not a buyer of stocks that have higher yields because strong data sends interest rates up. In turn, higher rates nullify the advantage of higher yielding equities. So utilities, consumer packaged goods, master limited partnerships and real estate investment trusts are all to be avoided."

The rapid rise in 10-year bond yields last week, combined with (or caused by) concern that the Fed may begin to cut back on its QE bond buys and signs of strengthening in the economy, has led some to conclude that interest rates are turning up - spelling doom for dividend stocks and warnings to avoid asset classes such as Utilities, MLPs and REITs.

Since many of us, and particularly retirees, have portfolios we have created over time with a diverse mix of solid dividend paying stocks including these sectors, we are faced with the classic dilemma of what to do in the face of this change in the market.

For example, I am a retiree and have had long standing positions in Duke Energy (NYSE:DUK), Spectra Energy (NYSE:SE), Amerigas Partners (NYSE:APU), Magellan Midstream Partners (NYSE:MMP). Health Care REIT (NYSE:HCN), Kraft (KRFT), Procter & Gamble (PG) and others in these sectors.

High Yielding Equities Are Indeed Richly Priced

The fact is that dividend paying stocks have had a very nice run in the past year as investors searched for yield and were unable to find it in bonds or other fixed income asset classes. Many of these stocks have run up so much they have become expensive based on historic norms for their PE multiples.

In a recent Seeking Alpha article I noted this and recommended the selected trimming of positions that had run too far and have become overly expensive, or had grown to an outsized percentage of a portfolio. Verizon (NYSE:VZ) and Phillip Morris (NYSE:PM) were two examples in my own portfolio.

Those advocating a rotation out of dividend paying stocks correctly point out that as interest rates rise, there will be increased competition among asset classes for yield, and bonds will become more attractive drawing investors (buyers) away from high yielding stocks.

We saw this in reverse over the past few years as the Fed drove bonds (the traditional asset class for income seekers) and bond yields down, creating the current rotation into high yielding stocks.

Now, if interest rates are poised to rise (as they did strongly last month on the ten year note - up from 1.61% at the beginning of May to 2.172% at the end of May), we could well see a rotation out of high yielding equities and back into bonds as yields rise.

It was difficult not to notice how hard utilities, MLPs and REITs were hit in the selloff at the end of May. In utilities, for example, Duke Energy was down 8% and Exelon (NYSE:EXC) was down 10%; in REITs, Realty Income (NYSE:O) was down 17% and Health Care REIT was down 14%; in MLPs, Kinder Morgan Energy Partners (NYSE:KMP) was down 6%.

As a long-term investor, however, I cannot agree that the thing to do here is to avoid (or bail out of) high yielding stocks for several reasons:

  1. Selling out of these stocks because interest rates are expected to rise is not investing - it is trading and market timing.
  2. While interest rates may indeed rise there is a great debate over whether the rise we saw in May was the real thing or overdone. Goldman Sachs and UBS are on opposite sides of that debate. Goldman believes the bond selloff (which raises yields) is the real thing while UBS says the market overreacted. At issue is the guessing game over when the Fed will cut back on its QE bond buying.
  3. Since no one knows what the Fed will do or when, and since those actions are dependent on how strong (or weak) the economy is going forward, the premise for avoiding or rotating out of dividend stocks is based on guesses.
  4. Long-term investors hold dividend paying stocks to collect the dividend over extended periods of time - looking also for some growth over time. This kind of investment plan and thesis calls for staying with solid companies as they rise and fall over time - more likely adding to positions in times of weakness rather than bailing out.
  5. The current selloff could also easily be nothing more than the long awaited pullback/correction after the markets' recent 6 month rise.

What to Do

My investment thesis is to buy and hold a diverse group of strong companies that pay a dividend and offer growth potential over time. They can be found in every sector of the market. Having a diverse group of these companies means that as rotation occurs where one sector falls out of favor and another takes its place, you will see these companies periodically get mispriced either too high or too low.

Examples of such companies (all of which I have owned for some time) are: Linn Energy (LINE); Magellan Midstream Partners and Kinder Morgan Inc. (NYSE:KMI) in MLPs; Duke Energy, Spectra Energy and Amareen (NYSE:AEE) in utilities; Health Care REIT, HCP, Inc. (NYSE:HCP) in REITs; Verizon and Vodafone (NASDAQ:VOD) in telecommunications; Kraft, Mondalez (NASDAQ:MDLZ), Altria (NYSE:MO) and Procter & Gamble in Consumer Goods; Conoco Phillips (NYSE:COP), Total (NYSE:TOT), Phillips 66 (NYSE:PSX) and Holly Frontier (NYSE:HFC) in Energy and Refining; Intel (NASDAQ:INTC) and Microsoft (NASDAQ:MSFT) in technology; Raytheon (NYSE:RTN) in defense; Nucor (NYSE:NUE) in steel.

Rather than sell completely out of a position or sector when it becomes too high, I prefer to trim it back and then refill the position when the market takes it in the other direction.

The market will rise and fall with changing economic news and the companies I own will do the same. A long-term time horizon reduces the noise of day-to-day events and eliminates guessing on the market's direction.

Interest rates may well be poised to rise - but as a long-term investor I will not sell out of them or avoid them even if the market rotates to other sectors or asset classes. If they decline below what seems to be fair value as the market rotates, I would add to positions.

Disclosure: I am long AEE, EXC, MO, PG, SE, APU, HCN, KRFT, MSFT, INTC, PM, TOT, COP, HFC, MDLZ, NUE, PSX, VOD, DUK, KMI, MMP, RTN, VZ. 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.

Additional disclosure: Disclaimer: Investing is uncertain. Opinions, statements and references to securities in this article should not be considered recommendations to any person or entity.

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