Positioning Your Equity Portfolio For High Yield With Moderate Risk, Part IV

by: Monty Spivak

In previous articles, here, here and here, we looked at holding many more securities, with high yields, to improve the return and risk profile of your portfolio. Now we will examine which investment domains provide the high dividend yields and lower risks sought by income-oriented investors. Some of this summarizes and/or clarifies the information of the previous articles.

I have targeted my securities acquisitions to these areas, but remain cautious and patient – do not overpay! Although only one person buys at the bottom price, your goal should be to invest at a relatively lower price in order to obtain a higher yield. You may want to hold a little cash for these buying opportunities if you believe that a further correction is imminent.

1. To recap, build a portfolio which is less weighted in large-caps, and over-weighted in mid-cap and small-cap stocks. This is the thesis of this series of articles. In other words, buck the trend:

a. 60% - 70% of your portfolio should be in small and mid-cap stocks, rather than the standard model to overweigh large-cap, growth or dividend-growth stocks.

b. Growth and higher dividends are generally available on the smaller end of the spectrum.

c. Most small-cap companies are riskier propositions, so buy small positions in small increments. Certain smaller-cap companies may be large in their market niche, so your risk may be mitigated. As well, a mid-cap company in Canada may be a micro-cap company in the US, so local conditions also apply.

2. Buy more Australian and Canadian securities - higher yields; healthier (resource-oriented, export-oriented) developed-country economies; and lower sovereign debt.

a. Sovereign balance sheets should become an important investment criterion. Australian-domiciled exporters and multinationals are a safer way - from a governance, currency, and language perspective - to invest in Asia.

b. Canadian banks, oil and gas, and REIT sectors have many investment candidates. Canadian banks may be particularly better risk/return opportunities than generally perceived. To emphasize a comment in an earlier article, the high-risk Canadian mortgage portfolio is basically on the books of the Government of Canada (via the CMHC agency). There is almost no exposure to the PIIGS sovereign debt or their financial institutions, and the governance – around capital, lending policies, and many other banking endeavors – is very highly regulated. Therefore, the risk profile of the Canadian banks is lower than those for most other countries. Currently, you will receive a 5% dividend return, but yields should get better with the market decline - take a look at CIBC (NYSE:CM) and Bank of Montreal (NYSE:BMO) – both traded in New York.

c. Australian energy, utilities, and telcos have solid investment candidates. Their utilities are often structured as business trusts, with stapled securities, and provide above-average yields. Duet Group (OTCPK:DUETF), as noted in a comment by Philipsonh, provides a high yield, and has been working hard to improve their balance sheet over the past year.

d. European mega-caps, courtesy of the PIIGS’ debt, may provide buying opportunities – particularly if Italy or France gets in real trouble. If the UK market is impacted, there may be excellent global high-yield, low-tax investment candidates.

e. On the other side of this equation, if the US budget does not address the debt issues, the lower US dollar (USD) may provide additional leverage for non-US investors to buy USD denominated multinationals (and conversely, US investors’ opportunities to benefit from their currency-diversified portfolio). I do not hedge the currencies, as some to the advantage (and risk) of diversification is from foreign currency holdings.

f. If ADRs are not available, consider buying more securities OTC. This may require more research and effort.

3. Use Closed-End Funds, with managed yields, to attain high-yield and diversification in difficult-to-access or low-yield market segments (such as Asia, precious metals, etc.). There are many choices in the market, and a few SA authors who have provided us thoughtful analyses – perhaps you may want to take a look at some articles in this space by Douglas Albo. For the record, although I have a few CEF holdings, I do not own any of those that he writes about.

4. Buy mainly in the defensive industries. These companies can probably sustain their dividends in tough times and are less likely to go out of business.

a. Even in industries which are necessities, keep your average security holding small for market caps of under $5B to reduce your risk profile. Invest in smaller increments for the higher-risk securities.

b. Energy and infrastructure companies are excellent defensive industry candidates. Energy consumption – even without an upward trajectory – requires very-long-life assets (such as dams and power-generation stations) with steady cash-flow. These are often regulated, which basically guarantees a distribution. Perhaps one caveat is to watch one’s exposure to nuclear power, as one minor reactor accident or a green political decision could eliminate profit potential for a very-long time horizon. Germany is taking steps to shut-down their reactors by 2022, as mentioned in a comment by martinfrosa; this is having a negative impact on power providers E.ON (OTCPK:EONGY) and RWE (OTCPK:RWEOY).

c. Large financial institutions which are “too big to fail” are guaranteed by their respective governments. Although their dividends are not a sure thing, it does make some of them utility-like dividend payers – with government-quality equity. Of course, the quality of their local governments may not be the best. On pull-backs, watch for opportunities to buy under-valued preferred shares (and other special classes of shares, such as Trust Preferred Securities) in the US and global financial sector.

d. Telecom, food, pipelines, logistics companies which form the backbone of trade, and other high-yielding companies should also remain on your investment radar.

e. Nicholas Pardini proposed that you short American companies and industries which are non-essential services to consumers in his article. Not my style – I prefer long positions with yield - but a valid and interesting investment proposition.

5. Producers of commodities / materials provide the building blocks of many downstream economic activities. Some have had a great run and others are relatively low-priced with high yields. If shares of certain producers of foods, metals, or energy sources, decline, and the fundamentals and yield are attractive, then odds are that the price will recover within your long-term investment horizon.

a. There are several Canadian and US small-cap oil and gas companies which meet reasonable risk, high-yield criteria. Moreover, some have far better ratios than the global mega-cap companies, such as BP (NYSE:BP), Total (NYSE:TOT), and Royal Dutch Shell (NYSE:RDS.B). I suggest that the North American small and mid-cap oil companies do not appropriately reflect the value associated with the low geopolitical risk. If there is a revolution in the Middle East, Asia, or South America, one can be certain that Zargon (OTCPK:ZARFF), Linn Energy (LINE), and the other smaller O&G producers have no significant exposure.

b. Unfortunately, relatively few mining stocks - other than perhaps Southern Copper (NYSE:SCCO), or some preferred issues – come close to meeting my hurdle rates, so these may be best addressed through CEFs with option-writing and managed distributions. Look at these corrections as potential buying opportunities. That said, be attentive for a disruptive change, such as the huge increase of the supply of natural gas, on the commodity’s price.

6. Buy global companies with dividend growth, if there is an attractive entry point. Again, given the market volatility and risk, I am not considering securities with less than a 5% AFTER TAX yield, so my opportunities are limited. Your yield hurdle rate may be higher or lower; for example, you may choose to accept a 3% and growing yield consumer-product equity as a component of your portfolio, but your exposure to this sector has current-yield consequences. That said, many articulate and analytical people have demonstrated the advantages of dividend-growth investments, which are over-represented in consumer products. An apt summary of this position is from one of our colleagues, David Van Knapp:

... the prospect of capital gains is one of the attractive features of dividend-growth stocks for many investors. In a perfect world, capital gains and dividend growth come from the same source: rising earnings. In fact, rising dividends are often a precursor to capital gains: It is confident management teams and boards that declare dividend increases of 8%-10% or more, and they often do it because they "know" (in ways that a non-insider cannot know) that earnings are going to increase at a healthy rate for the next 2-3 years.

Frankly, I want to avoid betting that I can buy and sell for capital appreciation at opportune times – share-price appreciation may happen, but it would just be fortuitous. Yoyomama (Five Plus Investor) recently commented on this, and I cannot find better words to describe this perspective:

capital appreciation depends on several factors - market conditions, the quality of stock you buy, technical strength, and the price point you enter. If you buy the greatest stock in the world (or, the lower paying dividend stock) at a 52-week high, when the market is on the cusp of a freefall, guess what's going to happen to your stock... It's a fallacy to believe, low dividend stocks grow in capital appreciation, and high dividend stocks do not. Capital appreciation is entirely dependent on how well you buy.

7. The anticipated high-risk market demands a healthy current dividend yield. You may want to take positions in yield-oriented investment categories, primarily; US mortgage REITs, Business Development Companies, and Master Limited Partnerships (MLPs).

a. Certain US mid and small-cap companies – common and preferred shares – present yield-oriented opportunities. These are often beneficiaries of dividend tax credits to local investors, which may magnify the after-tax yield. I intended to name a few, but Dividend Dog has already published a few that I like. He provides lists which are more than the usual collections of mREITs, MLPs, and BDCs (although I would prefer to see lists with these classes of securities segregated).

b. Mortgage REITs (mREITs): Annaly (NYSE:NLY), and other mortgage REITs are tempting to all of us – who can believe the double-digit yield in a zero-yield world? Plan to invest with a small position and experiment with holding this very-high-yield/high-risk security type. There are daily articles on SA regarding the securities in this space, so there are many opinions and observations to assist with your decision.

c. Business Development Companies: This is another investment class that basically flows-through their income to the shareholder. Again, the high-risk provides the basis for a high return. Perhaps it is my interpretation, but some SA authors seem to like Ares Capital (NASDAQ:ARCC), with its 9.5% yield and $3B market cap, and PennantPark Investment (NASDAQ:PNNT), with an 11% yield and $440M market cap (PNNT is also a dividend champion). Again, there are many BDCs in the market, and each has its own investment types, risk profile, financials, and management team attributes. Perform your own research to ensure that your risk appetite is reflected in this quality of investment, and you may want to take a look at this article, Impact of a Potential Recession on the BDC Industry before you invest, in order to gain a view of the downside risk.

d. U.S. MLPs are a much lower risk/return model, and generally provide higher-than-average current yields. There is a lot of information available, and frequently-published comparison articles to assist with your investment decision. I am concerned that many seem to be trading near record-low yields, and record-high prices. The price of the underlying commodities often impact the price (and yield) of these relatively-safe infrastructure and resource investments. Jim Cramer likes Kinder Morgan Energy Partners L.P (NYSE:KMP), with its $17.7B cap and 6% yield. Most of the major players do not provide a sufficient after-tax yield to qualify for my portfolio, but they may meet yours (particularly for tax-sheltered accounts in the U.S.). For non-Americans, the distributions may have impactful tax liabilities – e.g., 35% taxation on distributions inside of tax-sheltered plans in Canada - so investigate this before you buy.

8. Expand your position in preferred shares at opportune times, but again, these may correct with the banking instability and future increasing interest rates, so watch your target investments and sit on the sidelines until you attain your value proposition.

a. Seek preferred shares which continued to pay their dividends through the crash, and ideally these are cumulative preferred shares (if they miss a dividend, they must pay it before they can pay dividends to common shareholders, or at redemption).

b. Buy preferred shares that are trading below their redemption amounts – particularly if they are past or close to their redemption date – in order to be positioned to avoid capital losses (of perhaps even for capital gains).

c. I would suggest that you consider convertible preferred shares, as they may provide better inflation protection and perhaps some latent capital growth.

d. Lastly, recognize that when rates (eventually) start to rise, all preferred stock prices will be negatively impacted. If you hold these shares to maturity (unless they are perpetual), you will enjoy the yield (let’s say 7%) until you recover your capital. Although rates may rise, it may be a while before inflation exceeds your after-tax 7%.

9. If the pound sterling or euro denominated securities take a big hit, look at food, utility, and other "essential product" securities in these European markets. Mega-cap telecoms, such as France Telecom (FTE), Telefonica (NYSE:TEF), and Deutsche Telekom (OTCQX:DTEGY), are currently paying high yields, and may end up paying extremely high yields (even after potential dividend cuts). Although “wires in the ground” telcos are not that popular with some investors, each of these has a substantial mobile business. That said, with the exception of the UK, the 20% - 30% withholding taxes on dividends in many European jurisdictions dilute the yield, so should temper investment decisions in this area (or at least you should position them outside of your tax-sheltered accounts for a compensating tax credit).

10. Invest as safely as possible to preserve capital and create a high income stream.

a. Should one invest at all, or just hold cash? Sovereign insolvencies, US deficit mismanagement, China’s inflation rate, and many other economic factors, all contribute to our investment climate uncertainty. Holding fiat currencies – basically every paper currency in the world – may not be a solution. Perhaps we are better-off owning part of a business than cash, which is basically a sovereign promise of value?

b. Gold is a non-sovereign currency, but it does not generate an income. For the high-yield investor, it will be difficult to structure bullion holdings as part of the solution.

c. Of course, timing is everything. It is unlikely that you will be the one to buy at the low, or execute the transaction that sells at the high, but you should manage the timing of your purchase - the recent volatility and interest-rate increase “holiday” may make certain investments particularly attractive relative to the risk. On the other hand, if the European debt crisis drags the global economy into a recession, then it will be difficult for companies to maintain their high yields, and the value of your investments may be “under water” for years. All investments are risk/return assessments.

d. Treat your entire portfolio as a yield “machine”. At any time, some securities may be above, and others below, break-even. The plan is to recover your pool of capital at the end of your investment horizon, so you may have time for your stragglers to recover.

Again, the high-yield goal is to mitigate your risk while getting paid early, often, and as much as possible. The nature of this strategy is that one needs to trade-down to smaller and more yield-oriented securities. If this is not your strategy, or represents only part of your strategy, then the above suggestions would not apply.

Perhaps the most difficult part of this series was to decide upon, and document, what one should not buy – or perhaps sell! Part 5 will identify industry, geographic, and market segments which would generally have less appeal to the yield-oriented investor.

Disclosure: I am long CM, BMO, OTCPK:DUETF, OTCPK:ZARFF.

About this article:

Author payment: Seeking Alpha pays for exclusive articles. Payment calculations are based on a combination of coverage area, popularity and quality.
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