Dividend Stocks: Which Way To Go - Blue Chips Or High Yield?

by: John D. Thomason

With the Federal Reserve's latest statement (January 25, 2012) serving notice that the near-zero interest rate policy is likely to extend through late 2014, an individual investor seeking income has no practical alternative to dividend-paying stocks. While there are many stocks to choose from, at the highest level, there are really only two choices: invest in bellwether, large-cap, blue-chip stocks yielding, on average, 2% to 3%; or invest in higher-yielding stocks that are less well known, and are likely higher risk. The high-yield stocks tend to be concentrated in just a few groups or sectors. While not an all-inclusive list, some of the most well known high-yield groups are Master Limited Partnerships (MLPs), Real Estate Investment Trusts (REITs), Business Development Companies (BDCs), and Rural Telephone Companies. While investing in blue chips vs. high yields does not have to be an either / or decision, it would be helpful if one could evaluate the extent to which risk is increased when reaching for the higher yields, to determine a reasonable allocation between the (presumed) safer large-cap blue chips and stocks from some of the higher-yielding categories.

A good place to start in assessing the question of how much to allocate to high-yield stocks would be to review some historical results of stocks representative of the various categories. While any investment review of historical periods has to be cognizant of the fact that future results will not necessarily play out as in the past, it is still worth considering, to gain some perspective.

Accordingly, I have conducted a review of eight stocks over the past five calendar years. The review assumes that each stock was purchased at the close on the last business day of 2006, held for five years, and then sold at the close on the last business day of 2011. The first of six tables following shows, for each stock, the relevant buy and sell prices, and each dividend that would have been collected over the time frame. Although not used in the return calculations, the dividends in effect at the point of purchase and sale, plus the calculated yields, are also shown in a separate, smaller table just below the initial table. This provides a view of the stock that the dividend investor had available at the point of purchase and sale. The next three tables show, respectively, the total dividends collected and the associated returns, the capital gains or losses on the sales and the returns, and the total results and the corresponding returns. All returns are shown for the entire period, and also are shown as annualized values, which are merely the period returns divided by five. The return calculations are simplified, and do not consider the time value aspects of when the dividends were received and when the gains / losses occurred. Since all of the stocks paid dividends quarterly, and all gains / losses occurred at the end of the period, this simplified approach is adequate for the purposes of comparison. A sixth table shows the returns for dividends only and in total, from best to worst. The stocks are:

Johnson & Johnson (NYSE:JNJ) - Dow30 Stock, $178B Market Cap, Healthcare.

Procter & Gamble (NYSE:PG) - Dow30 Stock, $178B Market Cap, Consumer Non-Cyclical.

3M Company (NYSE:MMM) - Dow30 Stock, $60B Market Cap, Industrial Supplies

Exxon Mobil Corp (NYSE:XOM) - Dow30 Stock, $418B Market Cap, Oil Major

Annaly Capital (NYSE:NLY) - $16B Market Cap, Financial - Mortgage REIT

Ares Capital (NASDAQ:ARCC) - $3B Market Cap, Financial - BDC

Enterprise Products Partners (NYSE:EPD) - $43B Market Cap, Energy Pipelines, Midstream Operations. Organized as an MLP.

Consolidated Communications (NASDAQ:CNSL) - $552M Market Cap, Rural Telecom Company

The tables are next, 1st through 6th.

These results are interesting, but need to be viewed with some discretion. I have some cautionary thoughts to share regarding them:

NLY has certainly been a winner over the time period. But one must keep in mind that the last three or four years have been ideal for Mortgage REITs, and the next five years may not be as favorable for their unique business models. More details on this topic are available from my most recent article HERE. That article in turn provides links to additional Seeking Alpha articles on Mortgage REITs by various authors.

EPD, like nearly all MLPs, has been "discovered" by investors, resulting in a significant price run up over the time frame, which accounted for over 2/3 of the total return for EPD. I, for one, do not believe that buyers at today's prices will see that kind of appreciation going forward. Also, no one in polite company ever mentions any concerns about U.S. tax law changes that could impact all MLPs (and not in a good way). While I concur that this is not likely any time soon, never say never.

BDCs are more vulnerable than most companies to a significant deterioration of business conditions, as was seen during the financial crisis, because, in general, the companies BDCs loan to or possibly have an equity interest in are smaller, more fragile businesses. ARCC, the BDC selected for the review, did navigate the financial crisis better than most BDCs. See my recent article on BDCs by clicking HERE. Similar to the Mortgage REIT article, the BDC article lists several Seeking Alpha authors and their articles related to BDCs.

CNSL was unique of the eight companies reviewed in that the dividend stayed the same for the entire five years. The issue with the Rural Telecoms is that they have to find alternative revenue streams, such as offering broadband, to make up for the inexorable decline in their land-line telephone installations. The results for our Rural Telecom representative would not have been as encouraging if, instead of CNSL, the company selected had been Fairpoint Communications (NASDAQ:FRP), which went bankrupt, or Frontier Communications (NYSE:FTR), a stock that has lost two-thirds of its market value over the last five years.

Before I give my thoughts on conclusions to be drawn from the review, in the interest of full disclosure, note that I am not a financial professional, nor am I certified in any way as a financial advisor. I am an independent, small investor sharing experiences that hopefully will be interesting, as well as helpful, to others in similar circumstances.

So, based on the study, what are my conclusions? First, it does appear that taking higher risks can result in higher returns, as long as nothing catastrophic occurs. Of course, that is true of all investing. Avoiding the big loss is the key to satisfactory returns. Unfortunately, with the higher yielding stocks, the big loss is generally more likely, compared with large-cap blue chips. The first cautionary recommendation I would make would be to limit how much of a portfolio is to be allocated to the various high-yield groups. Further, depending on funds to be allocated, I believe one should own a "basket' of stocks in each group, in lieu of just a couple of firms, to spread the risk. Also, avoid over-concentration in any one group.

Regarding MLPs, I don't consider that these companies present the same level of company-specific risk as companies in the other high-yield groups. The problem I see here is that as MLPs have become more popular, there are few bargains to be had. Also, note that there are companies organized as MLPs that are not energy MLPs. I would avoid these, limiting MLP holdings to energy-related MLPs. Further, I would recommend midstream and pipeline MLPs over production MLPs, to avoid commodity risk. Finally, the tax complications, which are a consequence of MLP holdings, must be considered before investing in these firms. As noted, the political risk is low, but I don't believe it is non-existent.

For the sake of completeness, a few additional high-yield groups that have not been discussed should be mentioned. NLY, the REIT included in the study, is a mortgage REIT, a type of REIT that owns mortgage paper, not property. There are many, many property REITs available, and while the yields are not commonly as high as the high-yield groups reviewed, they are typically in the 4% to 5% range, higher than blue chips. Utilities have been popular with dividend seekers for many years, and as with property REITs, there are many to choose from, with yields also in the 4% to 5% range. Closed-end funds, which trade like stocks, are yet another group of stocks that offer attractive yields in many cases.

Finally, a few formerly high-yield groups need to be discussed, to present a cautionary tale of the risks that can arise if a portfolio is too heavily concentrated in stocks of a particular group. First, consider the banks, which as a group offered some of the highest dividends available a few years ago. While there are a few exceptions, bank dividends mostly collapsed as a consequence of the financial crisis, and have yet to recover. Another group that was popular with dividend investors for a time was shipping stocks, especially tanker shippers. Their yields have collapsed with the collapse in shipping rates, and a couple of formerly high-yield dividend payers in this sector have either gone bankrupt, or are otherwise in serious straits. [Examples: General Maritime (NYSE:GMR), Frontline (NYSE:FRO)]. And finally, let's not forget the painful saga of the Canadian Trusts, which were very popular at one time because of their high dividends. That all ended on October 31, 2006, which was the date that the Canadian government announced changes in Canada's tax policies, effectively presaging a phased ending of the Canadian Trust form of business organization. The trusts' market prices collapsed 25% to 50% over the next few months, and even though most companies survived to re-form as regular corporations, prices and dividends are still below the levels that they were at before the announcement.

In conclusion, the record of dividend payments can be revealing when evaluating dividend stocks for investment, and inclusion of some higher-yielding stocks in a portfolio can increase the overall returns. However, recognize that these stocks do present higher risks to a portfolio than the typical "defensive" large-cap blue chips that would make up a dividend portfolio. Risks can be abated to a degree by avoiding having too high an allocation to any one company, and also to any one stock group.

Note: Data sources for the stocks discussed: TD Ameritrade - Charts, Comparisons and Events, Dividends, for dividend dates and amounts; and Think or Swim - Charts, for year-end closing prices; and E*Trade Snapshot view, for Market Caps (as of January 25, 2012).

Disclosure: I am long JNJ, PG, NLY, ARCC, CNSL.