A Growing Dividend Portfolio That Will Survive Rising Interest Rates

by: Matthew Zeets

Interest rates are causing fits for many REITs and other high income investments.

By combining stocks from many different industries, we mitigate risk (as opposed to owning say, all REITs).

The yield stands at 5.25%, even with a cash allocation of over 20% of the portfolio to be able to add on dips.

Recently I decided I wanted to come up with a high income, dividend growth portfolio that can survive rising interest rates. Many high income industries have been hit fairly hard over the last year or two from rising interest rates. The damage rising interest rates bring is two-fold for many of these industries- 1) rising interest rates means rising cost of capital due to large amounts of debt that will need to be refinanced at higher rates and 2) people see these high-income names as bond like substitutes, so as the return on basically risk free treasuries rise, the yield demanded by other income sources increases.

While there is no doubt that many high income stocks will struggle with higher interest rates, others will thrive. Times like these allow us opportunities to pick out babies that have been thrown out with the bathwater so to speak. Not every high income name will struggle and having a diversified portfolio can also take care of part of the risk. I've researched stocks in a lot of different industries and I've come up with my favorites. My allocations come from Real Estate Investment Trusts (REITs), Business Development Companies (BDCs), oil and gas, tobacco, healthcare, and tech. There are definitely ways you could diversify even further, but for now I'll just share what I've come up with.

Source: Morningstar

My current allocations are still a little biased toward equity REITs as you can see. While I see most REITs continuing to struggle if the Federal Reserve keeps rising interest rates 3 times a year for the next 5 years, I also see them at very good prices if the Fed has to slow down anytime in the next few years. While most REITs will not be able to raise their dividend as fast as the Fed is currently raising interest rates, many will still be able to pay an increasing dividend for decades to come and could go back to outgrowing interest rates if the Fed falters at all.

If you do personally think interest rates will keep rising as fast or faster than they are now for years to come, then you should probably avoid REITs and stick to more defensive sectors. To offset the lower yield of defensive sectors, you could pick more BDCs set to do well from rising interest rates. BDCs have their own inherent risks, but many do have portfolios that will do quite well in a rising interest rate environment. There are a lot of different ways you can make up a portfolio like this one, but these are the picks I like.

As far as allocation, I wanted to keep a decent amount in cash (~23%), as I still want to have a flexible portfolio that can add to stocks that dip. While I do own all these stocks listed, this portfolio is just a simulated one with allocations based on if I were building it today. I started with play money of $100,000 and made the initial "purchases" on 3/27/2018. I consider 10% of the portfolio the maximum for any 1 holding (other than cash) and have allocations between 1/3 and 2/3 of this amount to start off with. This gives me room to add if I think valuations get ridiculously low. Reasons for higher allocations are usually for when I see a fantastic stock that is way undervalued and I see taking off in the next year or two. Reasons for lower allocations are usually to buy a great company at a fair price but don't really see them as undervalued (MAIN).

While the yield is currently at 5.25%, it would be closer to 6.8% with no cash position. Also MAIN has paid a special dividend for several years and RSO will start paying a higher dividend likely in the next 6-12 months. I've picked many of the other names because they should be able to raise their dividends for many years to come. Here are the allocations:

Source: Morningstar

Below I've also included a little information about each individual holding, though I recommend looking into any one of them further if you're interested in investing in it of course.

MO- When I first looked into Altria Group (MO), I was expecting to find a company that started struggling somewhere in the last 5-10 years with so many more regulations on cigarettes nation wide, as well as it being taken away from so many bars/restaurants. What I found is that MO has continued to thrive. Their top line has been stagnant, especially compared to the days of old, but with very well controlled costs they still finding ways to keep churning out higher profits year after year with earnings of $2.38/share back in 2012, steadily growing to $3.49/share last year.

MO is about 23% off their 52 week high of $77.79 due to concerns over the FDA continuing to make stricter regulations, but they are still better positioned to make the move into heated tobacco products than smaller competitors. The biggest reason I like MO is because of how well they would do in a recession. I don't have many stocks in traditional defensive sectors, as I think there are too many other gems in higher yield industries out there, but this one is my top pick of a traditional consumer defensive stock. Their growing 4.7% dividend should do well.

ETP- Energy Transfer Partners (ETP) is a logistics MLP that makes most of their money by transporting crude/gasoline/natural gas through their pipelines. They have an extremely high dividend (13.9%) that either the market does not believe is around to stay or is punishing for their high amounts of debt. They had a very good recent quarter as EBITDA has finally started to rise quickly from all the projects they've been finishing. In 2018, they will have to execute well as they have several more projects they are pouring CapEx into, but have little room for error as they basically don't have access to more capital from debt markets or common share issuance. They're covering their dividend and the projects coming online continue to add exceptional growth to the top and bottom lines. After these projects get online, they can finally start paying down debt, which should help the share price considerably. Somewhat risky, but there could be very large capital gains in addition to the gigantic dividend if things go as planned.

GILD- Gilead Sciences (GILD) is a large biotech company that has dominated treatments and cures for different liver diseases for the last few years. They recently made a meaningful move into oncology with their purchase of Kite Pharma (KITE). Their revenues and earnings are still falling because of the precipitous decline of their HCV franchise Harvoni/Solvadi due to curing their patients of the disease. Because of this they are at a very low P/E multiple of ~10x in an industry that is usually closer to 20x P/E. Even if their HCV franchise went to 0 overnight, they would still trade at a very low multiple (~13.5x) and with the purchase of Kite, they have avenues for growth in the next few years. The biggest risk with them is government reform of drug pricing, as it is with so many big biotech companies. Only a 3% dividend but with a very low payout ratio and avenues for growth, I expect this to grow for years or even decades.

HTGC- Hercules Capital (HTGC) is a BDC that has fallen with most income stocks as interest rates have risen, but they actually stand to benefit from interest rates rising with a significant portion of their loans being variable rate loans. They currently have a 10% dividend and the main risk continues to be if management tries to change from an internally managed BDC to an externally managed one, but it seems from their last attempt that this won't be happening anytime soon.

IBM- IBM (IBM) just broke their negative Y/Y revenue streak of 22 quarters with Q4 2017 earnings results. With the benefits of being in the best part of the mainframe cycle and with continuing forex help, they were able to finally post some growth. Strategic imperatives (the areas IBM focuses on growth) also grew closer to 50% of revenue every quarter. Within the next year or two, they should be able to consistently grow more with strategic imperatives than they lose from legacy businesses. Also they have 3.9% dividend and great cash flows to support the high level of shareholder returns. The way I understand it, tax reform will hurt them some, but they still are able to return a very high percentage of cash flow to shareholders and still look great in the long run as they return to growth. They are not a high growth stock, like so many in the tech industry are, but their valuation and how they look to finally be turning the corner warrants a buy.

KNOP- KNOT Offshore Partners (KNOP) operates shuttle tankers that are designed to transport crude oil from off-shore oil wells into the mainland, instead of the other common method of building pipelines. They have an exceptional dividend (10.3%) with an excellent coverage ratio (> 1.4x) and long-term contracts that have shown to be much more resilient to the oil downturn than offshore drilling contracts. Shuttle tankers are more specialized than offshore drilling vessels and weren't nearly as overproduced when oil was flying high. I expect KNOP to be able to keep paying/growing the dividend for many years and for the price to appreciate as they continue to get assets handed down by their sponsor, Knutsen, and are able to continue to raise the dividend.

MAIN- Main Street Capital (MAIN) is the premiere BDC in that they are valued at a large premium to NAV (Net Asset Value), but for good reason. They have a very low cost of capital due to their size, being internally managed, and great management that has performed exceptionally for many years. Basically, their low costs warrant their premium to NAV which in turn leads to lower costs. They have dipped some with the rest of income stocks due to rising interest rates and are currently at a 6.3% dividend, but they have also paid a special dividend for several years which puts their yield closer to 8%.

MPW- Medical Property Trust (MPW) is an REIT that owns hospitals and other medical buildings. They have a very nice dividend (8%) and have been expanding in recent years. The large acquisitions they were closing were making the coverage ratio pretty tight for a while, but things look to be calming down and I expect they'll be able to keep growing the dividend at a slow pace.

RSO- Resource Capital Corporation (RSO) is a mortgage real-estate investment trust (mREIT) that focuses in commercial real-estate (CRE). They were struggling mightily for several straight years, but have started their turnaround story recently, which I explain in my article, Resource Capital Corporation: How Is Management Performing? They actually have dropped in price since that article and are now around $9.50/share. I still see them being at $12-$14 range within the next 2 years and start paying a > 10% dividend in 6-12 months.

RDS.A/RDS.B- Royal Dutch Shell (RDS.B) is my favorite of the big oil majors. While they do have a much higher debt profile than Chevron (CVX) or Exxon Mobbil (XOM), they also have a much higher dividend of 5.7% for RDS.B vs. about ~4% for CVX and XOM. Also, they are managing to bring down their debt quite quickly after purchasing BG Group a couple years ago. It looks like to me that they are in a very good place financially and should continue to be able to bring their debt down. I expect their dividend to get more in line with CVX and XOM as their debt falls, so their price should keep climbing. I personally hold RDS.B because it is in a Roth IRA and from what I understand, it makes the most sense to go with RDS.B in tax advantaged accounts and RDS.A in regular accounts.

SPG- Being a behemoth of an REIT by market cap helps Simon Properties Group (SPG) to have an upper hand in cost of capital with their superior debt ratings over other smaller mall REITs. SPG management is also top-notch and saw the writing on the wall when they split off Washington Prime Group (NYSE:WPG) back in 2014. Basically, they realized that the stronger malls would still thrive, but weaker malls would see traffic decrease at a faster rate as more and more people shopped online. When they spun off WPG, they did so above $14/share, whereas WPG is less than $7/share these days, showing what a good decision it was to part with those assets when they did.

Management continues to renovate properties where they see improvement needed and selling off assets they see as poor financial decisions to hold onto. They've done a fantastic job continuing to grow the dividend by large amounts ($1 quarterly dividend in 2012 vs $1.95 quarterly dividend now). I expect them to continue to grow their dividend at a faster than average pace for REITs over the next few years and that's even with a current yield of 5.1%. They are still almost 30% off their highs of $210 back in 2016 as they have been brought down with all mall REITs.

STOR- Store Capital (STOR) is a triple net lease REIT that pays a 5.1% dividend. It is a newer company, but has fantastic management with lots of experience in the REIT realm, and Berkshire Hathaway bought a sizable position in 2017. Also, despite interest rates rising, their cost of capital has still been going down just due to being a newer company and continuing to get better debt ratings as the company grows and establishes credibility. It has a lower payout ratio and should grow more in coming years than bigger peers like Realty Income (O) and National Retail Properties (NNN).

TCPC- TCP Capital (TCPC) is a BDC that has done a great job managing their ~10% dividend while keeping their book value very steady since their IPO back in 2012. Most mREITs and other BDCs with this high of a payout struggle to maintain their book value. They truly have been exceptionally well run but still don't trade at the exceptional premium they deserve. I imagine it will happen after enough years. The best part about them, which I wrote about in my article Top Notch BDC for Rising Interest Rate Environment, is how well they are positioned for rising interest rates with most of their assets being variable rate loans and most of their debt being fixed rate.

WPC- W.P. Carey (WPC) is a triple net lease REIT that pays a 6.6% dividend and has a probable significant catalyst coming in the next few years that should allow it to increase its dividend substantially. Definitely could be one of my picks that struggles if interest rates continue to raise at the current pace for the next 3-5 years, but any sort of slow down in rate increases and this name will outperform.

Disclosure: I am/we are long ETP, GILD, HTGC, IBM, KNOP, MAIN, MO, MPW, RDS.B, RSO, SPG, STOR, TCPC, WPC. 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.