Seeking Alpha

How To Boost Your Yields Using The 'Income Method'

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Includes: AM, EPR, IMBBY, JNJ, MAC, MIE, MPW, PCI, PEGI, PEI, QQQ, SO, SPY, T, TGRP, VET
by: Rida Morwa
Rida Morwa
Research analyst, REITs, energy, Dividend income for retirees
Summary

A set of very simple, almost obvious tactics allow quite large growth in portfolio dividend income.

The consistent application of these principles is what yields results. Any one instance isn't very big, but together when consistently applied, they are powerful.

We show you the results from HDO contributor PendragonY's own portfolio when he used these techniques combined with HDO picks.

Note: Co-produced with PendragonY.

Introduction

In this report, we will show how author PendragonY was able to increase the dividend yield for his portfolio using the income method, which we also call the immediate income method. At High Dividend Opportunities ("HDO"), we are income investors who follow a strategy to boost the yield on investments and maximize your income. This strategy works both when an investor is in the accumulation phase saving for retirement and when they are living off the income their portfolios produce after they've retired. We pick securities that pay a relatively high distribution to the price to obtain them. In the accumulation phase, this allows the investor to grow their income stream by reinvesting the large cash distributions into more dividend-paying shares. In retirement, this large cash flow allows the investor to cover their expenses without selling shares and to have enough cash left over to buy more shares to ensure that their buying power keeps up with inflation.

PendragonY is an Income Expert at High Dividend Opportunities, started moving his portfolio to be more in line with our model portfolio when he joined the team in October of 2018. During 2019, he moved even more of his portfolio to our picks and those picks now make up around 50% of his total portfolio. Here's a screenshot from the Portfolio Tracker tool provided to our members to show how much of his portfolio is now invested in HDO picks.

https://static.seekingalpha.com/uploads/2019/12/29/16392-15776140744924462.png

Source: co-author’s records using our "Portfolio Tracker"

As can be seen, he has around half of his portfolio invested in core HDO picks. But they produce 60% of his dividends. That has significantly enhanced his dividend payments for the year.

Below is a chart showing the dividend income from the portfolio since 2016. Plotted is the dividend income he received each month. While the amount for December 2019 is an estimate, since it's based on already declared payments, it is pretty accurate. Notice that for most months the income received increases each year. 2018 did have a few months where that wasn’t the case, as one company delayed its dividends by a few weeks (and thus moved the payment into the next month).

https://static.seekingalpha.com/uploads/2019/12/5663201_15770483806670_rId5_thumb.jpg

Source: Broker and Author Records

Let’s take a look at how such consistent results were produced. As can be seen, the dividend income began to grow much faster starting in March by which time he had added a number of picks consistent with Immediate Income pick to his portfolio. While he continued to use techniques he had been using for many years, having access to the higher-yielding picks selected by the Immediate Income strategy greatly increased the growth in income he was able to achieve.

Make Sure You Pick Companies with Well-Supported Distributions

While it sounds very simple and obvious, one of the most important things an investor can do to grow income is to make sure that the companies they invest in can support the distributions they pay. That will minimize the impact if any investment reduces its payments to you. When you have few or no distribution cuts, the efforts you make to increase your yield from one or more investments will all go toward increasing your total yearly income rather than offsetting losses.

So when you buy bonds, you look at the cash flow and the net assets of a company. In other terms, you look at how well both the interests and principal are covered by the cash flows and income of the issuing company. Even how much the company pays in dividends, on both common and preferred shares, can tell you how safe the interest payments are on these bonds. This is because the dividends on the common and preferred stocks act like a cushion toward protecting your bond and the interest payment. In case of trouble, the company always can reduce the dividend payment, which will result in more cash flow for the bonds.

It's much the same for preferred shares. In this case an investor needs to look at the common share dividends to provide some protection to the cash the company pays you as a preferred shareholder.

We always look first to see if the distribution is well supported. Investors don’t want to shell out hard-earned cash to get a big distribution only to see it cut after a handful of payments. Sure, at times a company might be in better shape if it reduces the dividend, but in that case, it's often better to buy in after the dividend is cut (and perhaps the shares have sold off more than the cut warranted).

Another great way to boost your income is to target out of favor high dividend stocks when the price has been driven down on irrational fears that are not supported by fundamentals. One such company we targeted in August 2019 was Vermilion Energy (VET) whereby we locked in a yield of 14%. Since then VET has strongly rallied providing us with 16% returns to date.

Another good example is Macerich Company (MAC). We like this company and its high dividend, currently $3 a share, will help grow their dividend income when it is used to buy more dividend paying shares (either of MAC or of another position in the portfolio). These purchases of MAC allowed portfolio income to increase by $591 (based on declared dividend) for cost of only $5,390.

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Source: Broker Records

Buy more shares of securities that pay you cash to own them

This is another tactic that sounds rather simple and obvious. But it's important if you want to grow your income consistently. As an income investor, you can use your dividends to buy more securities that will pay you fat dividends when you own them. So that means as cash comes in you use it to buy more bonds, more preferred shares, more shares in fixed income CEFs such as PIMCO Dynamic Credit Income Fund (PCI) with a yield of 8.2%, and more common shares that pay high dividends. These new investments will then give you even more cash to buy yet more such investments.

Every investor should have a watch list, which is a list of securities that one currently wants to buy and the maximum price to pay for those securities. With such a list an investor can just pick a stock off the list to buy when cash becomes. Periodically the list needs to be updated, based on any changes to company fundamentals and to reflect any sales and purchases. Each investor should maintain their own watch list. Our service providesmodel portfolios to help investors with this task.

One example of this happened in October 2019 when Imperial Brands (OTCQX:IMBBY) was recommended as a top pick when it was yielding 13%. By buying 140 shares, this increased the dividend income by $46 per month or $560 per year. Repeated, regular increases like that are exactly how to increase the whole portfolio’s income over time.

Retired investors ideally should be at a point where their portfolio generates more cash than they need to pay their expenses. This extra cash can then be used to buy more income-producing securities. This is one way that retired investors who are using most of their dividends can ensure that the keep up with inflation.

Diversification Key to Protect Your Income and Principal

One important consideration is diversification. One way to manage hits is to limit position size to remain a good diversification level. So your "watch lists" need to be updated when purchases are done so that the value of a position does not to exceed the recommended limit (or recommended allocation per share) even though the price is otherwise at a good value.

The reason to keep a highly-diversified portfolio and position sizing are two key ways to reduce risk. Some stocks or sectors can become out of favor by investors, and go down in price significantly, and cause volatility in a portfolio. Therefore even companies with good cash flow sometimes fall in price. If you only invest in one company, you are golden if it does well, and may sink if it the price does poorly. So if you keep each position you invest in at only 2% or 3% of your overall portfolio, this reduces the risk of your portfolio and the price volatility. So if a hit is taken for a particular stock, this would result in a very small impact on your the portfolio. Importantly, by keeping a highly-diversified portfolio of high-yielding stocks, you will be solidifying and strengthening the future income you will receive from your investments.

Buy more shares when they are priced at a good value

This is yet another tactic that sounds simple and obvious. If you buy more shares when those shares are priced at a good value, you get more future dividends for the cash you spend. This helps you grow your income. We always recommend to our investors to keep on the lookout for good companies that go on sale, and we regularly compile a list of these shares so that our members can take advantage.

For instance, the preferred shares of Pennsylvania Real Estate Investment Trust (PEI) have pulled back recently and are now yielding 9%. These shares are on a big sale. The reason is that the mall REIT sector has been out of favor by investors lately. This has put downward pressure on the prices of all mall REITs, creating some unique opportunities. PEI has taxable income and so must pay dividends, and it's in a much better shape having finished several major redevelopment projects.

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Source: Broker Records

Rotate out of investments when they get too pricey

As income investors, we tend to worry more about the income our portfolio produces rather than capital gains. But that doesn’t mean we ignore capital gains or overall returns. Sometimes a company’s shares run up so much in price that it makes sense to sell some (or even all) and redeploy the cash into other securities that have a better valuation. Doing this will improve our income. We regularly rotate out of investments that have become overpriced.

Recently, we determined that Medical Properties Trust (MPW) had reached a level of overvaluation due to investors piling into REITs as fear of a recession increased in 2019. This has resulted in the entire REIT sector reaching extremely high valuation levels. Now that investors have more confidence that recession risks are pretty low, and that we are unlikely to see a recession over the next two years, it's time to act. We expect investors to be dumping REITs in favor of value stocks that have not seen much upward price moves in the past two years. This is why we recommended selling MPW and re-allocate to other high-yielding stocks elsewhere. In his portfolio, he trimmed his position in MPW and used those proceeds to buy shares of MAC, which we think has better prospects. MAC also has a higher yield which means the swap also generates more income. This swap generated an increase of the $52 of dividends paid by the MPW shares, to $102 from the MAC shares (nearly doubling the income).

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Source: Broker Records

By the same token, big gains in Southern Company (SO) and Johnson & Johnson (JNJ), both Dividend Growth companies rather than Immediate Income companies, saw big gains, so trimming 25 shares each produced some cash. Using that cash and some dividend payments from his portfolio allowed him to buy more shares of EPR Properties (EPR) with a yield of 6.3% and Antero Midstream Corporation (AM) with a yield of 16%. Both stocks work as Immediate Income picks. While SO and JNJ are big favorites of dividend growth investors, both have significant capital gains and have a much lower yield than when they were first purchased. This swap resulted in a big increase (approximately $320) in income per month. When there is a big run-up in share price, it's often best to trim or even entirely sell a position to both protect the gains and generate more income.

https://static.seekingalpha.com/uploads/2019/12/5663201_15770483806670_rId10_thumb.jpg

Source: Broker Records

Pattern Energy Group (PEGI) was another good investment that we recommended to rotate out of. In this case, it wasn’t because the shares had become too pricey, but rather because the company had been acquired. The position paid some very attractive dividends that were used to buy more high dividend-paying shares. But he sold soon after the sales offer was confirmed. The big capital gains realized by selling PEGI allowed him to reposition assets into more shares of other companies. So a single year in PEGI produced $868 in income and around $5000 in capital gains which were then used to buy even more shares of high dividend-paying stocks.

https://static.seekingalpha.com/uploads/2019/12/5663201_15770483806670_rId11_thumb.jpg

Source: Broker Records

Buy Stocks that increase dividends over time

In keeping with the general set of tactics that seem simple and obvious, the last one is to buy stocks that increase the amount they pay as time goes by. While your portfolio income can go up even if all your shares continue to pay you the same distribution, owning some securities where the company does all the work to increase your income can be a big help.

The Immediate Income Strategy targets undervalued high-dividend companies, including dividend growth stocks that are undervalued. One such recommendation is AT&T (T), which is one of the larger holdings in the portfolio. Pendragon has 1,000 shares, so when it increased its dividend by a penny a quarter per share on Feb. 1, 2019, that increased his dividend income by $10 each quarter. AT&T already announced that the dividend will go up another penny this coming February, which will again result in a $10 increase in quarterly income without any further action.

EPR increased its dividend starting in February 2019. The dividend went from $0.36 per share per month to $0.375. At the time, the portfolio contained 355 shares of EPR, so that small bump resulted in $5.33 more in dividends each month. That was roughly 4% more from EPR no additional effort or funds.

Risks

As with all investments, there always are risks that not all goes as planned. While one can take actions to avoid them, and to mitigate the damage, those risks still exist.

The biggest risk to any dividend-focused strategy is that a company could reduce its dividend. This is why it's imperative to keep an eye on fundamentals like cash flow, revenue, market share, and profits. In order to mitigate this risk, we recommend to limit your position size. On average we recommend to allocate positions sizes of about 2% to 3% of the overall portfolio. This way, even if a company unexpectedly reduces its dividend, the impact on your overall income and cash flow will be minimal.

While our aim is to buy and hold high dividend stocks for the very long term, at times the fundamentals of a company deteriorate and require us to exit the position. In such cases, a "Sell Alert" is issued in order to exit such a position. The risk here is that sometime the share price might have dropped already before we send the "Sell Alert" to our members. However, issuing such alerts is necessary because it tends to reduce the risk of further losses. This risk is not unique to our Immediate Income strategy or to income strategies in general. It's essential that investors keep a close eye on all their positions, and not to hold on to stocks that have had a change of outlook because a deteriorating outlook can result in more losses.

Another risk to consider is that some stocks may reduce their dividends. It helped that none of Pendragon's positions reduced their distributions in 2019. While Cohen & Steers MLP Income and Energy Opportunity Fund (MIE) has already announced a distribution reduction for the year 2020, his portfolio already has been re-positioned to make up for that reduction in dividends. MIE remains a strong buy because the manager of MIE (Cohen & Steers) made a smart move by conserving its position in high-yielding MLPs that would result in higher returns in the year 2020. We believe that management's decision was made to maximize shareholder value to its investors. MIE’s dividend could very well increase in 2020 as the midstream sector continues to higher prices which management is likely to use to increase the dividend payout.

Limitations

Diversification and limiting position size is a key consideration to reach an ultimate diversification level. This means that a portfolio will have around 30 to 40 positions at a minimum. The big limitation here is that at times, when there's a recommendation to take profits on a particular stock, there are not always good opportunities to reinvest the funds. In such a case, an investor must hold on to his/her cash position until a good opportunity arises. This would result in some lost dividend income.

The opposite also is true and presents a limitation. Sometimes if you are fully invested, you may not be able to take advantage of an opportunity, and could miss taking advantage of a pullback.

However, there's a very good mitigating factor by investing into high-dividend stocks because you can always use the high dividends that you receive from your portfolio to take advantage of such opportunities.

Looking Ahead

We are now early in 2020. As dividends come in, there will be opportunities to deploy the cash your receive to further increase your income. Currently EPR trades at an attractive valuation, and its monthly dividend will offer a monthly recurrent income to allow you to use this cash for upcoming opportunities. The energy sector, particularly the midstream sector, has been out of favor for a long time, reaching an extreme undervaluation. With oil price have stabilized in a good range, it's a good plan to start picking up more shares of Targa Resources (TRGP) and Cohen & Steers MLP Income Energy Opportunity Fund, both yielding close to 9%.

For the year 2020, the Federal Reserve took a decision to keep interest rates on hold for the year. This will bode well for higher dividend stocks.

Taking a Proactive Strategy in Investing

While a recession is unlikely anytime soon, we like to be one step ahead and have been recommending a good allocation to fixed income assets to ensure that our income will continue produce solid cash flows in both good and bad times. Currently, we are recommending a 40% allocation to fixed income, including preferred stocks, bonds, and high quality fixed income closed-end Funds. Taking such a defensive position mitigates the impact of a general market pullback because fixed income tends to be much less impacted when we see a general pullback in equity prices, such as a pullback in the S&P 500 index (SPY) or the Nasdaq (QQQ). Many fixed income products are inversely related to the price of stocks, and can go up in price when the equity markets go down.

As we tend to see every year, general market pullback happen, resulting in high dividend stocks dipping in price. We expect this to happen in 2020 as well, and we look forward to take advantage of each and every dip to accumulate the best opportunities the market offers.

Final Thoughts

In 2018, PendragonY’s portfolio generated $29,240 in dividend payments. Provided that all his positions continue to pay the dividends they have declared. He's on track to collect $37,649 in 2019 and probably more in 2020 using the "Income Method." In 2019, he was able to increase his income by approximately a 28% increase from the year 2018. And it was done using the simple techniques described in this article by increasing allocations to solid undervalued high-dividends picks.

By using this method, he was able to increase the average yield of his portfolio from just over 5% to around 7.4%. A good contributing factor was that he took advantage of the big drop in share prices at the end of 2018. Before the market recovered, this allowed him to pick up many dividend-paying shares at very attractive prices. It also helped that none of his positions cut their distributions in 2019.

Can every investor do this well? Certainly not every year. But certainly many can do this well over the course of a year or two using the Immediate Income Method. By increasing the average yield of your portfolio, from just over 5% to close to 8%, can make a big difference in your income. The model portfolio provided to our investors has many options of dividend stocks (from C-Corps, REITs and BDCs), closed-end funds, bonds (and baby bonds), and preferred shares. This provides plenty of investment options for investors to increase income. Using these tactics over the last decade, PendragonY has managed to increase his portfolio income 12% or more every year. Most investors should be able to do the same with a little effort and education. The Income Method offers investors a ready-made list of securities, and regular updates on such investment choices, cutting down substantially on the effort needed to grow your income at a good pace. If you are an income investor, using a ready-made list of attractive high yield investments can help you achieve more income and dividend growth in 2020 and beyond than you have averaged in the past.

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Disclosure: I am/we are long EPR, IMBBY, MIE, PCI, PTY, MAC, T, VET, AM. 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.