Checking Under The Hood Of Income Investments
Summary
- Investing in a new security requires due diligence.
- We look at three areas of research that should be conducted before hitting the "buy button."
- Regardless of investment style, these should never be overlooked.
- Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Get started today »
Co-produced with Treading Softly
Here at High Dividend Opportunities, we benefit from a vast array of life experiences. Among our members and our experts, we have a worldwide range of knowledge that we can rapidly share and assist each other with. We personally love seeing members stepping up and helping each other with basic investing questions or technical data that others may struggle with. We focus on "high dividend" stocks and often look for a new investment can be like shopping for a car.
When you buy a new car or new-to-you car, you will source them out through various means. Online car sites, car dealerships, family and friends. You also may opt to read reviews about a potential purchase from a trusted source or take it to your favorite mechanic for a once over.
Likewise, you don't want to run out and buy a new stock based on a brief look alone. You can shine up a terribly running car, and unless you crank the engine you'd never know!
So where do you start looking at a potential investment to know if it's a golden find, or a lemon waiting to ruin your portfolio?
Lift The Hood, Check the Internals
Whenever you're buying a car, the paint could be shiny, fancy and looking sleek, but if the engine is broken, all you are buying is a driveway ornament. Likewise, as many pundits can proclaim how great an investment is by labeling it as "value," "blue-chip," or "SWAN," it does not mean it will have the engine power to propel your portfolio properly.
Consider Global Partners (GLP) which yields 10.6%. GLP at first glance doesn't look appealing.
- It's an MLP that issues a K-1.
- It still has incentive distribution rights for its general partner.
- It has low trading volume
Yet first glances alone would cause you to miss out on a phenomenal investment. GLP has great positives:
- Exceptionally recession-resistant business model as fuel demand is extremely inelastic.
- Growing, covered distributions.
- Level traded range making reinvestment easy for income investors.
Data by YCharts
GLP has overwhelmingly generated its return via distributions while trading upward approximately 7% in a year. This level of capital appreciation or preservation along with growing distributions is a win-win.
Fundamental analysis to ensure strong cash flows and dividend coverage is a must, not just a sexy name and paint style.
How Are the Wheels Looking?
Some of you may be rolling your eyes at this point. "Why check the tires? You can simply replace them!" For cars this is true. For investments? Not so much. Tires provide traction. Traction is necessary to move a vehicle forward. Worn down, balding tires can have all the engine power behind them and the car will not move down the road efficiently.
For an investment, the balance sheet is the equivalent of tires. The dividend can be well covered. However, if management lacks the ability to get the company into the future or propel the company toward this vision, the writing is on the wall. The balance sheet reflects how “stretched” things have gotten. Examine the current ratio, the debt to EBITDA and the bank covenants to see how things actually are vs. what management says.
Golar LNG (GLNG) is an excellent example of this. The future vision is great! Natural gas and liquefied natural gas will most likely play a prominent role in the future. Countless vials of digital ink have been spent proclaiming how excellent an investment this company is. Meanwhile, management has bungled its growth and made poor choices that have come back to haunt them. The tires are worn out. Like a Tesla (TSLA) without wheels or axels, the value story lacks the ability to get going. The share price reflects it as investors are losing hope in the story.
Data by YCharts
GLNG is trading at 10-year lows.
Saratoga Investment Corp (SAR) with a yield of 8.8% is a completely different story.
SAR's management took over a struggling BDC, they changed its name and went to work improving its portfolio and credit quality. Investors in SAR - including HDO members! - have been the largest beneficiaries of their success.
What about long-term performance? Getting the ability to put wheels to your plans also requires perseverance. Ares Capital (ARCC) with a yield of 8.9% is a great example of this. Management has shown the time-tested ability to produce results. This translates to reliable dividends and strong capital appreciation.
Furthermore, investors have been showered with special dividends - this past year it was an additional $0.02 per quarter per share - which have continued to boost overall returns.
Management is often viewed as an "intangible" value proposition. Are they worth their paychecks? In the GLNG case, probably not. SAR and ARCC? Definitely. When you place your capital in a company, you're trusting the management to get it done. Likewise, when you buy a car, you need it to get you places, on the tires it has.
Will it Last?
Cars depreciate over time. Over time the mechanisms require replacement or maintenance to keep it going. Many fancy, high-end cars end up requiring additional costly work vs. the low end work horse of a car. It never ceases to amaze me how much longevity that a simple Toyota (TM) can have.
You need a car to get you where you need to go in good times and bad, regardless of the weather. When you sit down and turn the key in the ignition, you expect it to do its job.
Likewise, investors and retirees need income regardless of the economic climate. Creditors don't care if a recession has come, they want what they feel they are due! Likewise, you need your investments to not quit and not stop producing valuable income when times get hard.
With a recession looming, it's best to know that your investments will not quit on you when you need them in the clutch. One sector that has languished while the market has been booming is the midstream space. High-quality midstream securities work much like utilities, they have long-term contracts and stable income.
You can achieve instant diversification across the midstream space by investing in CEFs like Cohen & Steers MLP Income and Energy Opportunity Fund (MIE) or First Trust MLP&Energy Income Fund (FEI), both of which yield over 10%. These MLP funds also have the added bonus of paying their distributions monthly - which allows for easy reinvestment or bill paying. They also allow you to avoid any added tax headaches that a K-1 cause.
Does It Appeal To You?
Now we're entering the realm of subjectivity. Every investor has different goals. Every one. Yes, we will admit we all probably want to make a solid return on our investment, but timelines, yield requirements and expected return vs. risks taken will vary. Are you investing for retirement? A legacy to leave behind or do you need income today?
Ever wonder why there are so many different versions of cars, trucks, and SUVs? It's because consumers want variety since they like what they like. Likewise, an investment might make a fantastic momentum trade, but if you're a buy and hold investor - it's not for you.
We evaluate the whole market (SPY) (DIA) (QQQ) using our unique Income Method. It drives how we view any investment. We have certain criteria before we'll invest in a dividend-paying security. Likewise, you need to decide what your goals are in investing before jumping in with both feet. Management teams and earning calls are designed to present their companies in a positive light or with a positive spin. Likewise, salespeople are trained to sell you a car - not to decide what is best for you.
Blindly entering the market has burned many investors as they do not know what they want, how long they want to hold it. They end up jaded, suffering financial harm and misled by great sales tactics.
Here's some sample requirements:
- Pays a steady reliable dividend or distribution.
- Historically maintains a 1x coverage ratio.
- Future ability to cover dividend remains strong with bonus points for growing coverage.
- Management able to fulfill their vision responsibly.
- Fiscal responsibility - not piling on the leverage aimlessly.
Don't Buy at Any Price!
The biggest mistake many new car buyers and investors make it finding the vehicle or investment they like but buying it when it's overpriced. We must always remind ourselves that any vehicle whether for transportation or income can be overpriced versus its quality.
Recently we highlighted The GEO group (GEO) yielding +11% as an undervalued company. GEO has faced political headwinds as it became a favorite company to hurl charged claims against. Ironically, we have seen historically that prisons are necessary and governments once depending on privatized prisons has an incredibly hard time replacing them. Why? Very few people want a new prison to open up next door to them, so finding land, building the prison and staffing it can take years. All the while, GEO offers turnkey solutions to this problem.
Other securities will be a great value today, but the price will run up tomorrow. Don't chase them. Set a limit order at your desired price and wait for the market to come to you. If it doesn't come to you, you're not suffering any loss, but chasing a high-flying security only multiplies the risk of its potential downside.
Conclusion
Buying a car or picking a new investment can be an exciting time. It also can feel like a daunting task. It's important:
- To view the company's fundamentals to ensure its internals are good.
- To kick the tires to ensure management can get it done.
- To ensure it will last.
- To make sure it "fits" your portfolios unique style and requirements.
- To make sure you don't chase its price up.
Being an income investor is very rewarding. Not only dividend investing generates regular cash flow needed to supplement one's income needs, but dividend investing is a defensive investment style that generates regular cash flows for investors and tends to outperform when markets are volatile. This is an investment style that I personally follow for my own retirement account.
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This article was written by
I am a former Investment and Commercial Banker with over 35 years of experience in the field. I have been advising both individuals and institutional clients on high-yield investment strategies since 1991. I am the lead analyst at High Dividend Opportunities, the #1 service on Seeking Alpha for 6 years running.
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In addition to being a former Certified Public Accountant ("CPA") from the State of Arizona (License # 8693-E), I hold a BS Degree from Indiana University, Bloomington, and a Masters degree from Thunderbird School of Global Management (Arizona). I currently serve as a CEO of Aiko Capital Ltd, an investment research company incorporated in the UK. My Research and Articles have been featured on Forbes, Yahoo Finance, TheStreet, Investing.com, ETFdailynews, NASDAQ.Com, FXEmpire, and of course, on Seeking Alpha. Follow me on this page to get alerts whenever I publish new articles.
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Analyst’s Disclosure: I am/we are long SAR, GLP, GEO, FEI, MIE, ARCC. 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.
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Comments (76)
This will lead to a) need for MANY more single prison beds and isolation units, and thus prisons, and b) a desperate need for better efficiency in delivery of services, which private prisons deliver better than any governmental entity.
Ergo, stock prices shooting upwards; I will be gradually adding to my positions.
I bought some EQM on your advice a while back. I am down a whopping percentage now. What would be your advice at this point...??Tiger
Looking at the auction results over the last decade or more would suggest that not all cars depreciate. In fact some cars, the most desirable manufactured say fifty or sixty years ago have enjoyed staggering appreciation. One model that comes to mind a Ferrari 275 GTB/4 has appreciated 24000% since it sold new in 1967 and there are other cars that have dwarf those figures. But you are correct most cars depreciate.
