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Two Good-Yielding Unconventional Income Stocks

|Includes: Moelis & Company (MC), TIS

THIS IS A REPRINT OF AN ARTICLE THAT APPEARED AT LEST 72 HOURS AGO ON FORBES.COM

It's not easy to be an income investor nowadays. Interest rates and yields are low, and when you do finally locate a decent yield, you're met with warnings that could make a Navy Seal quake with fear. Still, with a bit of strategic creativity, opportunities can be uncovered.

For those who want to get right to the dessert, the stocks are Moelis & Co. ($MC), and investment-banking firm whose stock yields 4.32% and Orchids Paper Products ($TIS), a producer of paper products (mainly paper towels and bathroom tissue), whose stock yields 4.90%. I'll discuss each company below. But there's a very important topic I like to cover up front.

Why I'm Writing About These Stocks

I use a strategy that I described here and which will be available shortly (after a mandatory 90-day new-strategy incubation period) on Portfolio123 as the Smart Alpha Equity Income strategy. Like many non-speculative approaches, this one avoids the highest riskiest "junk"-level yields. As to the rest of the income-investor's universe, the model deemphasizes garden-variety income-strategy metrics (dividend growth, payout ration, etc.) and instead evaluates the riskiness of dividend streams based on a broader but rigorous set of fundamental factors and with market sentiment. In tests, the model has shown itself able to substantially outperform a hypothetical portfolio consisting of three popular equity-income ETFs; Vanguard Dividend Appreciation ($VIG), iShares Select Dividend ETF ($DVY), and Utilities Select Sector SPDR ($XLU).

Table 1 compares the model to the ETFs in terms of basic Portfolio123 rankings for Quality, Value and Momentum.

Table 1

 

Average score of holdings per Portfolio123 rank for . . .

Quality

Value

Momentum

Smart Alpha model

67.58

31.34

63.77

VIG

70.81

47.23

59.50

XLU

51.40

16.46

47.88

DVY

58.66

28.97

49.39

In assessing how we should react to these scores (scale is 0, worst to 100, best), Table 2 summarizes some of the initially data presented on October 24th.

Table 2

 

Annual % return based on backtest covering

Yield % (as of 11/19/15)

15 years

3 Years

Smart Alpha model

11.81

20.24

4.11

Three ETFs as portfolio

5.90

11.90

3.05

What we see is that the model is good in terms of Quality, as it was designed to be and noticeably above two of the ETFs in this respect. But what's really interesting is Momentum, a ranking system that includes price-based factors as well as others relating to analyst sentiment. That's important as a gauge of future dividend prospects since it incorporates judgments about the future that cannot be captured by data.

Table 1 holds the key to why I refer to $MC and $TIS as "unconventional" income stocks. Rarely if ever will any stock excel in every criterion an investor may consider. Some are "generalists" that are OK in many respects. Others capture the spotlight based on strength in one or just a few areas. $MC and $TIS are noteworthy based on high Momentum-Sentiment scores.

Themes In Common

Both companies are young by income-stock standards (many firms favored by dividend-seekers are old and mature). So if the names are unfamiliar (as they were to me until I discovered them in the Smart Alpha model), this is likely a big reason why. $MC was formed in 2007, $TIS was created in 1998 from the assets of a different bankrupt firm, but didn't settle into its present form and go public until 2005.

Both are small caps. The market caps respectively for $MC and $TIS are and $565 million and $306 million. This is another likely reason why they are not well known. Also, this may have something to with why their yields are up at intermediate levels. Many income-portfolios don't give as much attention to mid- small- and micro-cap stocks as to blue chips.

Finally, a case may be made for each of these issues even if (OTCPK:WHEN) the market faces challenges going forward.

Moelis & Co. ($MC)

Moelis is an independent investment-banking firm, a new-generation firm that arose from the chaotic changes that rocked Wall Street in this generation. Actually, it's odd to think of MC's business model as new. If anything, it eschews what Wall Street has become and appears to be pursuing a back-to-the-future business model.

The key here is that it's independent. It's an investment banker - period. Its activities are advisory. MC is not engaged in sales and trading. It's not engaged in lending. It's not engaged in underwriting. In other words, it's not a modern financial supermarket, a one-stop-shopping conglomerate. It's advisory business is independent of all those other activities, or as we've so often seen, agendas. The advice MC gives to its clients is free from conflict, free from the pressures of cross-selling any number of other services, and free from the high risk of confidentiality breach that exists in organizations with many moving parts.

Another aspect of independence is advice that's independent from employee self-interest. The firm's professionals are not compensated on the basis of commission. It's "collaboration, client impact, and lasting relationships" that count. Equity is a meaningful part of the compensation picture, thus aligning staff interests with those of shareholders (hence the commitment to return cash to holders on an ongoing basis, mainly through dividends since the small float is not amenable to large buybacks).

The company grew revenues to $512 million from nothing when it started in 2007, due partly to expansion in industry demand, partly to gains on the part of independent bankers as a category partly to the expansion by $MC of the regions it serves and the nature of the services it can render. It helps too that the company staffed up heavily during its early nightmare crisis years, when good talent was readily available. So now, with market conditions stronger, it need not aggressively chase new hires.

Mergers and acquisitions is a big part of $MC's business, as can be expected of anyone in this field. But what happens if interest rates go up. Answer: A lot of companies that can easily handle borrowings now will find it more challenging. And that raises the prospect of debt restructuring. $MC has built its capabilities in this area and is ready for action if the Fed does what we all know it will eventually have to do. That will enable cash flow to cover the dividend better than it does now (which is already pretty good - in the trailing 12 months, cash from operations was almost three times the amount of the dividend).

Orchids Paper Products ($TIS)

The name of the company looks scary: "Paper." I don't know about you but my first reaction was . . . as in for newspapers, magazines, brochures, books, business documents, etc. all of which are going digital, which means demand is declining.

First impressions can be quite wrong, as they are here once one looks at what this company does. It makes what it calls "parent rolls" which then become finished products the bulk of which are paper towels and toilet tissue. If there is any category of paper that cannot and will not ever be digitized, that's it. The closest anything in the equity market comes to being a risk free investment is an investment based on the notion that we will never use smartphones to clean or wipe anything.

That's not to say there are no risks with $TIS, but these are normal business risks such as raw material cost (a bit of pressure now, but this sort of thing always ebbs and flows), demand, distribution and competition. And in terms of these risks, $TIS comes out quite fine from the perspective of an income seeker, who prioritizes consistent stable cash flows over dynamic growth. Demand here is driven more by population growth than the ups and downs of GDP.

Competition can be an issue in consumer products ($TIS sells to institutional customers, but the "at home" business is where most of the company's focus lies) due to spending needed to promote brands. $TIS has brands but you probably never heard of or can't recall them. The company sells through discounters, Dollar General being its largest customer. (Walmart is in there too, but DG is the company's big gorilla). So these are no-name brands sold on the basis of price, or $TIS' own brands that are presented by some retailers as their store brands.

Because these are low-ticket items and $TIS sells into the most price-sensitive part of this market, watching costs counts. For $TIS, transportation costs loom large. That's why it sells mainly within 500 miles of its main south central U.S. facility.

But it's pushing the envelope. It acquired some production assets in Mexico that are now logistically opening up the broader southwest market. Also, even super-discounting is not a monolith; there are "value," "premium," and "super-premium" aspects even within the context of $TIS' world, and the company is trying to push more product up its value chain.

Perhaps the big risk here involves expansion efforts. Between internal projects and acquisitions, operating cash flow did not cover the dividend in the trailing 12 months; external capital helped. But this is not likely to be permanent feature of the company. (It's not as if we're dealing with the latest and greatest semiconductors.) The yield seems more than ample to cover $TIS' controllable (by management) business risks.

And, of course, the prospect of rising interest rates is a risk for everybody. In the near-term, yields go up and that's a threat for $TIS and everything else. But at least it should not interfere with business prospects (dividend security and possibly dividend growth potential) even if rising rates causes the economy to slow. These products are necessities. Nobody is going to do without. What they'll do is skimp on price and the best way to do that is to shop at a place that sells $TIS' offerings.

Disclosure: I am/we are long TIS, MC.