Jim Jubak: Go for high yield stocks
I can’t say that right now it is the best time to invest in yield stocks but Jubak here describes the good valuation and fundamentals of why good high yielding stocks should be added in these times.
A glance at all 3 counters would show that actually their yield do not match up to what we can get on an asian context. Perhaps why we get 10% plus yield is probably asian stocks on my Dividend stock tracker are actually smaller cap and higher risk compare to these large companies.
Nevertheless, don’t just look at the yield but the ability to increase it and a sustainable future business model.
First, jubak highlights his strategy of yielding portfolio:
For those of you coming in late, let me start by summarizing the strategy behind my unfixed-income portfolio. Then I’ll move on to telling you why high dividends have provided so little protection this year and the logic behind buying high-dividend stocks now.
The strategy, which I’m calling unfixed-income investing, is designed to help you keep up with inflation — and more — while growing the yields of your income investments over time.
This strategy starts with common stocks that pay high dividends. My goal is to find equity investments with yields above the percentage paid by five-year Treasury notes (2.94% on Sept. 12) or, even better, above the yield on 10-year Treasury notes (3.71% on Sept 12). And these common stocks should be as safe as or safer than the five- or 10-year Treasurys under current market conditions.
Then I add a third criterion: These common stocks should have superior histories of raising dividends year in and year out. It’s this last element that gives income investors a fighting chance to beat today’s low yields and stay ahead of inflation. How does it work? By putting the power of dividend compounding to work for long-term income investors.
Let me use US Bancorp, my first unfixed-income pick, as an example of how this works. The yield on US Bancorp — 5.05% on Sept. 12 — is certainly high enough to make the cut. And this conservatively run bank is certainly safe enough.
But it is US Bancorp’s commitment to returning 80% of earnings to shareholders that made it the first stock in my unfixed-income portfolio. Combine that commitment with the bank’s steady rate of earnings growth — 8.5% annually over the past five years — and what you get is a stock with constantly increasing dividends for shareholders. In 2003, the stock paid 86 cents a share in dividends. The dividend payment has climbed steadily to $1.70 a share in 2008, an increase of 98%.
Look at what the power of dividend compounding can do for US Bancorp’s dividend yield in the long run. If US Bancorp can grow dividends per share by just 10% this year and next — that would be below the average annual 16% increase of the past five years — by April 2010, an investor would be looking at a dividend of $2.06 a share. That would represent a 6.1% yield for an investor who bought at the Sept. 12 closing price.
The current yield of 5.05% is great now, when the 10-year Treasury note yields 3.7%. And the 6.1% future yield will look even better if future U.S. interest rates are lower because of slower growth or a huge demand for fixed-income investments from aging boomers.
Think of buying a stock like this now as purchasing an option on increasing future dividends and higher yields.
Jubak next mentions about people looking at dividend stocks as safe bear market hedges. here he mention a company that is linked to a vested company in Macquarie Infrastructure Company:
Dividend stocks haven’t been safe in this market for two reasons.
First Reason
First, a bear market — and that’s still where we are with the long-term trend still pointing down — acts as a kind of massive margin call on investors.
As stocks sink, some investors face actual margin calls. Lenders call them up and ask them to repay the money they borrowed and then used to buy the stocks in their portfolios.
Other investors get de facto margin calls. They may need to shrink their balance sheets (as the banks are doing) by selling assets. They may need to sell stocks or bonds to raise cash to meet redemptions from their own investors (as hedge and mutual funds are doing). They may decide they have to sell (as banks, hedge funds and investment banks are doing) to cut the risk in their portfolios, because the cost of financial insurance in the derivatives market is too expensive or simply unavailable.
If you have to raise cash in a bear market, you don’t sell only your losers. They’ve already dropped so much in price that selling won’t produce all the cash you need. (And besides, no investor ever likes to sell and admit a loss.) Instead, sellers sell everything.
This selling can get really heavy if the investors who have to meet this “margin call” are leveraged at 10- or 20-to-1. That, of course, is exactly the kind of leverage that banks and investment banks used, borrowing and then investing $10 or $20 on every dollar of actual capital. When you’ve got to deleverage to that degree, you sell anything that has held its value reasonably well. The fact that the Dow Jones Utility Average — I’m using utility stocks as a stand-in here for all dividend stocks — was up 16.6% in 2007 made those stocks such attractive selling candidates in 2008.
Second Reason
The second reason for the plunge in the price of dividend stocks applies to only some high-yield stocks. The growth strategies at some high-yield companies were themselves built on leverage. When it got hard to borrow more money to buy more assets, these companies had to slow or stop their growth. And many of them had to start deleveraging themselves when lenders told them they wouldn’t renew loans unless the companies put up more collateral or reduced their borrowing.
That’s exactly what happened to Macquarie Infrastructure. The company had built a very successful growth strategy on borrowing cheap money and then using it to buy infrastructure assets — toll roads and bridges — that came with a decent cash flow. Because the money to buy that cash flow was borrowed, Macquarie’s initial relatively modest return was multiplied. When you make an investment of $100 million that produces cash flow of $10 million a year, that’s a 10% return. But when you put up only $10 million of your own money and borrow the rest for $5 million — meaning your total outlay is $15 million — then your return, again $10 million, is a huge 67%.
The financial crisis and the inability to raise capital hit just about every dividend-paying company built on this structure — from Macquarie to U.S. oil and gas pipeline limited partnerships — to one degree or another, with the severity of the damage depending on how much leverage was used.
Jubak reassures us that the sell down does not mean a deterioration in the fundamentals of the underlying utilities and infrastructure assets
Understanding these two major reasons for the plunge in the price of what are supposed to be safe, high-yielding stocks should be reassuring to income investors. First, the sell-off in these shares that has resulted from the margin call on the market as a whole hasn’t inflicted any real damage on these companies. Utility shares may have been sold by investors who need to raise cash, but the fundamentals of the utility business aren’t any worse than they were in 2007, when stocks in the sector returned nearly 17%.
Second, I think we’ll see a return of the borrow-to-buy-assets model once the credit crunch is over. Companies such as Macquarie were putting their borrowed cash into real and very concrete assets that will be churning out cash flow for decades. Until borrowing gets easy again, these strategies won’t return anything like what they used to. But investors can easily avoid investing in the companies that pursued these leveraged investments until the financial crisis is over.
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