Showing posts with label high-yield. Show all posts
Showing posts with label high-yield. Show all posts

Monday, July 28, 2014

Dividend Yield or Dividend Growth:My Experience With Both

There is a ranging debate of whether someone should go with high yielding companies today, or they should go with lower yielding investments, which however offer the promise of increasing payouts at a faster clip. As I have discussed earlier, there is a tradeoff between dividend yield and dividend growth, with the decision of which path to take ultimately being dependent on the underlying unique characteristics that an investor has in his or her own opportunity set.

Nevertheless, I still get asked the following question. The question goes something like this: Why go for an investment that yields 3%, with the potential for a 7% in annual dividend growth, when someone can get an investment yielding 6% today? Even if all the expectations turn out to be correct, an investor would have to wait for a long ten years, before they collect a 6% yield on their cost. With the other investment, they would have been collecting that 6% yield for 10 years already.

I usually answer those questions with examples, which discuss the probabilities of different events happening. However, the reason why I usually go with the lower yielding stock is due to my experiences. Actually, one of my investing mistakes pretty much sums up why I do what I do.

I will tell you what the risks behind the thinking in the question asked above are, by discussing my experience with ONEOK Inc (OKE).

I bought shares of ONEOK Inc (OKE) in three separate transactions in 2010 – 2011 at the following price points - $25.31, $25.71 and $30.20. I liked the fact that shares were offered at a low P/E ratio, had adequate current yield, and offered the opportunity for growth. As a general partner in ONEOK Partners (OKS), there was plenty of opportunity for growth. And I think there still is. ONEOK Inc paid a quarterly dividend of approximately 21/cents per share.

In 2011, I decided that I wanted to earn more in distribution income right away, rather than wait for a few years. I also believed that the shares were too high. So I ended up selling all my shares at $36.18/share and purchasing shares of ONEOK Partners at $41.71/unit.

Since then, ONEOK Inc spun-off One Gas (OGS). Investors received one share of One Gas (OGS) stock for every four shares of ONEOK Inc (OKE). If I had stayed with ONEOK Inc, I would be earning a quarterly dividend of 56 cents/share from ONEOK shares as well as dividends from One Gas shares, where rate is 28 cents/quarter. This comes out to a total of 63 cents/quarter for shares that were bought at an average price of $27.07/share, or an yield on cost of 9.30%. Instead, I am earning an yield on cost of 7.10% by sticking to ONEOK Partners (OKS). If growth continues further, as it should, investors in ONEOK Inc will be generating even higher yields on cost, due to high distribution growth.

I violated two of my rules. One is never to sell, even if I had a 1000% gain on the investment.  The other rule is that activity is bad for your performance. According to research, 80% of the time the investor is better off staying with their original investment and not doing anything else. I also chased yield by replacing ONEOK Inc (OKE) with ONEOK Partners (OKS).

I also ended up paying taxes on a portion of the gains. The opportunity cost of the taxes I paid could be very high, because this is money that could have quietly compounded for decades for me and made me even wealthier in the future. It could have meant more money for the causes and people I care about when I die. Instead, I threw the money away and gave it to the government.

Overall, the investment in ONEOK Partners has been satisfactory. However, I made a few mistakes, and probably should not have sold the original shares purchased in ONEOK Inc. Once again, as Warren Buffett says, some of the largest mistakes he has made were mistakes of omission, not mistakes of commission. Other mistakes of omission I have made include watching Williams Companies (WMB) go from $32 to $36 in 2013, and not purchasing because I wanted to buy it cheaper. The company might still be a good investment, given the high forecasted growth in dividends. As a matter of fact I recently initiated a position in it, and I am hoping it drops from here.

I believe that smart people, learn from the mistakes of others. Hence, I hope that my smart readers will learn from those mistakes I made. The goal of every investor is to always be learning, and always be improving. If one stops learning and improving, they have a high chance of failing to reach their goals and objectives. The goal is to get a little smarter every single day, and removing ignorance one item at a time.

Relevant Articles:

The Tradeoff between Dividend Yield and Dividend Growth
Why I am replacing ConEdison (ED) with ONEOK Partners
ONEOK Partners (OKS) Dividend Stock Analysis
Seven Dividend Stocks I purchased for the long-term
Types of dividend growth stocks

Wednesday, June 4, 2014

Focus on High Yielders with Growing Distributions

In a previous article, I mentioned that as a long term dividend investor, I do not try to pursue a strategy of active dividend investing. As I gain more experience however, I tend to closely scrutinize companies which are not performing up to my requirements. In general, these companies tend to have a higher yield, slower or nonexistent distributions growth, and have neutral business growth outlooks at best. I have previously simply held on to such companies, and reinvested distributions elsewhere. But recently, I have began reconsidering whether my income portfolio would be better off disposing of these potential high yield traps.

Many dividend investors focus on dividend yield in their starting analysis of potential income investments. In general, the higher the yield, the higher the dividend income that the investor would receive. This could be even more common for investors who have not saved a sufficient amount of money, which is why they are searching for any type of a shortcut, in order to get them to the desired level of income in retirement.

The main risk with such a strategy is that by focusing exclusively on the yield or the desired level of income, the retired investor could end up overlooking certain factors, which could be devastating for their retirement. If the dividend paying company cannot support the distribution payments, chances are that it would cut or eliminate it. This would cause severe drops in income, along with decrease in the stock price, as fewer investors would be willing to purchase an asset with limited or no income potential.

In my process of looking at dividend stocks, I look for several things, before I even decide to analyze a stock. I look for a trend of consistent dividend increases, a dividend payment that is adequately covered from earnings or cash flows as well as attractive valuation. After I uncover a stock that fits these loosely defined quantitative criteria, I tend to analyze qualitative factors, in order to guesstimate whether the company would be able to generate higher earnings per share over time. Each company is different, but some of the most common drivers behind future growth include expanding the business in new territories, introducing new products, acquiring competitors, reengineering the business in order to attract new clients. Another important set of drivers include having products or services, where the number of customers is expected to increase, and where the quality of the company’s offering helps it maintain pricing power.

For example, the low interest rate environment has made many retirees switch to dividend paying stocks. The primary outcome of this hunger for yield is that many companies in the utilities and real estate investment trust arenas have been bid up by investors. As a result, their yields are at multi-decade lows. One example includes Consolidated Edison (ED), a regulated utility that supplies electricity and steam power to millions of customers New York City. The company has boosted dividends for 40 years in a row. However, in 2012 it yielded less than 3.80%. In addition, it had only been increasing distributions by less than 1% per year over the past 17 years. At this rate, the purchasing power of your dividend income stream has been ravaged by the eroding power of inflation. I analyzed the stock and noticed that going forward, because of the unfavorable regulatory environment for utilities in New York, the company could not count even on decent earnings growth to support a higher dividend growth rate. As a result, back in 2012 I decided to sell the stock and purchase units of ONEOK Partners (OKS), which have the capacity to deliver much higher distribution growth over time, had sustainable distributions and as an added bonus yielded more. I only kept a few shares in another legacy account, for which it was not cost-beneficial to sell.

In previous articles I had mentioned that I want to hold a diversified portfolio of stocks coming from as many sectors that make sense. In general, the more I study historical dividend stock information, the more I realize that utilities are great only for current income for a period for 5 -10 years. Utilities in general tend to have poor dividend growth rates, which are typically overlooked by yield hungry income investors. In addition, many utilities tend to cut dividends every couple of decades or so, after which they start raising distributions again. Many utilities do provide with the added income stability during a period of economic turmoil, such as the one observed during the 2007 – 2009 financial crisis. However some like Ameren (AEE) did cut distributions during that tumultuous time.

Utilities of course are not the only sector that dividend investors should scrutinize closely, in their quest for rising dividend incomes. Some companies that I used to own, such as Cincinnati Financial (CINF) have had a hard time covering distributions in recent years, and have raised distributions only by nominal amounts for the past six years or so. While having a long streak of consecutive dividend increases is impressive, and speaks a ton about the company’s dedication to rewarding long-term shareholders with a rising stream of cash each year, I do prefer to see substance. In other words, I would much rather hold a slightly lower yielding stock, with a shorter streak of dividend increases, which however has the potential to generate higher earnings and dividends growth. This is a preferred investment in comparison to a higher yielding, but lower growth company such as Cincinnati Financial (CINF) or Consolidated Edison (ED). As a result of my dissatisfaction with Cincinnati Financial, I replaced the stock with shares in five Canadian banks in early 2013.

To summarize, while it is important to thoroughly analyze stocks before purchasing them, it is also important to not get married to positions. Buy and hold investing does not mean buy and forget – regular monitoring of positions is a must for the serious dividend investor. This would ensure the longevity of the dividend income stream by identifying potential troublemakers well in advance, and replacing them with opportunities with better prospects.

Full Disclosure: Long ED, OKS

Relevant Articles:

Active Dividend Growth Investing
Margin of Safety in Dividends
Utility dividends for current income
High Dividend Utility Stocks – Are they a trap for dividend investors?
Spring Cleaning My Dividend Portfolio

Tuesday, May 13, 2014

Should I buy more high yielding stocks in order to retire early?

Most readers know I focus on dividend growth stocks, which are companies that tend to grow distributions every year. I search for companies that typically yield more than 2.50%, have demonstrated growth in earnings and dividends over the past decade, and have a strong foundation that can support further distribution growth.

Per my dividend retirement plan, I expect to be able to cover expenses through dividend portfolio around sometime 2018.

However, I do focus on a lot of companies where average yield is somewhere in the 3% - 4% range. These companies have sustainable dividends, and dependable dividend growth rates, that are very likely to exceed 6%/year for the next decade.

Some readers have asked me however, why don’t I merely focus my attention on higher yielding stocks, that pay anywhere between 6% – 8% today, and speed up my financial independence. I could load up my portfolio with companies like:

Kinder Morgan Energy Partners, L.P. (KMP) operates as a pipeline transportation and energy storage company in North America. This master limited partnership has managed to increase distributions for years in a row, and currently yields 7.50%. Check my analysis of Kinder Morgan.

American Realty Capital Properties, Inc. (ARCP) owns and acquires single tenant, freestanding commercial real estate that is net leased on a medium-term basis, primarily to investment grade credit rated and other creditworthy tenants.This  real estate investment trust has managed to increase dividends for years in a row, and currently yields 7.60%.

Realty Income Corporation (O) is a publicly traded real estate investment trust. It invests in the real estate markets of the United States. This real estate investment trust has managed to increase dividends for years in a row, and currently yields 5%. Check my analysis of Realty Income.

I equate higher yielding companies with higher risk. In a competitive marketplace for stock securities, a reasonable investor cannot expect to find higher yielding stocks, without incurring higher risks.

If a real estate investment trust (REIT) wants to buy an apartment complex that generates an 8% yield, it might not be a very good idea to issue stock or debt to investors that yields more than 8%. However, even if they end up paying a lower yield on equity or debt, but they need to refinance that debt in a few more years at higher rates, this could be bad for dividend incomes. The problem with most high yielding companies is that they are pass through entities, which essentially share all of their free cash flows with investors, by sending out fat dividend checks. This leaves those companies exposed to hiccups in financial markets, which are vital for their growth and for access to capital.

In addition, there is always the increased risk that those pass-through entity structures are abolished by the Tax authorities. With a pass-through structure like a REIT, master limited partnership (MLP), or a Trust, there is no taxation at the entity level. All the taxation occurs at the individual shareholder level. In comparison, corporations like Coca-Cola (KO) pay taxes at the corporate level, and then individual investors pay taxes on dividends they receive in taxable accounts. This is why pass-through entities like Realty Income, American Realty Capital Properties, Kinder Morgan Energy Partners can afford to pay such fat dividend yields – they essentially do not pay income taxes and rely on capital markets for capital on capital spending, and acquisitions. However, if the revenue starved governments decides to get a higher share of the tax mix, they could start taxing those entities. This would effectively reduce attractiveness of pass-through entities, lead to steep dividend cuts, and losses for investors.

This is why I believe that there is generally a higher risk of a dividend cut with high yielding stocks.

In addition, there is a high risk of lack of dividend growth. This will reduce purchasing power of my principal, and result in constant downgrade to my lifestyle.

I also believe that by owning a portfolio consisting predominantly of pass through entities, I am taking a concentrated risk, which is contrary to the ideas of diversification I have been preaching on for the past six –seven years.

If I needed $30,000 in annual dividend income, but only had a portfolio worth $500,000, I could do two things. The fist is to design a portfolio with an average yield of 6%, and call it a day. The second thing would be to invest in a mix of more reasonably priced companies, wait for a few more years of savings and patiently compounding my capital before achieving my goal. The risk with the first scenario is that those higher yielding stocks stop growing dividends, which would reduce purchasing power of my income. In addition, if there are dividend cuts, my lifestyle would be even worse off. If you need $30,000 to live on in year one, you would likely need $30,900 in year two assuming a 3% inflation.

What good is a high dividend stock that yields 6% today, if it gives me a 50% chance of a dividend eliminations within next decade, compared to a stock yielding 3% that has only a 10%-15% chance of a dividend cut. If I earn 6% this year, but next year I get a 50% dividend cut, I am not better off eventually than an investor who started out with a 3% yield that was unchanged in year two. As an investor, my goal is to maintain and increase my real income, and only suffer the least amount of losses. If I just focus on the yields today, I might end up missing out on the risks I am taking in the process.

With a more moderate dividend growth stocks yielding somewhere between 2.50% - 3.50% today, I have a better chance of reaching my goals, having a sustainable income stream, and a better fighting chances against dividend cuts and inflation.

I believe that I only need to get rich once. Therefore, my goal is to be patient, and build my dividend foundation slowly and carefully, rather than be in a hurry, and avoiding excessive risks.

Full Disclosure: Long  KMR, KMI, ARCP, O, KO

Relevant Articles:

The Four Percent Rule is Dependent on Dividend Yields
High Yield Dividend Investing Misconceptions
Five Things to Look For in a Real Estate Investment Trust
Dividend Champions - The Best List for Dividend Investors
My Entry Criteria for Dividend Stocks

Wednesday, May 7, 2014

Personal Dividend objectives versus the market environment

Successful dividend investing is an outcome from following a sound investment strategy and having a small dose of luck. Another very important factor however is investor psychology. If investors have incorporated unrealistic objectives when they set up their strategy, they might end up setting themselves up for failure.
One example of unrealistic expectations that quite a few dividend investors have is the hunger for high yield stocks. These investors are searching for companies yielding 6 percent or more. The typical dividend growth stock with sustainable distributions and with reasonable chances of continuing future dividend increases yields anywhere between 2% - 4%. The reason why these investors need a high yielding stock is most probably because of inadequate retirement savings. An investor with a $500,000 nest egg can easily earn $15,000 - $20,000 from a diversified dividend portfolio today, which would boost distributions above the rate of inflation for decades to come. However, if our investor requires at least $30,000 in annual distributions from their income portfolio, they have only two options left. The first one is to come up with an extra $300,000 or to focus on higher yielding stocks in order to address the income shortfall.

This increase in dividend yield however, carries with it a disproportionate increase in risk to the principal and income.

The issue with most high yielding stocks is that they are typically concentrated in just a handful of sectors. Currently, it is possible to easily find stocks yielding above five to six percent in master limited partnerships, real estate investment trusts, some utilities, tobacco, and telecom stocks to name a few sectors. This exposes the investor to sector risk, as it leaves the portfolio undiversified.

The second issue is that most of these companies already have very high distribution payout ratios. As a result, they cannot afford to boost dividends above the rate of inflation. This inability to boost dividends, leaves retirees exposes to the decreases in purchasing power of their income over time. Over a typical 30 year retirement, this could mean consistently downgrading your lifestyle.

Third, because these companies have very high distribution payout ratios, they have a higher chance of dividend cuts than your regular dividend stocks like Procter & Gamble (PG) or Coca-Cola (KO). When a company with a high payout ratio experiences declines in earnings, it would be much more likely to cut distributions than a company with a low dividend payout ratio.

Fourth, most companies that pay high dividends can lose principal much faster if the distributions are cut or eliminated. For example, when Centurylink (CTL) cut distributions in 2013, its stock fell by more than 30% in a single day. When American Capital (ACAS) eliminated dividends in 2008, its stock fell by 40% on the day and was down 90% within a couple of months.

Fifth, the concentrated portfolio of high yielding stocks could be more vulnerable to certain types of risks such as a rise in interest rates, than your normal dividend growth portfolio. The low interest environment has led plenty of yield hungry investors bid up income stocks to unreasonably high valuations. When interest rates start inching up, these companies would likely drop in price. In addition, because many of these high yielding companies rely on continuous debt and equity offerings to grow or maintain their asset base, this increase in cost of capital would increase the risks of dividend cuts.

Unfortunately, investors cannot expect to construct unrealistic portfolios while having only their own goals and objectives in mind. Instead, investors need to realistically focus on what the market offers right now, and make the best out of it. Investors need to focus on building a diversified income portfolio, which grows dividend income every year, includes companies with strong earnings growth potential that have been purchased at attractive valuations. Each of these investments needs to be analyzed in detail, with its past record and prospects researched very well. Investors should not tell the market what they want from it, but what market can offer them at the moment. Imposing your will on market will likely lead to disappointment down the road.

Full Disclosure: Long PG, KO

Relevant Articles:

How to be a successful dividend investor
How to read my stock analysis reports
How to define risk in dividend paying stocks?
The Tradeoff between Dividend Yield and Dividend Growth
The importance of yield on cost

Wednesday, April 17, 2013

High Yield Dividend Investing Misconceptions

One of the biggest misconceptions about dividend investing out there is that investors should change their strategy, depending on their age. I believe that this misconception comes from the traditional world of retirement planning, where advisers told clients to allocate higher and higher amounts to fixed income instruments as they got older.

Over the past 40 – 50 years, fixed income has tended to yield more than stocks. As a result, income hungry investors in retirement seeking current income purchased CD’s, bonds and other fixed income instruments. This chasing of yields exposed them to inflation risks. Unfortunately, investors who need yield at all costs typically do not have the foresight to look beyond the next five years. Had these investors simply followed the same investing strategy throughout their investing career, without adjusting for age, they should have done just fine. I believe that following the simple four percent rule should have been their benchmark for generating retirement income from a portfolio that includes stocks and bonds. As I mentioned in an earlier article, the four percent rule essentially relied on the dividend and interest income of a portfolio, which is what the traditional retirement industry has failed to understand. In another article I discussed that for my retirement I plan on relying on the dividend income from my portfolio, which yields around 4%. I would also rely on some interest income as well. I have followed the same investing principles for the past five years, and would follow them for the next fifty years ( hopefully).

Currently, I view the misconception that investors should invest differently depending on their age fully embraced by everyone. Any time I write an article outlining the dangers of focusing simply on yield, I always receive a backlash from a group of investors. The investors that always disagree with me are those who are anywhere between their 60s and 80s. It looks like these investors simply need the income, but it also seems that they are not giving much thought about whether this income is going to continue for the next 20 – 30 years. My article on the sustainability of Pitney Bowes (PBI) and Windstream (WIN) was not well received. I did notice that many investors were hopeful, although the factd spoke that these distributions are unsustainable.

Investors who make a mistake and get lucky are actually much worse off than investors who make a mistake and pay for it. If you leveraged yourself to the maximum in 1999 to purchase all the Altria (MO) stock that you could get, and you made money from this exercise, you learned a bad lesson. If you applied this lesson in leveraging your portfolio to purchase high yielding Canadian energy trusts in 2007, or US Banks in 2008, you would have lost everything. Investors who today are purchasing high yielding telecom stocks such as Frontier (FTR) or mREITS such as American Capital Agency (AGNC) without understanding their risks, might find out that they have been playing with fire in a few years.

These investments would likely generate high yields for the next five years. This might even continue for a longer period of time, if our yield starved investors get particularly lucky. However, I highly doubt that these companies would maintain their dividends for the next thirty years. If investors spend all the dividend income from these high yielding investments, they would be out of luck when the dividends are cut. However, looking at the brief history of these investments, I would much rather stick to traditional dividend paying stocks yielding 3 – 4 percent on average today. If a four percent yield is not sufficient for you, then chances are that you do not have enough money to retire. You might try to purchase some time by investing in securities yielding more than that, but you increase your risk of dividend cuts. If your portfolio consists of high dividend stocks yielding 8% on average, and dividends are cut by 50%, then you will need to find a job to cover the difference. Finding a job in your 70s and 80s is not an easy task however.

A company that cuts an unsustainably high dividend is usually punished by a steep decline in its stock price. Thus, investors experience the double whammy of lower income, and a depreciation in asset base. This is a problem, because if our investors need to replace the investment with something else, they would have less money to do so. This is a particular problem for situations where the dividend is eliminated completely. American Capital Strategies (ACAS) is a great example for this scenario. In 2008 the company cut dividends, which prompted a sell-off from $10/share to less than $1/share within 2 – 3 months.
Stocks are not inherently “bad investments” simply because they have high current yields. If these companies can afford to pay the dividend, and can grow earnings over time then these could be very good investments. However, high yielding companies which cut dividends over time, pay fluctuating dividends, have unsustainable payout ratios and are in declining industries are investments that should probably not be touched with a ten foot pole by individual yield hungry investors, without fully understanding what they are getting into.

The best way to invest your money is to focus on the best opportunities out there. The more experience I get with dividend investing, the more I realize that current yield should not be the most important factor in selecting investments. It should not even be in the top five reasons to select an investment. It is number six in my list of entry criteria. Investors who salivate over the high yields without understanding whether the business can grow revenues and earnings to pay for the dividend are committing a sin against their asset base. However, I am somewhat impacted by the four percent rule, in that I do believe that a portfolio that yields anywhere between three to four percent is the optimal solution in today’s market environment. I do own stocks whose yield is 1% such as Visa (V), as well as stocks whose yield is 6% such as Omega Healthcare (OHI). I just purchased the ones that made sense at the time.

In my portfolio, I screen the lists of dividend champions and dividend achievers every week, looking for attractively valued stocks to purchase or to research. I keep an open eye for attractively valued companies with room to grow distributions out of growing cash flow and earnings. After analyzing companies, I only invest in those ones where I can see earnings and dividend growth for the next two – three decades. For example, I expect that Coca-Cola (KO) would still be a company with recognizable brands that will be selling a product that customers desire and are willing to pay for.

Other companies that will be around over the next 20 -30 years include energy infrastructure plays such as Kinder Morgan (KMP) and Enterprise Product Partners (EPD). These companies create the infrastructure to store and transmit oil and natural gas across the US.

Full Disclosure: Long V, OHI, KO, KMP, EPD

Relevant Articles:

Dividend Champions - The Best List for Dividend Investors
Are these high yield dividends sustainable?
Don’t chase High Yielding Stocks Blindly
Four Percent Rule for Dividend Investing in Retirement
Dividend Investing Misconceptions

This link was featured in the latest Carnival of Wealth

Monday, April 8, 2013

Five Things to Look For in a Real Estate Investment Trust (REIT)

Real estate investment trusts (REITS) represent a unique opportunity for dividend growth investors. They provide exposure to real estate, without the hassle of direct ownership. REITs are structured as trusts for tax reasons, and as a result, they do not pay federal income taxes at the entity level. The dividends they pay to shareholders are typically treated as ordinary income, and do not qualify for the preferential rate on qualified dividends. However, because income is taxed only at the shareholder level, there is more money for distributions to shareholders. In addition, a portion of your typical REIT distributions is non-taxable and it is treated as return of capital for tax purposes. This decreases shareholder's basis in the stock. The return of capital portion is caused by depreciation expense. By law, Real Estate Investment Trusts have to distribute at least 90% of income to shareholders, in order to maintain their preferential tax status.

There are five factors I analyze at a REIT, before putting my money to work in the sector. I used three REITs I own in this exercise - Realty Income (O), Digital Realty Trust (DLR) and Omega Healthcare Investors (OHI):

Funds from Operations (FFO)

Earnings per share are not an adequate way to look at REITs. Instead, analysts use Funds from Operations (FFO). FFO is defined as net income available to common stockholders, plus depreciation and amortization of real estate assets, reduced by gains on sales of investment properties and extraordinary items. I like to look at the trends in Funds from Operations per share over the past five or ten years, in order to see if there is any fuel for dividend growth. The slow growth in FFO led me to sell my position in Universal Healthcare Realty Trust (UHT) in March.

I usually prefer to see growth in FFO/share over the past five and ten years. REITs are pass-through entities, which means they return almost all of their free cashflow to shareholders. As a result, they sell shares and bonds each year in order to fund their expansion projects. These projects usually cause an increase in total revenues and FFO, but because of the dilution to existing shareholders, I want to see growth in FFO/share. This shows me that new projects are accretive to the FFO for all the shareholders. In the table below, I have placed the trends in FFO/share for three REITs I own:

FFO Payout

For REITs, I use FFO Payout Ratio, which is calculated by dividing the dividend payment over the FFO/share. I usually prefer to see a REIT whose payout ratio is below 90%. While REIT revenues are typically stable, I want to have some margin of safety in the form of a lower FFO Payout Ratio. Ideally, it would be flat or trending down over time. An FFO ratio above 90% couple with slow growth in FFO/share could jeopardize distribution growth. In the table below, I have summarized the FFO payout trends in three REITs I own:

Occupancy and Tenant Diversification

Diversification is an important thing to have in any portfolio, as it offers some level of protection to the company when something unexpected happens. I usually scan through the list of top tenants, and make sure that they do not account for an extremely large portion of revenues. I define extremely large as somewhere above the range of 50% - 66% of revenues. In addition, I also want to see stable and hopefully growing occupancy percentages over time. The occupancy ratios vary somewhat for different REITs. For example, Realty Income has an occupancy ratio of 97%, Digital Realty Trust has an occupancy of almost 94%, whereas Omega Healthcare Investors has an occupancy rate of 84%. The top ten tenants account for 64% of Omega Healthcare Investors revenues, but 35% for Digital Realty's revenues. The top ten tenants of Realty Income account for 37% of revenues.

Plans for growth

The fuel behind future distributions growth is growth in FFO/share. The growth in FFO/share is one of the factors that will determine whether distributions grow above the rate of inflation, stay flat or even worse - get cut or eliminated. I usually like to see a company that can manage to deploy capital raised in the public markets into projects that have attractive rates of return, have signed long-term leases and have escalation clauses that would allow them to charge higher rents over time. In terms of growth, Digital Realty Trust, Omega Healthcare and Realty Income all rely on strategic acquisitions of quality properties. Realty Income went one step further in 2012, when in completed the acquisition of American Realty Capital Trust. As a result, it was able to boost monthly distributions by 19.20%.

Debt, Cost of Capital and Risks

Understanding leverage is an important part of understanding REITs and risks behind REITs. Most Real Estate Investment Trusts pay for new projects either by issuing stock or issuing debt. If they issue too much debt and the projects do not work out as expected, the interest costs might eat into the profit. If it is difficult to renew the debt, or it gets more expensive, this could eat into the profit as well. This is why it is important to review the maturity schedules for the REITs you are interested in analyzing. Currently, issuing debt is very cheap, which should bode well for various projects. When the debt has to be refinanced in ten years however, it would likely cost much more to renew it. Realty Income, Digital Realty Trust and Omega Healthcare Investors do not seem to have problem accessing capital markets, nor do they have steep amounts of debt maturing soon. Omega Healthcare sold 12 year bonds in 2012 at 5.875%, while Realty Income managed to sell $450 million notes maturing in 10 years at 3.25%. Realty Income also sold 5 year notes, which yielded 2%. Digital Realty Trust sold 12 year, 400 million British Pound notes at 4.25%. Digital Realty, also managed to sell 300 million in ten year notes at 3.625%.

Dividend Growth

The table below shows the dividend growth for Realty Income, Digital Realty Trust and Omega Healthcare Investors.

I prefer to look for consistent dividend growth over time. A long streak of dividend increases for at least ten years is important. A company that manages to maximize existing investment opportunities for the benefit of growing distributions to shareholders is the right company for my money. Although dividend cuts in the past cause a red flag, if the company has managed to build a ten year streak of dividend increases, and has FFO growth coupled with adequate levels of debt, I would take a chance on it.

Relevant Articles:

- High Dividend Growth REITs: Digital Realty Trust (DLR)
- Realty Income (O) – The Monthly Dividend Company
- Three High Yielding Dividend Machines Boosting Distributions
- Four High Yield REITs for current income
- National Retail Properties (NNN) Dividend Stock Analysis
- Spring Cleaning My Income Portfolio, Part II

Tuesday, March 19, 2013

Are these high yield dividends sustainable?

When I analyse dividend paying companies, I always look for strong competitive positions. This is because a company in a strong competitive position might be able to enjoy rising profits for several decades. As a result, it might be able to boast a long streak of regular dividend increases. However, changes in technology can jeopardize a company’s economic moat. This could mean that the company might be unable to not only afford to keep raising dividends. In addition, such companies might find themselves in a precarious position, where the dividend has to be sacrificed, in order to maintain the business.

The dividend rate is usually determined by the company’s Board of Directors, who take a look of near term prospects for the business. If the Board expects that the company would be able to generate a higher amount of earnings over the next two, five and ten years, they are much more likely to boost distributions. As a result, sometimes there might be a short term disconnect between current year earnings per share and dividends per share. In this article, I have highlighted two high yield dividend stocks, whose dividends are at risk of a dividend cut. I have always argued that dividend investors should avoid chasing yield at all costs.

Over the past 20 years, we have seen plenty of companies fall victims to the rapidly changing world. Even some boring companies with strong moats have been victims of the process. Examples include newspapers, photography, mail and fixed line telecoms. These industries would have to adapt very well to the new world of technological innovation, or they would be extinct. Even if these companies can support the current high dividend payments for the next one or two years, their long-term prospects are grim.

Windstream Corporation (WIN) provides communications and technology solutions in the United States. The company derives its revenues from wireline operations. The long term trend is for erosion in wireline revenues, given the wide adoption of wireless technology. The company has managed to plug the hole in its dwindling customer count by making acquisitions. That being said, the dividend payment has not been covered for several years. Windstream’s peer CenturyLink (CTL) recently cut distributions in February 2013, which led to steep declines in shares of other fixed-line telecoms such as Windstream (WIN) and Frontier (FTR).  Given the expected erosion of the company’s customer base, and the competition from wireless, cable and VoiP technology, it seems like it is only a matter of time before the firm would find that it has to cut the dividend.

Most analysts are using cash flow payout ratios when analyzing telecom firms such as Windstream. Their calculation adds non-cash items such as depreciation expense to the net income amounts as the denominator in the cash flow payout ratio.  While using a cashflow payout ratio is appropriate for a real estate investment trust, it clearly shows a lack of basic understanding behind the wireline telecom model. A REIT owns a building with a useful life of 30 years, which would probably would still be there for a few decades after it stops accounting depreciation, and would still be a useful asset for generating revenues. A company like Windstream on the other hand, needs to continuously invest in its technology and equipment simply to keep its operations functioning normally. The telecom equipment that you had purchased even five or ten years ago would likely need some improvement or replacement. In addition, the company is also trying to invest in its future in order to still be able to generate revenues after the wireline segment dies off. As a result, analysts should be looking at earnings only, and those who ignore this logic have an increased likelihood of suffering devastating losses in dividend income and principal investment amounts. A look at the company’s ratio of capital expenditures to depreciation over the past four years shows that for every dollar in depreciation, the firm had to invest almost one dollar in new capital projects.

In Millions of $
Capital Expenditures

At the same time, the dividend payout ratio has been increasing over the past four years, and has reached stratospheric levels:

Diluted EPS Excluding Extraordinary Items
Dividends per Share - Common Stock Primary Issue
Dividend Payout Ratio

As a result, I find that the dividend is at a risk of a cut at present levels.

The second company I will profile today is Pitney Bowes Inc. (PBI), which provides software, hardware, and services to enable physical and digital communications in the United States and internationally. This dividend champion has raised dividends to shareholders for 30 years in a row. The company has slowed down on the rate of increase in dividend payments in recent years. The dividend has been increasing at 2 cents/year since 2008. Currently, the stock yields an above average 9.70%, and has a dividend payout ratio of 70%. The forward dividend payout ratio is 77%. The stock is trading at a forward P/E ratio of 8, which is low. The yield is very high and the P/E is very low. This could be the market’s way of saying that the current dividend payment might be difficult to maintain, and that it could be at risk of a cut. A company’s stock price could be temporarily pushed down by shareholders who do not believe in the long-term outlook for a company. If the stock price goes up, the yield and P/E would return to normal levels. The low P/E ratio could signal a stock that is undervalued, or it could be the market’s way of saying that future earnings would be much lower going forward. Overall, a dividend yield of 10% is something that you do not see every day. In most cases of common stocks of your typical corporation, this high yield is a warning sign of an impending dividend cut.

The issue with the company is that it is providing postage processing equipment such as postage meters to organizations. Revenues have been declining, and the outlook for the business is not very bright. The company has tried to reposition itself in the new digital document environment, and eliminate costs from its structure, but the truth of the matter is that physical mail processing by organizations is destined to decline over time.

Full Disclosure: None

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This article was included in the Carnival of Personal Finance # 403

Wednesday, June 20, 2012

Dividend Investors – Do not forget about total returns

Dividend investors often get into the strategy because the dividend component of total return is more stable. This makes it an ideal strategy for retirees to live off dividends and not be dependent on short term market fluctuations.

Some dividend investors however focus exclusively on yield, which could result in sub-par performance. Choosing a utility yielding 5%-6% today with a high payout ratio and low or no earnings and dividend growth over a dividend growth stock such as Johnson & Johnson (JNJ) might lead investors disappointed down the road. Even if retirees are looking for high dividend stocks for current income, they should not ignore the fact that they would likely remain retired for two or three decades. A stock yielding 6-8% today that does not grow distributions would deliver the same amount each year. The purchasing power of these dollars would be much lower however. In fact even a 3% inflation would decrease purchasing power by 50% over 24 years. This means that a Coca Cola can selling for 75 cents today would likely cost $1.50 in 24 years. On the other hand, a company which yields 3% today, but grows distributions at 6% would pay a yield on cost of 12% in 24 years. Even if the purchasing power is cut in half by inflation, this is still a respectable inflation adjusted yield on cost of 6%.

Utilities are dividend staples, which investors usually purchase in their search for current income. Utilities typically provide above average yields, although their dividend payments do not grow much over time. As a result the purchasing power of these high yields decreases each year. Most of these utilities also pay most of their earnings out in the form of dividends. This means that if these companies could easily cut distributions if cost of capital increases or regulators are not willing to increase rates to provide for sufficient return on new investment. If this happens, investors would suddenly realize a much lower yield on cost on their original investment which would also have much lower purchasing power. Of the 15 companies included in the Dow Jones Utilities index, only a handful have not had dividend cuts over the past 2 – 3 decades.

It is evident, that utility dividends are highly cyclical. In essence, the best time to purchase utility stocks might be right after a dividend cut.

Investors should focus on total returns as well, because increases in share prices would protect the purchasing power of the principal over time. By focusing solely on obtaining the highest current yield, investors could actually risk depleting their principal and suffering from dividend cuts at the worst times imaginable.

The types of companies which are suitable for all investors, no matter what their age, are dividend growth stocks. The types of companies investors should look for include:

The Procter & Gamble Company, together with its subsidiaries, provides consumer packaged goods and improves the lives of consumers worldwide. The company operates through six segments: Beauty, Grooming, Health Care, Pet Care, Fabric Care and Home Care, and Baby Care and Family Care. The company has raised dividends for 56 years in a row, and has managed to boost them by 10.90%/year over the past decade. Yield: 3.60% (analysis)

The Coca-Cola Company (KO), a beverage company, engages in the manufacture, marketing, and sale of nonalcoholic beverages worldwide. The company has raised dividends for 50 years in a row, and has managed to boost them by 10.10%/year over the past decade. Yield: 2.70% (analysis)

McDonald’s Corporation (MCD), together with its subsidiaries, franchises and operates McDonald’s restaurants primarily in the United States, Europe, the Asia Pacific, the Middle East, and Africa. The company has raised dividends for 35 years in a row, and has managed to boost them by 27.40%/year over the past decade. Yield: 3.10% (analysis)

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. It operates in two segments, Upstream and Downstream. The company has raised dividends for 25 years in a row, and has managed to boost them by 8.80%/year over the past decade. Yield: 3.50% (analysis)

Philip Morris International Inc (PM)., through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has raised dividends since 2008, and has managed to boost them each year since. Yield: 3.50% (analysis)

Full Disclosure: Long ED, KO, PG, MCD, PM ,CVX

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Wednesday, September 7, 2011

Two High Yield Dividend Growth Stocks I am buying

When it comes to dividend investing, many investors tend to be either yield chasers or pure dividend growth investors. The real world however is not black and white. As a result, a more nuanced strategy where at least some minimum yield is requested before one purchases a stock that regularly raises distributions should deliver solid income over the long term.

I follow a similar strategy in my income portfolio. I purchase stocks with rising distributions which can afford to pay the dividend but I also have a minimum yield requirement of 2.50%. I tend to be skeptical over stocks which have high current yields, unless my individual company analysis proves otherwise. My analysis of the two income plays listed below has identified them as companies with sound business models. The recent downturn in the stock market has made the following dividend growth stocks with high yields attractive at the moment:

Philip Morris International Inc. (PM), through its subsidiaries, engages in the manufacture and sale of cigarettes and other tobacco products in markets outside of the United States. The company generates most of its revenues from outside the US, where the legislation is not as draconian. The company will be able to increase earnings by generating cost efficiencies in its cost reduction programs, acquiring companies internationally as well as innovating in growing markets in order to position itself favorably. Last but not least, tapping into the growth of emerging markets such as China and India, where it has a low presence could provide another opportunity for future growth. The company has raised distributions in every year since the spin-off from Altria Group (MO) in 2008. Phillip Morris International will be able to keep increasing dividends at the high single digit percentage points in the foreseeable future, while yielding 3.70% today. (analysis)

Kinder Morgan, Inc. (KMI) owns and operates energy infrastructure in the United States and Canada. Kinder Morgan owns the general partner and limited partner units in Kinder Morgan Partners (KMP). KMI also owns 20 percent of and operates Natural Gas Pipeline Company of America (NGPL), which serves the high-demand Chicago market. Another valuable asset behind KMI is the Incentive distribution rights behind the general partner, which entitles it to 50% of the distributions above certain thresholds. This is why any growth in KMP distributions would really accelerate growth in KMI dividends. KMI is set up as a corporation, which is why investors should receive a form 1099- DIV at the end of the year and have their dividends taxed at no more than 15%. The company will likely raise distributions at the low double digits for a few years, and currently yields 4.60% (analysis)

Owning these two high income dividend growth stocks makes sense for investors looking for high yield and a rising income stream. Investors should however always understand the risks behind each investments they purchase and try to spread it by obtaining allocation to different sectors in their diversified dividend portfolios.

Full Disclosure: Long PM, MO, KMI

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Wednesday, April 27, 2011

Highest Yielding Dividend Stocks of the S&P 500

The S&P 500 is one of the most followed stock market index in the world. Mutual fund managers benchmark their returns against it, yet somehow studies show that the vast majority underperforms the index in any any given year. There are many ways to invest in the S&P 500, including mutual funds (VFINX), exchange traded funds (SPY) or even stock index futures. I benchmark my dividend income against the S&P 500. Many of the best dividend stocks in the world have a substantial weight in this important stock market barometer. With its average yield of 1.70% however, many dividend investors choose to ignore the index, and instead focus on its components.

It is interesting to note that 386 companies included in the index pay dividends. The average yield on those is 2.30%. Below I have highlighted the ten highest yielding dividend stocks of the S&P 500:

Altria Group (MO) engages in the manufacture and sale of cigarettes, wine, and other tobacco products in the United States and internationally. This dividend champion has raised distributions for 43 years in a row. The company has a forward dividend payout ratio of 76%. Yield: 6.10% (analysis)

AT&T Inc. (T) , together with its subsidiaries, provides telecommunication services to consumers, businesses, and other service providers worldwide. This dividend champion has raised distributions for 27 consecutive years. The high dividend payout ratio, and the fact that the company is in a highly competitive industry cast a shadow on the sustainability of the distribution payment. Right now the dividend payout ratio is 72% based off forward 2011 EPS. If the acquisition of T-Mobile goes through, the payment of $25 billion dollars in cash could potentially jeopardize the current dividend. (analysis)

Frontier Communications Corporation, (FTR) a communications company, provides regulated and unregulated voice, data, and video services to residential, business, and wholesale customers in the United States. Between 2004 and 2010 the company paid a quarterly dividend of 25 cents/share. Last year however it cut the distribution rate by 25% to 18.75 cents/share. The company has been unable to cover its dividend out of earnings since 2006. More than two-thirds of its distributions are non-taxable as they are essentially a return of capital. Yield: 9.40%

Windstream Corporation (WIN), together with its subsidiaries, provides various telecommunications services primarily in rural areas in the United States. Since 2006 the company has paid 25 cents/share every quarter. Windstream has been unable to cover its dividends from earnings in every year since 2008. One the bright side cash flow from operations has been relatively stable, although the company has ramped up capex spending in recent years. Yield: 7.90%

CenturyLink, Inc. (CTL), provides a range of communications services, including local and long distance voice, wholesale network access, high-speed Internet access, other data services, and video services in the continental United States. The company is a member of the elite dividend aristocrats index, and has raised dividends for 37 consecutive years. In comparison to the previous two telecom players, CenturyLink has been able to cover its distributions from EPS, although its payout ratio is a scary 92.70%. Yield: 7.20%

Reynolds American Inc. (RAI), through its subsidiaries, manufactures and sells cigarette and other tobacco products in the United States. The company has raised dividends for 7 years in a row. The company has managed to double EPS over the past decade, and raise dividends by 9% per year as well. The forward dividend payout ratio is 79.70%. Yield: 6.20%

FirstEnergy Corp (FE) is involved in the generation, transmission, and distribution of electricity, as well as energy management and other energy-related services. The company has maintained its dividend payment since 2008. It’s dividend payout ratio however is at 69.40%, which is sustainable for a utility company. Yield: 5.90%

Pitney Bowes Inc. (PBI) provides mail processing equipment and integrated mail solutions in the United States and internationally. The company is a member of the dividend aristocrats index and has raised distributions for 29 years in a row. Yield: 5.90%

Pepco Holdings, Inc. (POM) operates as a diversified energy company. It operates in two divisions, Power Delivery and Competitive Energy. The company cut dividends by 40% in 2001 to 25 cents/share, and has since raised them by 8& to 27 cents/share. Based off forward 2011 EPS, the payout ratio is over 85%. Yield: 5.80%

Lorillard, Inc (LO), through its subsidiaries, engages in the manufacture and sale of cigarettes in the United States. The company has paid a rising dividend since becoming a separately traded company in 2008. It yields 5.40% and has a high dividend payout ratio as well.

It is evident that the highest yielding stocks in the S&P 500 include sectors such as telecom, tobacco and utilities. All of the top ten companies have very high dividend payout ratios. This increases the risk of a dividend cut, as any decline in earnings would make it impossible to maintain the high distributions. Of particular concern are the telecom companies, since the cash cow businesses of telephones is a dying one. The cell phone industry is highly competitive and is becoming a basic commodity, since customers could expect similar levels of service, and similar prices as well. The only differentiator could be phones offered, but this is a short-lasting advantage, as new phones are introduced and it is impossible to tell which ones would be embraced by consumers.

The tobacco business is also in decline, as more people are starting to realize the health effects of smoking on their well-being. In contrast with telecoms however, tobacco companies have strong pricing power and a loyal customer base, which is addicted to its products. While taxes are raised each year on cigarettes, the levels of price increases that cigarette makers generate more than offsets the decline in consumption by customers. In addition, while there might be speculation that unfavorable court rulings could potentially make all tobacco companies bankrupt, this is highly unlikely. The taxes that tobacco products generate fill in government coffers with billions of dollars worldwide, and tax increases are favored by the electorate. It would be difficult to replace the tax revenues from tobacco products if they were banned.

Full Disclosure: Long MO

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