Wednesday, September 21, 2011

Dividend Investing Risks

Every article on long term investing stresses the importance of the power of compounding. Basically, investing a certain amount of initial capital at a particular annual return for a given time period would lead to a much higher amount at the end of the investment period.

While this concept is valid, investors should not rush in blindly and purchase any type of asset for long-term compounding of their wealth. In order to stack the odds in their favor, dividend investors should develop a focused strategy. This would allow them to compound their money for as long as possible, while increasing their wealth.

Some of the factors I use in order to minimize risks of ruin include developing an entry criteria, holding over 40 stocks in my dividend portfolio and reinvesting dividends selectively. It also doesn’t hurt to focus on companies with strong competitive advantages, which are able to generate rising earnings and therefore can afford to pay me a rising dividend payment every year.

After all, compounding might be one of the eight wonders in the worlds according to Einstein. However, one fails to do their homework, they could end up suffering huge losses in principal and income. After all, investors who meticulously reinvested dividends in companies like Fannie Mae (FNM), Lehman Brothers (LEH), General Motors (GM) or Enron (ENE) ended up losing almost everything, even if they compounded their wealth for generations.

I have identified a one high yielding sector, which has been bid up by investors looking for yield in a zero-interest environment.

Since I first reviewed pipeline Master Limited Partnerships a few years ago, I have fallen in love with this sector. After all, there is nothing sexier than a business which is a virtual monopoly in the distribution of oil, gas, and other commodities through its toll-like pipelines. Building a pipeline is extremely costly, which minimizes the risk that a competitor would target your clients. Pipelines are highly regulated, and their rates typically increase by the rate of inflation every year. While commodities prices are highly volatile, the volumes of carbons delivered each year is relatively stable. In addition, stability is further aided by the fact that pipeline MLPs typically are not exposed to the price fluctuations of the commodities they transport. Add in to that the fact that large portions of the distributions are not taxable and the fact that MLP’s distribute almost all of their cashflows to unitholders, and it is no wonder MLPs have been seen as a safe haven by dividend growth investors. MLPs not only pay high yields, but they also offer strong distribution growth over time, which keeps purchasing power of distribution income intact.

The major risks behind MLPs include legislation and interest rates. If the debt ridden US government decides to abolish the favorable pass-through entity structure that the MLP’s enjoy, the sector would be hard hit similar to what investors in Canadian Royalty Trusts experienced since 2006. Currently, MLP’s are not taxed at the entity level, but at the individual unitholder’s level. If MLPs are converted to corporations, they would likely end up distributing much less to unitholders.

In addition, since most MLPs distribute most of their free cash flow to unitholders, they grow their business by selling additional units or selling debt in the public markets. If the yields these MLP’s pay are much lower than today, investors would likely ignore these partnerships. In addition, if interest rates increase, MLPs would find it more expensive to obtain debt financing, which could mean that some projects would not be realized because their rate of return would not be sufficient to cover the increase in interest expenses. By having limited access to capital in order to make acquisitions to grow the business, investors would suffer from stagnant distributions and lower unit prices because of the rise in interest rates.

Some of the largest MLPs include Kinder Morgan (KMP) and Enterprise Products Partners (EPD). They have the highest weighting in the Alerian MLP Index.

Enterprise Products Partners L.P. (EPD) provides a range of services to producers and consumers of natural gas, natural gas liquids (NGLs), crude oil, refined products, and petrochemicals in the continental United States, Canada, and Gulf of Mexico. The partnership has raised distributions for 14 years in a row and currently yields 5.80%. (analysis)

Kinder Morgan Energy Partners, L.P. (KMP) owns and manages energy transportation and storage assets. The partnership has raised distributions for 15 years in a row and currently yields 6.60%. (analysis)

While there are risks to MLPs, a reasonable allocation to the sector could boost current portfolio yields and also deliver distributions growth over time. As dividend investors, it is important to take reasonable risks, and manage them accordingly by not being overcommitted to a certain sector.

Full Disclosure: Long Kinder Morgan Partners and Enterprise Products Partners

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