The Portfolio That Pays and Pays
What’s an income-hungry investor supposed to do? Banks are paying next to nothing on deposits. Yields on bonds are paltry, and as interest rates for new bonds rise over the next few years, existing bonds are expected to lose value.
Top investment expert Charles B. Carlson, CFA, says the solution is a portfolio of carefully chosen dividend-paying stocks. These stocks can provide a stream of income that historically has grown much faster than the annual rate of inflation. The trick, however, is to choose stocks whose share prices won’t be severely hurt when interest rates rise and whose dividends will grow.
Bottom Line/Personal asked Carlson how to incorporate dividend stocks into an income-producing portfolio and how to choose the right ones…
A Portfolio Strategy
It’s true that even the best dividend-paying stocks are riskier than high-quality bonds. You can’t be sure that their share prices won’t suffer setbacks. But if you are able to hold the shares for at least a few years, many of them are worth the moderate risk. Keep in mind that a high-quality company can continue to pay a predictable, growing dividend in good times and bad. That ability often is a strong sign that profits are rising and will continue to do so…and that the stock’s total returns (dividends plus capital appreciation) over the next decade have a good chance of beating what high-quality bonds could provide.
Try to assemble a portfolio of dividend-paying stocks with an average yield higher than that of 10-year US Treasury bonds, which was recently around 2.4%. I’m not advocating that you abandon all your bonds, because they do provide more stability and certainty than stocks. You need to decide how much volatility you are comfortable with and then determine what mix of dividend-paying stocks and bonds you want in your income-centered portfolio. For example, some of my clients have income-centered portfolios that consist of as much as 60% in dividend-paying stocks and 40% in short- and intermediate-term bonds and cash.
If your portfolio doesn’t produce enough income to fund your lifestyle in certain years, you can use a “total return” strategy to supplement your income. In addition to drawing on dividends and bond interest, the principal from maturing bonds can contribute to your income rather than being reinvested in new bonds. Also, you can sell shares of stock to meet your cash-flow needs.
How to Choose
Investors often focus too much on how high the yields on dividends are…
Don’t be blinded by yield. The highest-yielding stocks often are a dangerous bet for long-term investors because the yields tend to be unreliable. The stocks typically are from troubled companies whose yields have soared as their stock prices have been beaten down, usually for good reason. These companies may not have the cash to sustain their dividend payouts.
Focus on “dividend growers” instead. I like to invest in a company that has increased dividends by at least 5% annually for the past five to 10 years and that has enough cash flow to maintain that pace for the foreseeable future. This tells me that it has strong business fundamentals that are able to support a stable, reliable payout each year and that it likely will increase the payout even if the share price is stagnant or falls for a number of years. In past periods of rising interest rates, large-cap stocks with growing dividends have, on average, outperformed the Standard & Poor’s 500 stock index.
My Favorite Dividend Stocks
Here are nine high-quality companies with attractively priced shares that meet my criteria listed above and that you could easily hold for the next decade or more. Recently, their yields averaged 3%, and overall they have been much less volatile than the S&P 500. Over time, I expect their total returns to keep pace with the performance of that stock index. I typically hold equal dollar amounts of each stock in the portfolio and rebalance once a year.
Master Limited Partnerships (MLPs), such as the following, operate like regular corporations but distribute most of their cash flow to shareholders in exchange for tax-advantaged status…
Spectra Energy Partners (SEP) has 22,000 miles of pipeline stretching from the Gulf Coast to the Marcellus Shale basin in Ohio and Pennsylvania. Recent yield: 5%. Five-year annualized performance: 10%.*
Star Gas Partners (SGU) is one of the nation’s largest distributors of heating oil and propane. It serves customers in 16 states from Georgia to Maine. Recent yield: 4%. Performance: 14.7%.
Atmos Energy (ATO) distributes natural gas to three million customers in eight states with favorable regulatory environments for rate increases stretching from Colorado to Virginia. Recent yield: 2.9%. Performance: 8.8%.
Public Service Enterprise Group (PEG) provides electricity to four million New Jersey customers and sells excess power to metro areas in and around New York City and Connecticut. Recent yield: 3.7%. Performance: 5.7%.
Scana Corp. (SCG) generates and distributes electricity to 1.5 million customers in Georgia, North Carolina and South Carolina. To meet rising demand, it is building the first new nuclear power plant in the US in three decades. Recent yield: 4%. Performance: 5.3%.
JPMorgan Chase (JPM) is one of the most undervalued major banks. The stock was hurt by the company’s billions of dollars in settlements for questionable mortgage underwriting and other issues. But its balance sheet is in excellent shape, and earnings from its massive branch network and its investment bank and asset-management operations continue to improve. Recent yield: 2.4%. Performance: 8.5%.
Wells Fargo (WFC), the largest US bank in terms of deposits, will benefit greatly from interest rate increases, widening the margin between what it charges borrowers for loans and what it pays account holders for deposits. The company is expected to raise its dividend by more than 10% in 2015. Recent yield: 2.5%. Performance: 7.9%.
Comcast Corp. (CMCSA) is the largest operator in the cable-TV industry, serving 55 million households with video, phone and/or Internet access. The company’s stock was hurt when its bid to merge with Time Warner Cable ended in the face of regulatory opposition. But investors should view that as a buying opportunity for a company that will continue to dominate its cable-TV markets, as well as create its own media content through its NBCUniversal operations, which include TV networks, theme parks and a film studio. Recent yield: 1.5%. Performance: 12.9%.
Apple (AAPL). Even though the company waited until 2012 to reinstitute its dividends, the potential for dividend growth is enormous. Recent yield: 1.5%. Performance: 36.4%.
*Performance figures are 10-year annualized returns through July 15, 2015, unless otherwise noted.