How to Invest Like an Income Investor

Have dividend-paying stocks become too popular? Mark Deschaine recently asked just that in Deschaine & Company’s Viewpoint, which has long focused on dividend-paying stocks:

“In a world of zero interest rates and another mediocre year for stocks, dividends are garnering more investor and press attention. As a result, we’re increasingly asked if the dividend ‘craze’ has run its course. Or if it’s too late to consider dividends a part of one’s investment strategy. It’s hard to argue that dividend stocks haven’t become too popular when they appear in major features in the New York Times and Barron’s within a week of one another. 

“Yet we’re not worried for this reason: It seems every article extolling the virtues of dividend stocks is also replete with caveats to the risks of dividend investing. Which is a good thing. It’s only when we start to see articles that extoll the virtues of dividends without the usual obligatory homage to risk that we’d become concerned.

“Finally, dividend investing, unlike the Internet and Tech bubble of the late 1990s, is built on a foundation of basic eighth grade arithmetic. As long as we can continue to find stocks with a 4-5% dividend yield that can grow their dividend at 8-10% a year, we’ll do fine. It’s not built on some pie in the sky, earnings or revenue growth expectation.”

Most of the other advisors asking the same question are coming to similar conclusions. However, Roger Conrad, editor of the income-focused Utility Forecaster, does have a word of caution for income investors. In the January 27th issue of Utility Forecaster Weekly, he cautioned his readers to beware of the “safety gap” being created by widespread interest in dividend-paying stocks:

“Are you becoming a momentum income investor? Judging from the price charts of many dividend-paying stocks, more than a few investors are–many very likely inadvertently. Essentially, momentum investors use a range of technical indicators to time purchases of stocks that are deemed to be in accelerating rising trends. Conversely, they sell or go short when their indicators show upside momentum has stalled.

“The strategy was highly popular in the late 1990s, particularly with day-traders betting aggressively on the mostly upward action in technology stocks. It was discredited in the eyes of many following the tech wreck of 2000-2002. And it remains so today for many investors, a lot of whom have shifted their attention to buying dividend-paying stocks.

“Ironically, there’s every indication the basic premise behind momentum investing–that rising stocks are always the best bets–appears to be very much alive and well. The difference is dividend-paying stocks, not technology stocks, are the preferred vehicle this time around.

“In a market where many investors are almost paralyzed by fear of another 2008, stocks deemed ‘safe’ are awarded with hefty premiums. Meanwhile, stocks where investors smell risk have been dumped, some driven down to exceptionally low levels.

“In terms of percentage yields, the gap has rarely been wider. Of the 208 essential-service companies I track in Utility Forecaster, yields range from under 3% to more than 15%. Yields for the 160-plus companies represented in the Canadian Edge coverage universe range from as low as 2.5% to as much as 16.2%. Australian Edge How They Rate companies go from less than 2% to well over 15%. Even MLP Profits–which exists to track every master limited partnership in the U.S.–ranges from just 4.2% to 12.2%.

“So long as people are investing like it’s 2008–or 1932–there’s going to be a safety gap, as investors search for what’s truly bullet-proof and eschew everything else. When the consensus becomes slightly more positive, the yield gap will narrow somewhat, as the battered attract buyers. But we can count on the gap to widen again when bad news strikes.

“To some extent a yield gap is justified. Companies growing dividends, for example, should always trade at a premium to companies that aren’t. Similarly, companies whose dividends are backed by very secure and steady businesses and conservative financial policies should trade with a lower yield than companies where the dividend is at risk of being cut.

“Today’s yield gap, however, is by far the highest ever for companies tracked in Utility Forecaster, which has been around since 1989. It’s far higher, for example, than during the actual meltdown of 2008, when all companies were battered. And that goes for distribution-paying MLPs as well as dividend-paying Canadian and Australian stocks.

“The reason: Income investors are essentially piling into dividend-paying stocks when their prices are rising and dumping those whose prices are falling.

“Markets aren’t wholly irrational, even in the near term, when perception matters more than reality. There’s almost always at least some reason related to the underlying business that begins a selloff or a rally. A beaten-down stock, for example, reflects extremely low expectations that aren’t tough to beat. And unless the overall market is really reeling, someone will notice. Conversely, a stock that gets bid into the stratosphere is progressively more prone to disappointing high and rising expectations, and taking a hit.

“What appears to be different this time is the degree to which buy or sell action is sustained at some companies and not at others. ONEOK Partners LP (OKS), for example, is rightly considered a high-potential master limited partnership, thanks to a strong and growing portfolio of infrastructure assets tapped into the natural gas liquids (NGLs) boom. It’s increased its distribution 10 consecutive quarters, a solid 7% over the past 12 months.

“All this good news, however, is probably more than priced in for an MLP that’s returned 47% in the past 12 months, making new all-time highs almost daily. ONEOK Partners today yields just 4.3% to new buyers.

“Standing in stark contrast is dry-bulk tanker Navios Maritime Partners LP (NMM), which actually lost 4.8% over the past 12 months. Today the stock yields nearly 11% and has been extremely volatile as well. Quite unlike much-loved ONEOK, Navios is clearly a target of investor skepticism that it can maintain its dividend. This is despite the fact that Navios has actually increased its payout 2.3% over the past 12 months.

“The ONEOK-Navios 12-month performance gap is 51.8 percentage points. The yield gap is equally impressive at nearly 7%. Some may attempt to justify the difference on the premise that the tanker business is extremely risky in the current global economy. Navios, however, has basically locked in its revenue with long-term contracts for 2012, and most of it for 2013 as well.

“Moreover, it’s not as though ONEOK is a fee-driven infrastructure company, like Enterprise Products Partners LP (EPD), which, by the way, yields nearly a percentage point more than ONEOK despite equally strong distribution growth and a string of 30 consecutive quarterly increases.

“Rather, ONEOK Partners’ revenue is exposed to changes in prices of NGLs. That’s been a very good thing in recent months, and given global demand and high oil prices, it’s likely to be for some time to come.

“That, however, doesn’t alter the fact that ONEOK’s business, like Navios’, is exposed to commodity-price risk and therefore will be volatile in the long run. That makes a yield gap of 7% wholly unjustifiable, at least based on dividend safety and underlying business value.

“Where the performance and therefore yield gap do make sense is in terms of momentum. The higher ONEOK Partners has flown over the past year, the greater investor interest has been. And the more Navios has floundered the more investors have inferred risk and unloaded.

“This is the essence of momentum-based dividend investing. Although I can certainly understand its popularity, I know of few greater threats to income investors’ wealth here in early 2012 than getting caught in such a web.”

Conrad’s article was titled “Momentum Investing and Dividends: A Bad Match.” And that’s the gist of it: momentum investing and dividend investing are both perfectly valid investing strategies. There are well-respected and successful contributors to the Digests from both camps. However, they’re like oil and water–at least they should be.

Momentum investors focus on buying stocks that are already in strong uptrends and holding until the uptrend is broken. Their main concern is the stock’s price–when it’s rising, they want in, and when it stops rising, they get out.

Dividend investors, on the other hand, try to buy low to maximize their yield. Consider a stock paying $1 a year in dividends. If you buy that stock at $40, your yield will be 2.5%. But if you can snag it at $30, your yield will be 3.33%. And (assuming the dividend payout remains stable) that remains your yield the entire time you own the stock–even if the price goes up, and the yield quoted on Google Finance and elsewhere drops, you’ll still be receiving a 3.33% yield on the money you invested. As long as the company keeps paying its dividends, price doesn’t matter to the dividend investor.

Trying to combine these two strategies, as Conrad pointed out, just doesn’t work. You can’t try to buy low when you’re chasing stocks in uptrends.

So, to get back to the question of whether dividends have become too popular, the answer would seem to be “no, but.” The truth is, dividend-paying stocks have become so popular that a lot of them are acting like momentum stocks. But as long as you continue to invest in them like a dividend investor, and not like a momentum investor, that shouldn’t be a problem. That means buying unpopular stocks with high yields, not popular ones in uptrends. It means buying Navios Maritime Partners, not ONEOK Partners. And it means ignoring trends, popularity and, to some extent, prices, which can be hard to do, but will be worth the effort.

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