Market statistics will show that high-dividend-paying stocks have outperformed non-dividend-paying stocks (with lower volatility) over the long term. They tend to outperform during bear markets, and in a recession their stock prices depend less on earnings. But equity income investing is not just about picking those stocks with the highest dividend yields of their peers. A company must also have a track record of dividend hikes, a payout ratio below 50% (as a more moderate dividend is less likely to be cut), reliable management and growing earnings.
There can be some slack allowed on these earnings during a recession, but not much. Especially now, investor due diligence is critical at a time when many dividends are at risk as companies hoard cash in a competitive landscape. A time when companies with historically safe dividends like General Electric have done the unthinkable and cut their payouts to shore up balance sheets. Given those circumstances, high dividend stocks should not be purchased with a buy-and-hold mentality, but actively monitored for changes in the company's management strategy and financial position.
REIT investments must also be carefully monitored, especially in light of recent IRS changes to their income distribution requirements. REITs, whose structures require them to distribute 90% of their pretax income to investors, are now allowed to do so by issuing stock to supplement or replace cash payments, according to a recent IRS rule change in effect at least through 2009. Since cash dividends have historically accounted for about 65% of total equity REIT returns, these new stock dividends are a concern. They raise transaction costs and increase the risk that a holder will have to sell them at an inopportune time.
Yet even with that risk, REIT yield spreads are currently still more than 260 basis points, well above the long-term average of 118 basis points. If the housing markets stabilize, if REITs can continue to tap the capital markets, and if, because of that capital access, they can avoid paying stock as dividends, then these instruments could still be an attractive addition to an income portfolio.
Meanwhile, preferred stock investments, senior to common equity in the capital structure, offer attractive yields averaging between 8% and 12%, though a company could skip or defer dividend payments under the terms of most structures. Yields are still very high in this space given investors' fear and confusion after the apparent wipeout of preferred-stock holders in companies such as Lehman Brothers, Fannie Mae and Freddie Mac. As they do in corporate bonds, financials offer the best value within the preferred landscape right now-no surprise given the obvious risks.
Finally, MLPs, publicly traded energy partnerships that are registered with the SEC and trade on major exchanges, offer an opportunity to maximize income because they are required to return all profits to unit holders. Since most MLPs operate oil and gas infrastructure such as pipelines, processing plants and storage tanks, they are also attractive as investments in the underlying hard assets owned by the MLPs. The valuations of MLPs imploded during the 2008 market crisis, primarily because of their loan and hedging exposures to large investment banks like Lehman Brothers.
Even after strong performance this year, however, the valuations are still at reasonable levels. MLPs also have tax advantages, as taxes are assessed only on a fraction of the income paid out during the holding period, with the rest of the tax liability incurred at disposition. Because of that, MLPs are not generally good investments for tax-sheltered portfolios such as IRAs, since they can create unrelated business income tax (UBIT) exposure for investors. Also, it is important to note that MLPs, as partnerships, issue Schedule K-1 tax forms in March, so they can delay tax filings. The delays are perhaps worth having, though, considering the possible capital appreciation and the yields, which were between 8% and 10% as of September 1.
The Specter Of Inflation
Despite these advantages, income-oriented securities are not without risk. In 2008, some of them saw market value losses akin to those in traditional growth investments because they were concentrated in high-risk sectors like real estate, financials and energy.
But perhaps the greatest long-term risks to an income-oriented investor are rising interest rates and inflation, which erode the relative value of the income stream. As much as the Fed insists monetary policy will remain accommodative for the foreseeable future, upward pressure on interest rates will likely continue, especially in light of the growing federal deficit and accompanying inflation fears. As Ronald Reagan said in 1978, "Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man." Especially for income portfolios, active management is key to reducing this impact of inflation and protecting principal and income over the long term.