Desperately Seeking Yield Through Equities Part 10: The Importance of Context and Price

We have reviewed a number of investments in the equity sector that produce attractive dividend yields. Many of these are "special" or "unusual" equities in the sense that they are subject to peculiar regulatory restrictions (Business Development Companies - BDCs), are subject to special tax rules (Master Limited Partnerships - MLPs), are subject to price regulation (public utilities), or are required to pay out large percentages of earnings as dividends.

Context - Many investors see the world as consisting of stocks, bonds and cash and allocate among the three. Some of the "special' investments we have been discussing may not even show up on their radar screens. Stepping back a moment and viewing the universe of investment opportunities, it may make sense to think of some of these investments as occupying a space in the investment spectrum somewhere between bonds and equities. This is especially true of BDCs and mortgage real estate investment trusts (mortgage REITS) - both of which earn money by holding large quantities of debt instruments and are, thus, somewhat similar to bond funds.

Assessing the attractiveness of dividend oriented stocks must , therefore, involve an analysis of the comparative merit of bonds and ordinary stocks.

In the early 1980s, there were times when 10 year Treasuries were yielding 15%. In that world, the value of a BDC or mortgage REIT which pays a $5-a-share dividend, would be very different from that value in today's interest rate environment. Similarly, in the late 1990s, stock valuations reached untenable levels and created an atmosphere in which many of the dividend oriented investments discussed in this series of articles were cheap compared to ordinary stocks. Because the equities discussed in this series tend to fall between bonds and "ordinary stocks" on the investment spectrum, it is important to compare them to both of these alternatives. With the 10 year Treasury yielding less than 3% and having a "price earnings ratio" (the inverse of yield) of nearly 35, it is clear than many of the investments in this series are superior alternatives to Treasuries. In the early days of the recovery, corporate bond spreads were still large, but now they have narrowed and even "high yield" bonds are priced to produce modest yields. Thus, I would advise yield-oriented investors to prefer utility stocks, agency mortgage REITS, BDCs and some of the other investments described in this series to bonds.

A more difficult question is raised by the comparison to "ordinary stocks." A number of solid companies with good growth prospects are now paying decent yields. I am thinking of Intel (INTC) (3.2%), Procter & Gamble (PG) (3.3%), Johnson & Johnson (JNJ) (3.4%), Kimberly-Clark (KMB) (4.2%), and ConocoPhillips (COP) (3.5%). This yield pales in comparison with yields available from Annaly (NLY) (14.5% ), American Capital Agency (AGNC) (18.9%) and other mortgage REITS and are well below the levels paid by most BDCs and equity REITS.

However, the strong "ordinary stocks" have been increasing their dividends at rates of between 8 and 10% per year. Many of the best companies increased their dividends right through the 2008-09 panic and recession. In the long term, an investor may actually receive more dividend income from one of these "ordinary stocks" than from some of the stocks described in this series because of these steady dividend increases. In the short term, price appreciation in some of the ordinary stocks may more than make up for a lower yield.

I guess my bottom line is that bonds are overvalued, most of the specialty equities reviewed in this series are probably fairly valued, and many ordinary stocks are seriously undervalued. I certainly would not advise an investor to create a portfolio made up of entirely of the kinds of stocks reviewed in this series. They have their place in a portfolio and I would advise an investor heavily overweight in bonds to consider some mortgage REITS, BDCs, equity REITs, some utility stocks, strong telcom stocks, and even - ahem - some Philip Morris International (PM) as alternatives to bonds. But I would be less enthusiastic about switching from solid, blue chip stocks like the ones mentioned above to the stocks described in this series.

Price - Price is critically important in evaluating the stocks discussed in this series. None of these stocks are "runaway" growth stories which can reward an investor regardless of the entry price. Most of them have limited growth potential - although equity REITs, telcom stocks, MLPs and some BDCs can rack up some solid growth if circumstances are rightly aligned, it is very unlikely that there will be an Apple (AAPL) or Google (GOOG) in any of the groups of stocks discussed in this series. On the other hand, very few of these companies will go out of business or fall into Chapter 11 bankruptcy (although there were a few REITs that went down in the recent financial panic). In a real sense, then, there is no "best" or even "better" group of these investments in a fundamental sense. It all depends on the price. MLPs may or may not be attractive compared to BDCs depending upon the price of each set of securities.

In early 2009, American Capital (ACAS) was one of most problematic BDCs in terms of leverage issues, asset write downs and lender terrorism. However, at a price below $2 a share, an investor was essentially buying a pool of debt instruments at a drastic discount. It may turn out in retrospect that Gramercy Capital (GKK) and RAIT Financial (RAS) offer similar opportunities even as we speak. "Bad" companies can be good investments if the price is right. This is especially true for companies discussed in this series because very few of the "good" companies are going to be able to generate enormous growth in earnings or share price and very few of the "bad" companies will actually go out of business.

The agency mortgage REITS are an interesting special case here because they produce such enormous yields that an investor could withstand some price depreciation and still obtain an overall double digit return on his or her investment. For that reason, I like them here and would tend to load up on some of the names discussed in Part 2. Just remember that it is the U.S. Treasury that stands behind the agency securities that Annaly holds and, if the U.S. Treasury emerges as the next mega-deadbeat, look out below!!

As to the other groups, I believe an investor should constantly be looking for opportunities to buy on pull backs and should be attentive to finding the right entry point. Each of the groups discussed in the different parts in this series has a mix of growth potential, current dividend yield and downside risk. At this point, I tend to favor equity REITs, non-agency mortgage REITS, BDCs with growth potential, MLPs, AT&T (T), Verizon (VZ), and Phillip Morris International (PM) - in addition to agency mortgage REITs.

Disclosure: I am long INTC, PG, JNJ, KMB, COP, GKK, RAS, NLY, AGNC, PM, T, VZ, ACAS.