Eyes on the Dividend Prize

August 20th, 2015
in contributors

Investing Daily Article of the Week

by Ari Charney, Investing Daily

There's no way to sugarcoat it: This has been a challenging year for income investors. But even as we endure sharp corrections in some of our favorite sectors, it's important not to lose sight of our long-term goals.

Follow up:

Of course, we all want the stocks we hold to "win forever-all the time," as my four-year old would put it in his inimitable broken English. Unfortunately, even sectors that offer essential services such as utilities and master limited partnerships (MLPs) can hit a rough patch.

For those with new money to invest, the recent selloffs in utilities and MLPs offer an opportunity to start building positions while locking in higher yields than were available just a year ago. Lucky you.

However, for those whose portfolios are already fully invested in one or both of these sectors, the recent market action is so unnerving that it might make you question the viability of otherwise solid companies.

But it's important to remember that we invest in dividend stocks for several different reasons.

The first is the magic and power of compounding: The systematic reinvestment of dividends over five years, 10 years, or longer is one of the best ways to build truly enduring wealth.

I recently chatted with one longtime subscriber who offered a stunning statistic. He calculated that his original lump-sum investment in one of our utilities about 20 to 25 years ago is now effectively yielding 68%, thanks to reinvestment and dividend growth.

At the same time, we know a number of subscribers don't have the luxury of reinvesting their dividends. In this era of historically low interest rates, they've been forced to turn to dividend stocks to provide the crucial income stream that bonds used to provide.

Many such investors have, therefore, conditioned themselves to treat these stocks almost like bonds. That means they're largely indifferent to corrections, so long as their stocks remain fundamentally sound and the dividends keep on coming.

For these investors, the decision to sell is almost existential. Bailing out on one dividend payer requires quickly finding another dividend payer to maintain current income.

The third reason we invest in dividend stocks is important to both sets of investors: dividend growth. Too many income investors narrowly focus on current yield. But over time, dividend growth becomes a far more important contributor to both income and wealth generation.

On the wealth-building front, a rising payout really starts to accelerate the compounding effect. And on the income front, your paycheck is getting fatter year after year.

Finally, for both sets of investors, a steady stream of dividends can help offset some of the anxiety from falling share prices. After all, you're getting paid to wait for better times ahead.

If you're reinvesting your dividends during a downturn, you're being given new capital with which to pick up additional shares on the cheap. And if you're investing largely for income, you've still got money flowing into your brokerage account, while investors in stocks that pay no dividend get nothing but agita.

A Step Forward and a Step Back

Over the past eight weeks, utilities appear to have finally stabilized. The Dow Jones Utilities Average hit a bottom at the end of June and has since risen nearly 10%.

By contrast, the Alerian MLP Index, which is the benchmark for the midstream MLPs in our Income Portfolio, has dropped even lower in the wake of oil's renewed decline amid concerns over global growth.

The index hit an all-time high at the end of last August, and has since fallen 33.3% on a price basis. Over that same period, North American crude oil benchmark West Texas Intermediate is down 55.9%, while natural gas has dropped 31.1%.

After hitting a near-term bottom last week, the Alerian is up almost 5%, due in part to short covering, but also perhaps thanks to the sudden bullish about-face by Credit Suisse.

Earlier this week, the investment bank upgraded the sector to a "buy," while asserting the possibility of a 40% upside in total return.

Credit Suisse noted that midstream MLPs' distribution growth is tracking nearly 8% year over year, toward the top of the previously forecast range. And it said investors should favor MLPs with limited exposure to commodities, particularly pipeline companies involved in the transportation of natural gas.

The midstream MLPs in our portfolios are mostly insulated from direct exposure to volatile commodity prices, but that hasn't stopped the market from punishing them anyway, though oil and gas producers have been hit even harder.

Nevertheless, we hold some of the biggest and best-capitalized MLPs in the industry, and we expect them not only to survive the downturn with payouts intact, but to use this as an opportunity to acquire top assets on the cheap from troubled competitors. That's how the biggest and best companies extend their dominance over the long term.

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