Dividend plays for volatile times

By Jim Jubak

Every time I update my Dividend Stocks for Income Investors, started back in October 2005, I lament how tough the financial markets are for anyone trying to earn a decent, safe return from an income-producing portfolio.

Well, this time around, my first update since May, I'd have to say things are worse than ever, but my portfolio of dividend-paying stocks has come through the storm in good shape.

Nothing has blown up in 2007, although two investments, Macquarie Infrastructure (MIC, news, msgs) and Oneok Partners (OKS, news, msgs), did get pretty banged up in the August meltdown, and they each dropped about 14% between May 4 and Sept. 25. That's more volatility than I'd like to see in an income portfolio, certainly.

But at least I got paid for taking on the risk that produced that volatility. The average annual return for the portfolio over the past two years is 17.6%. That's up from the average annual return of 13% as of my May 4 update. And it's better than the 13.5% average annual return (with dividends) for the Standard & Poor's 500 Stock Index ($INX) for the period that ended Sept. 25 or the essentially flat return on such mutual funds as Fidelity Total Bond (FTBFX) and Vanguard Institutional Total Bond Market Index (VITBX).

That return is especially good if you remember that the initial goal when I started the portfolio was simply to beat the roughly 5% yield (now about 4.6%) on the 10-year Treasury note.

Let's see if we can keep that outperformance rolling -- and do something about reducing volatility at the same time.

Stocks in the Verizon mold

In uncertain times, the dividend stocks that deliver are those where cash flows are rock-solid and the dividends are just about guaranteed. The financial markets' uncertainty has worked to multiply the return from owning stocks like these far beyond the dividend yield (a company's annual dividend divided by its current share price).

Verizon Communications (VZ, news, msgs), for example, has been one of the best performers in this portfolio since I added the stock May 4, returning 12% in over the past four and a half months. That high return isn't hard to understand. Take a stock with a 4.2% yield (on May 4) at a company with an improving business that generates more than enough cash to cover and possibly increase the dividend, and then give the stock an extra boost from investors looking for a sure return in a crazy market and -- voilà! -- a 12% return.

Finding stocks that fit the Verizon model isn't easy, however. Many of the stocks that fit part of the bill -- sound or improving business and an all-but-guaranteed dividend -- have run up so much in price that the dividend yield is below 3%. Verizon itself has moved up, so that what was once a 4.2% dividend is now just 3.9%. That's not horrible, about what a two-year Treasury bill yields, but it makes surpassing my target of a 5% return a bit harder.

Some stocks that I like for the safety of their cash flows pay even less. ExxonMobil (XOM, news, msgs) now yields just 1.53%, Murphy Oil (MUR, news, msgs) just 1.07% and Imperial Oil (IMO, news, msgs) just 0.72%.

As always, the question is how far to reach for yield. I can certainly find stocks with strong current cash flows and high yields but where the strength of future cash flows seem very closely connected to the fortunes of the U.S. economy. For example, Nordic American Tanker Shipping (NAT, news, msgs) pays a dividend of 12.04%, but the company has just warned investors that the third quarter looks soft. According to the company, jitters in the financial markets have led to softness in spot rates for tankers.

I don't know if that's the reason, in which case the problem will pass quickly, or whether the weakness reflects some deeper trend in the global economy. But given that 11 out of the company's 12 tankers operate in the spot market, instead of being under long-term contracts, the company's business is very leveraged to the rate of growth in the global economy. Since I know that I don't know the rate of global economic growth in the next year with any certainty, reaching for that much yield is too risky right now.

I'd contrast that to the situation at Macquarie Infrastructure, whose stock has taken a pounding recently because investors don't like the company's practice of issuing lots of new shares. I have confidence in Macquarie's cash flow and its prospects for growth. In the first half of the year, revenue grew by 80% year over year. Cash available for distribution doubled in the year's first half. The 6.7% yield looks attractive rather than a risky stretch.

Continued: More dividend stocks to watch

 1 | 2 | 3 | next >