Five Dandy Dividend Plays

Income-focused investors may still want to stick with dividend-paying equities, even as bond yields creep higher

With yields on U.S. Treasury bonds topping the Fed funds rate of 5.25% this week for the first time in nearly five years, talk on Wall Street has turned to whether investors may start taking money out of dividend-paying stocks. The reasoning? Dividend-paying stocks find it hard to compete with Treasuries when bond yields are that high.

But no matter the climate, dividend-paying stocks are still an attractive option for investors, especially retirees. There's a good reason for that: the need for immediate income, coupled with the prospect of a continuing revenue stream as long as you hold the equity.

Although dividend investing is logically a long-term strategy, the recent spike in yields for Treasury notes and attendant worries about impending inflation have some people convinced that lower-priced bonds will start to look more alluring than stocks. The market has to wait until the latest inflation numbers for May—and whether key price gauges are moving uncomfortably higher—to see whether the moves in bond yields are justified.

But by focusing only on yields, investors may be missing out on opportunities to boost their total returns over time, according to Josh Peters, editor of Morningstar's Dividend Investor newsletter.

"Income investors aren't trained to look for dividend growth, and growth investors have been off looking for what's hot, like leveraged buyout [candidates]," he says. "Companies have large opportunities to continue to grow their business with cash flow they don't pay out to stockholders." Even so, many outfits have boosted their dividend rates as they look for ways to return cash to shareholders—and prop up their stock prices.

What are some smart dividend strategies in the current environment? This week Five for the Money looks at five ways to bet on dividends for the income-conscious investor. As always, investors should consult with financial professionals to learn more about the tax treatment of dividends from these stocks.

1. Canadian Oil & Gas Trusts

Don Martin, a financial planner at Mayflower Capital in Los Altos, Calif., suggests looking deeper than just the yield when considering dividend-paying stocks, as rising yields can sometimes signal a company that's having some trouble and whose share price is under pressure. For those who insist on high dividend yields, however, he suggests the Canadian oil and gas trusts, which are exempt from corporate income taxes if they distribute their income to unit holders.

Mary Brooks, a certified financial planner in Colorado Springs, Colo., has been using Canadian oil and gas trusts since 2004 to generate cash flow for her mother, who is 102 years old. "Long-term investments from this perspective aren't realistic, so I'm looking at the actual income we can generate. The parameters are different than when people are 80 years old," she says.

Brooks likes that the trusts are backed by hard assets in the ground. She's betting oil and gas prices will remain high, so she isn't concerned about exposure to price volatility.

She owns shares of Penn West Energy Trust (PWE), Primewest Energy Trust (PWI), Fording Canadian Coal Trust (FDG), and Knightbridge Tankers (VLCCF).

2. Energy Master Limited Partnerships

Another tax-exempt structure, which isn't vulnerable to falling oil and natural prices, is the energy master limited partnership. Peters at Morningstar calls this group his go-to sector for reliable and increasing income over time. These partnerships are formed around storage and transportation assets such as pipelines that don't depend on successful drilling results and can shrug off commodity price swings.

And since the tariffs they charge customers to move refined products from state to state are usually tied to inflation, their cash distributions include an automatic pass-through to inflation, ensuring that investors' income doesn't take a hit.

Peters recommends Buckeye Partners (BPL) and Kinder Morgan Energy Partners (KMP), both of which have yields of around 6% and are targeting distribution growth at 8% annually.

3. Dividend ETFs and Mutual Funds

Exchange-traded funds built around a portfolio of high-dividend stocks have become more popular in the past few years. ETFs have garnered lots of attention because of their low fees relative to those of actively managed mutual funds.

In a report on ETFs released in May, Morgan Stanley said it was no surprise that the highest-yielding large-cap stocks are included in most dividend ETFs. These funds tend to be overweight in financial and utility names and underweight in information technology companies.

Given the preference for higher dividend yields among those over the age of 65, demand for equities with higher yields should increase significantly as baby boomers swell the ranks of the retired in the years ahead, according to Morgan Stanley.

Kevin Brosious, president of Wealth Management in Allentown, Pa., who says he's always on the lookout for high-yield funds for his retired clients, likes the iShares Dow Jones Select Dividend Index Fund (DVY), an ETF with a 3.4% dividend yield and a dividend growth rate year-to-date of 7.7%. The ETF roughly tracks the performance of a custom index created by Dow Jones and comprising 100 stocks that are screened for their dividend-per-share growth rate, their dividend payout percentage rate, and their average daily dollar trading volume. The index is rebalanced at the end of each year. The fund itself contains 63 of the index's 100 names and also holds 52 nonbenchmark names included "to improve the yield on the product," according to Jane Leung, senior portfolio manager at Barclays Global Investors, which advises iShares Funds. "It's hard to say how much the nonbenchmark names have improved the yield."

Morgan Stanley cites the Vanguard Dividend Appreciation Index Fund (VIG) as one of the few ETFs that emphasizes the potential for dividend growth over a high yield.

And while comparatively high fees are making mutual funds look less appealing, sometimes the return rates are just too good to pass up. Brosious recommends the Alpine Dynamic Dividend Fund, an open-end, midcap value fund that has returned 26.4% over the year ended June 12 and just under 17% for the 3-year period, according to Lipper Funds.

4. Growth Stocks That Fall Between the Cracks

Even with lower expense ratios, Peters thinks ETFs take too big a chunk out of investors' income, roughly 15% by his estimate for ETFs with an annual yield of 3% to 4%. He recommends ETFs only for investors of limited means who can't afford to diversify through individual equity investments.

Companies that have managed to increase dividends at double-digit rates over time, he says, have been overlooked as most of the market attention has been directed toward "cyclical names that benefit from global growth and companies likely to be taken out by private equity."

Despite having a relatively low yield of around 2.6%, Coca-Cola (KO) and Sysco (SYY) each have impressive dividend growth potential of about 10% per year. 3M's (MMM) current yield is closer to 2%, but it also has a good chance of increasing its dividend by 10% annually.

The dividend yield will continue to be the primary bait, however, making the average investor migrate toward value rather than growth stocks, according to Brosious at Wealth Management.

5. REITs

Real estate investment trusts have been knocked down from the highs they traded at earlier this year amid a deluge of negative home sales and mortgage loan data and rising long-term interest rates (see, 6/12/07, "Rising Rates Won't Wreck REITs").

At the lower prices, they are beginning to look a bit more attractive, says Peters. As he explains in his latest newsletter, REITs don't qualify for the reduced federal tax rate of 15% that's been in effect since May, 2003, because they are required by law to pay no less than 90% of their taxable income to shareholders. But the portion of actual dividends that exceeds taxable income may be classified as tax-deferred returns of capital.

Peters likes First Potomac Realty Trust (FPO), which owns properties across the greater Washington (D.C.) area and has benefited from the boom in government spending for defense and homeland security. The company's 88% tenant retention rate and multiyear leases under which customers agree to pay most of the facilities' operating costs have produced a lot of free cash flow, for an average return on investment of 10%, he says. First Potomac's price has dropped to $23, from $30, and has a yield close to 6%. Peters believes it can increase its dividend to a healthy 8% a year.

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