Don’t Fall for the Same Dividend Capture Strategies As Everyone Else

A growth and income play we like right now is Diamond Offshore Drilling (DO) Why? The company has compelling yield, an improving growth profile, and its industry is experiencing a recovery.

Diamond Offshore owns and operates one of the world’s largest fleets of offshore drilling units; including 32 semisubmersibles, 13 jack-ups, and four dynamically positioned drillships, three of them with expected deliveries between 2013 and 2014. Its equipment lets the company offer equally diverse worldwide services in both the floater (ultra-deepwater, deepwater and mid-water) market and the non-floater, or jack-up, markets. Often criticized for its older fleet, Diamond Offshore in fact had been for years investing in its fleet, having devoted nearly $4.2 billion to it in new capital since 2009. Since then, the total number of rigs has declined, as the company divested 8 jackups and 2 midwater rigs, but the focus on ultra-deepwater and deepwater markets has resulted in Diamond having more than doubled its fleet there, from 8 to a total of 19.

The company focuses on deep- and ultra-deep-water market because that’s where demand and day rates are expected to remain strong for the next few years.

Of course, at first glance, Diamond Offshore, as a deepwater driller, may not look too enticing to most income investors: it’s not exactly in a recession-proof business. Its yield, on the surface, does not look very high, either: if you measure the size of its regular dividends, they fall at under 1 percent. However, over time the company has consistently paid “special” quarterly dividends—and said dividends, since mid 2010, have held steady at 75 cents a share. Add them, and the annual yield pops to about 4.7 percent.

Since January 1, 2006, Diamond Offshore has paid and declared more than $33 per share in overall dividends, and going forward, the special dividend looks safe, as Loews Corporation owns over half of Diamond Offshore—and like all stockholders also reaps the special dividend. Thus, with Loews remaining the majority owner, we think there is little risk to the “special” dividends.

Another positive—compared to its industry group—is Diamond Offshore’s balance sheet strength: The size of its long-term debt is about equal to the total cash it carries on its balance sheet. This, plus the recent debt upgrade create financial flexibility and further enhances our investment case.

A growth and income play we like right now is Diamond Offshore Drilling (DO) Why? The company has compelling yield, an improving growth profile, and its industry is experiencing a recovery.

Diamond Offshore owns and operates one of the world’s largest fleets of offshore drilling units; including 32 semisubmersibles, 13 jack-ups, and four dynamically positioned drillships, three of them with expected deliveries between 2013 and 2014. Its equipment lets the company offer equally diverse worldwide services in both the floater (ultra-deepwater, deepwater and mid-water) market and the non-floater, or jack-up, markets. Often criticized for its older fleet, Diamond Offshore in fact had been for years investing in its fleet, having devoted nearly $4.2 billion to it in new capital since 2009. Since then, the total number of rigs has declined, as the company divested 8 jackups and 2 midwater rigs, but the focus on ultra-deepwater and deepwater markets has resulted in Diamond having more than doubled its fleet there, from 8 to a total of 19.

The company focuses on deep- and ultra-deep-water market because that’s where demand and day rates are expected to remain strong for the next few years.

Of course, at first glance, Diamond Offshore, as a deepwater driller, may not look too enticing to most income investors: it’s not exactly in a recession-proof business. Its yield, on the surface, does not look very high, either: if you measure the size of its regular dividends, they fall at under 1 percent. However, over time the company has consistently paid “special” quarterly dividends—and said dividends, since mid 2010, have held steady at 75 cents a share. Add them, and the annual yield pops to about 4.7 percent.

Since January 1, 2006, Diamond Offshore has paid and declared more than $33 per share in overall dividends, and going forward, the special dividend looks safe, as Loews Corporation owns over half of Diamond Offshore—and like all stockholders also reaps the special dividend. Thus, with Loews remaining the majority owner, we think there is little risk to the “special” dividends.

Another positive—compared to its industry group—is Diamond Offshore’s balance sheet strength: The size of its long-term debt is about equal to the total cash it carries on its balance sheet. This, plus the recent debt upgrade create financial flexibility and further enhances our investment case.

All too often, investors watching market indicators allow their impulsiveness to carry them away. But history shows that long term investors — especially those focused on income-generation — should avoid concentrating on technical indicators, in somewhat the same way as addicts must avoid alcohol. Look, but don’t touch.

Our first argument is very simple. Pullbacks are part and parcel of a healthy stock market. Selling into each would generally prevent participating in a market upside.

And here is the second: while technical indicators often show general market trends, using them requires certain education as to their respective meanings. It always helps to investigate the factors driving the latest trend and try to determine whether it is shaping up to be a longer- or a shorter-term development.

Let’s take two indicators that you may have heard about from the financial media lately: the Dow Theory and the CBOE Volatility Index, or the VIX. The action in both, from the traditional point of view, hasn’t been all that positive.

As we’ve discussed before for example, the Dow Theory holds that any bona fide market trend in the broad Dow Jones Industrial Index should be confirmed by similar action in the Dow Jones Transportation Index and vice versa. In December 2012, the Transports broke out while the Industrials lagged. According to Dow Theory, recent gains in the Transports (see chart) should be matched by a breakout of the Industrials, above its previous, early October, high of 13,662.

Another indicator that garnered a lot of attention is the VIX, also called the fear index. The VIX is one of the best measures of market volatility, which is does by tracking the implied volatility of the S&P 500 index option prices. While, as you can see from the chart, the VIX does track the market sentiment fairly well, it’s not a leading indicator.

While it’s valuable as a contrarian indicator, a high VIX alone itself does not constitute a buy signal just like a low reading on the index does not necessarily signal a sell.

Consider the chart. While in May 2010 and again in June 2011, volatility spiked up, together with the European debt crisis and U.S. debt crisis, and would provide a good buy signal, the VIX lows of May 2010, 2011 and even 2012 would not be good points to sell.

In this case, these particular indicators also look to us more like tea leaves than solid or important, actionable signals. Of course, even with our belief that income investors should not trade the market actively, if the overall market picture, both fundamental and technical, turns bearish, we would advise investors to increase their cash allocation. But recent market action has not been bad at all: smaller capitalization stocks have been outperforming, and recently broke out to all-time highs, and large caps are nearing 5-year highs. So far, this one is the market to buy, not to sell, especially for income stocks.

The Dow Industrials have set a new all-time record high, while the S&P 500 is knocking on the door of one. The adage that bull markets climb a wall of worry has never been more apt, proving itself in stocks’ recent action in face of significant economic adversity and the negative publicity that has accompanied the U.S. government’s sequester taking effect.

Moreover, other parts of the world are not likely to compensate for the negative impact of forced austerity measures. The European Central Bank, for instance, lowered its growth forecast today. In fact, the ECB predicts that the economy of the union will contract in 2013, by more than it had expected earlier (-0.5 percent vs. a prior -0.3 percent forecast). For 2014, the ECB sees growth at only a 1 percent pace, down from a previously estimated 1.2 percent.

Encouragingly, here at home the government is less likely to be shattered in late March as progress is being made on keeping federal agencies funded and running. Also, we’re increasingly witnessing improving economic data readings. Better than expected job initial unemployment benefit numbers, at a six-week low, for instance, helped the rally yesterday; Tuesday it was the Fed’s Beige Book from which we learned that the Fed sees improvements in the labor market and housing.

One of the prominent investment stories of the week was the recurring saga of Vodafone (VOD) and its 45-percent stake in Verizon Wireless. This week, Vodafone rallied the most in four years on reports that Verizon (VZ) might want to put an end to the partnership, buying out the other company’s entire stake as early as this year.

This was not the first time in 2013 when Vodafone’s shares moved on speculation about the partnership sale. In early January, it was enough for Verizon Communications’ chief executive Lowell McAdam to say that Verizon could buy Vodafone’s stake that stock moved nearly 3 percent. (The next day, McAdam popped that balloon, denying that any talks on subject between the two companies were held, but adding that the possibility of buying out Vodafone had been “feasible for 10 years”.)

Now, however, maybe things have changed at last. On Feb. 25, Verizon reiterated interest in buying out the Vodafone stake in Verizon Wireless, despite the potential $100 billion price tag on a deal. “We think we have a way to do this,” Verizon Chief Financial Officer Fran Shammo told investors at a Morgan Stanley conference.

Verizon’s stock has also reacted positively to these speculations, despite the hefty price tag. That’s because Verizon Wireless is a very profitable venture. It’s also growing three times faster than its next largest rival, AT&T Inc. (T). In the last two years Verizon Wireless added about 9.3 million contract customers, while AT&T added 2.9 million.

Verizon Wireless is the crown jewel for any telecommunication company. Regardless of who owns it, all three telecom giants remain attractively valued income stocks.

Last Wednesday, in a Wall Street Journal op-ed, House speaker John Boehner addressed the upcoming sequester. In effect, he stated that the current conundrum resulted directly from the President’s refusal to negotiate a settlement earlier.

Either way, spending cuts now seem inevitable. Moreover, Congress appears no closer than before to compromise over the March 1 sequestration deadline.

The nation’s continuing financial mess and the approaching deadline, however, did not significantly deplete the optimism in the stock market. On Tuesday of last week, the S&P 500 raced to its highest level in five years above 1,530 before retreating somewhat. Gold, an investment many turn to for safety, fell to under $1,600 an ounce on continuing market strength. Last Thursday, the market sagged, but rebounded on Friday.

In another good sign, construction companies started new single family homes at an annual rate of 613,000, both the highest absolute monthly number since July 2008 and an increase of 0.8 percent from December 2012. Total housing starts fell, however, to a lower-than-forecast rate. Plus, wholesale food prices increased slightly (0.2 percent) in January, the first rise in four months. And the Consumer Price Index was unchanged in January, as it had been in December. Thus far, inflation remains in check.

We cannot predict exactly what lies ahead, but given the still-tepid recovery, valuations to us continue to seem reasonable, and the strength of stocks in recent months suggests that investors have already accounted for the upcoming sequester, at least in terms of market prices.

Moreover, while combined impacts from rising taxes (for individuals earning over $400,000 and families earning over $450,000) and payroll taxes, plus higher gas prices (which also effectively tax the US consumer) weigh on investors, the market mood remains positive. The stock market, as represented by the S&P 500, may need a few attempts to break to new record highs, but smaller-size companies are already there, another positive for the overall equities market. Plus, the Fed easing mode (record easing, we might add), has created a significant tailwind for shares. Equities, we believe, still have more room to grow.

Indeed, further market action rests both on the actions of the Federal Reserve Board, which continues its stimulus program—and low apparent inflation rate.

Minutes of the January 30 Federal Open Market Committee meeting also released last Wednesday confirm that the Fed remains committed to helping to heal the economy via both low rates and quantitative easing. As the FOMC discussed possible benefits and costs of more asset purchases, its members seemed to indicate that the central bank could taper or halt bond purchases even before seeing “substantial improvement in the outlook for the labor market.” Some members said the Fed should “vary the pace of asset purchases” due to changes in economic outlook or “ongoing evaluation of the efficacy, costs, and risks of asset purchases.”

The minutes also highlighted the idea that labor market concerns alone will not determine the Fed course. Very likely, policy will result as much from the means found to resolve internal division over potential effects of continued asset purchases.

The Fed will conduct further research before it next meets to address the concerns. Firstly, some members fear potentially significant capital losses in some cases when “a very large portfolio of long-duration assets” are sold. Others think that losses would not accrue harm to effective function of monetary policy. Secondly, some worried over “potential effects of further [bond] purchases” on financial markets, but others noted “little evidence to date of such effects.”

As the US dollar strengthened on expectations that the Fed will slow its bond-buying pace sooner than previously anticipated, gold fell still further. We continue to think, however, that the yellow metal should remain an integral part of investment portfolios – despite its recent weakness. Its fundamentals remain intact, and its importance in the environment of continuing global easing is hard to overestimate. In fact, this looks like a buying opportunity. Even if gold goes a little lower from here, in the long run, it will do well.

The stock market’s push to near record levels has rightfully captivated the lion’s share of attention these days. When combined with ongoing budgetary fireworks in Washington, the buyout of Dell Computer and a host of lesser headlines, equities have generated a fog masking trends in other financial sectors. We’re particularly surprised, for example, that more economic pundits have not discussed recent developments in one of our favorite precious metals—Platinum.

Rarer and more expensive per ounce than gold, platinum also proves more economically sensitive, due to its heavy industrial use – as a catalyst in automotive catalytic converters, in LCD glass, in computer electronics, jewelry and so on. Of the annual global platinum supply, some 73 percent—totaling roughly 4.25 million ounces in 2012—comes from South African mines.

Those mines are under pressure, from closures and labor unrest alike. Thus, while the world fixated late last year on the U.S. presidential election and its aftermath—the debt ceiling talks, Europe’s ongoing economic crisis and prospects for unlimited central bank quantitative easing in the U.S. and globally, platinum supplies steadily deteriorated. Some estimate put over 60% of South Africa’s platinum mines at either the break even line, or at an operating loss, based on 2012 prices of roughly $1,600 an ounce all year.

Accordingly, global platinum production in 2013 should fall to 5.68 million ounces, 2.7 percent lower than last year—and levels not seen in 13 years. Companies are closing mines while wages rise, creating a self-perpetuating cycle. As might be expected in such conditions, the price of platinum has been driven higher. Platinum contracts for immediate delivery reached more than $1,709 per ounce last week.

Slowing production comes simultaneous with automotive demand finally recovering from the several-year doldrums created by the financial crisis. Cynthia Carroll, CEO of Anglo American PLC, the world’s largest platinum producer, has called the rapidly falling production of so-called white gold, at a time of fast-rising economically-fired demand—nothing short of a crisis, and the single greatest challenge facing her company.

For those invested in our physical-platinum recommendation ETFS Physical Platinum Shares (PPLT), the news could not be better. Despite the cloudy forecast for South African mines, the outlook looks healthy for platinum prices. If the global economy continues to firm, something we consider likely, demand for platinum across several industrial sectors—autos, electronics, jewelry, etc.—will continue to heat up as well. Given weak current production, platinum prices simply have no where to go, but up.

Consequently, PPLT’s assets have grown alongside the stealth rally in platinum over recent weeks. It now boasts assets of roughly $874 million, stored as platinum bars in London and Swiss vaults. The fund is decently liquid, trading, on average, over 68,000 shares per day. Technically, a break over $1720, where rallies in October and February of last year topped out, would be significant. With platinum mines in disarray, we’d avoid the miners themselves and focus on the metal. We reiterate PPLT as a recommendation.

Just what the market expected: last Wednesday the regularly scheduled meeting of the US Federal Reserve Open Market Committee wrapped up.

The US central bank indicated it will continue with its current policies, and noted that the economy had “paused” in the recent months. No surprise there. The fourth quarter economic slowdown resulted from temporary factors, such as superstorm Sandy, the Midwest drought and subdued government spending (in turn resultant of the fiscal cliff debacle).

Economic data reported earlier last week indicated that the economy still needs help. The US GDP declined during the last quarter of 2012, the first contraction in three and a half years. The decline reported was significantly different from the gain that the majority of economists had expected; most estimates had predicted 1.1 percent growth.

Even consumer spending, for a time the most resilient part of the US economy, feels less buoyant these days.

Despite an increase in incomes (which rose 2.6 percent in the fourth quarter, the most in eight years), US consumers spent less than expected in December. We learned from the Commerce Department that household purchases rose only 0.2 percent; by contrast, the consensus foresaw a 0.3 percent increase.

No surprise, either, that the Fed decided to keep its bond buying at its current $85 billion per month pace. Moreover, short-term interest rates will remain near their current, near-zero levels. Only one member of FOMC, Federal Reserve Bank of Kansas President Esther George, dissented.

And yet the markets keep advancing. The unprecedented levels of liquidity – and a generally better-than-expected earnings season – support the market’s strength. And even though stocks may look somewhat overextended and due for a pullback, the overall conditions look healthy enough for the market to rise further. Plus, as the Fed noted, strains in global financial markets have eased somewhat, and there are notable improvements in the household spending, business fixed investment and housing.

Another piece of better-variety news. Phillips 66 (PSX), after beating expectations, increased its dividend again, this time by 25 percent. We like the shares even at their current level, and believe there is more upside in the stock.

We have just had another week of upbeat news that should continue to propel the markets forward.

U.S. jobless claims fell unexpectedly to a five-year low, with new applications for unemployment insurance declining by 5,000, to 330,000 in the week ending January 19. It’s the lowest figure for this measurement since the same week in 2008, according to the U.S. Labor Department.

The median forecast among economists had been much higher, at 355,000 new claims, as indicated by the results of a Bloomberg survey. While seasonal factors alone reportedly account for this major decline in new jobless benefits applications, even if that is the case the news is still quite good.

Another kind of good news also dominated mid-week headlines: The U.S. House of Representatives passed a bill that would temporarily suspend enforcement of the nation’s $16.4 trillion debt limit through May 18. Assuming the bill also passes the Senate and is signed into law, this means the U.S. Treasury Department will be able to continue to issue new bonds to cover federal obligations until May 18.

On May 19, the bill would reset the U.S. debt limit to a higher level reflecting any additional borrowing in the interim. But even then, the U.S. would not face another “fiscal cliff,” as the bill would also enable the Treasury Department to deploy “extraordinary measures” to fund operating liabilities, probably through most of July.

While 111 House Democrats and 33 Republicans opposed the bill (naysayers characterized the compromise as a mere gimmick to avoid dealing with the fundamental issues now) – it does require Congress to at least take some responsibility for starting to bring the U.S. fiscal crisis under control. Specifically, by mid-April, both the House and Senate would be required to pass a formal budget resolution – something they’ve failed to do since 2009. Such a resolution is necessary to establish a framework for federal budgets; in its absence, the U.S. government has been running “on fumes,” in a manner of speaking, for the past four years.

But this year things look like they’ll be different. The bill likely to pass the Senate next week would impose a penalty on members of either or both houses if their legislative body fails to produce a budget resolution. To be precise, it would dock pay for all those legislators whose house missed the deadline. No matter how briefly their paychecks would be withheld, rank and file House and Senate members will probably be quite averse to foregoing their $174,000 annual salaries. Ditto for the minority leaders at $193,400, much less the majority leaders at $223,500.

In other words, this bill has more gumption to it than any fiscal legislation that has come out of Congress in quite some time. A few analysts might consider such news buoyant, if not downright excellent. In any case, we think it’s very good.

But we also have a word of caution this week, especially for investors prone to consider buying stocks chiefly for their yield. It is never a good idea to use a single metric to assess equities (or bonds).

We never recommended this stock, but as far as yields go, Finland’s Nokia makes our case all too dramatically. For the first time in 20 years, the company announced plans this week to cut its annual dividend in order to solidify its cash position in the face of declining sales. The lesson is painfully clear: metrics other than yield should always be used if you consider an investment. And as a general rule of thumb, healthy companies do not pay dividends much higher than their industry average, much less the average market yield.

In the current low income environment, there is increased interest in all things “income,” including royalty trusts. U.S. Royalty Trusts are hybrid securities that carry characteristics of MLPs, stocks, and bonds. They are convenient for those who want to invest in oil and gas, without having to buy oil wells. However, this special investment class requires some knowledge of how trusts operate and an understanding of their specific risks—to both sector and individual trusts. 

A royalty trust is a corporation administered by a trustee and usually involved in oil and gas production or mining. It distributes the lion’s portion of profits from underlying assets to “shareholders” (trust unitholders) in similar fashion to MLPs, avoiding double taxation.

On the surface, each trust is a collection of oil or natural gas wells (currently or future producing) that pays attractive dividends. But what an investor must understand is that the trust, like its underlying petroleum or mineral assets, has a defined life with diminished output over time.

While they offer an ownership interest in oil/gas wells, herein lies their biggest problem: resource depletion.  As reserves deplete, the trust loses its underlying value.

This also makes royalty trusts act somewhat like bonds: as a rule, they have “expiration” or maturity dates. Unlike bonds, however, they don’t have a face value that should be repaid at maturity. Instead, the principal value in trusts is repaid—in part—in each distribution. Once their underlying asset is depleted, the value of the trust disappears.

Because you cannot invest in an index of royalty trusts, knowledge of geological conditions is important when selecting individual investments. Production issues can crop up resulting in larger or smaller than anticipated distributions, and thus impacting price. Remember also that, because of the depletion, each distribution is partially a return of capital.

Each U.S.-based, publicly-traded trust has distinct investment characteristics, beginning with physical properties of its oil and gas wells. Newer trusts, such as SandRidge Permian Trust (PER), and ECA Marcellus Trust I (ECT) include drilling operations that will happen throughout the period of the trust—offering investors some upside if wells come in better than anticipated. Most of the older trusts consist of producing wells, with minimal or no new drilling.

U.S. royalty trusts also mimic stocks and trade like stocks. Their distribution is not guaranteed.

Since oil and gas are commodities, many view royalty trusts as inflation protection. Of course, if the commodity price falls, so will income, as operating costs will not change. Lower than expected total well production and/or higher than predicted rates of depletion are other risks.

A case in point is VOC Energy Trust (VOC), currently yielding around 13 percent. Its shares nosedived after its quarterly distribution report warned of shrinking production at one of its sites where a horizontal well will be abandoned, impacting future production volumes. A quarterly distribution of $0.46 is down a third from $0.69 two quarters ago.

And because royalty trusts face depletion, part of their distribution is treated as return of capital. There could be other tax issues, too, including the need to file a return in each state in which the trust owns assets. As always, consult your tax advisor.

While royalty trusts stand out as dividend plays, prospective unitholders should carefully research a trust’s characteristics before committing funds to one or more of these hybrid securities. This royalty trust group, while attractive from a yield perspective, is characterized also by low liquidity and some tax complications.

An interesting discussion last night at dinner morphed into one of those debates that, while at times contentious, leaves you with a greater appreciation of the bigger picture facing all of us. Such intellectual gymnastics are not pursued enough in finance & economics these days, to everyone’s detriment.

The core concept of the discussion revolved around the major macro themes around the world, their impact on financial markets, and the ability of ETFs to provide exposure to them. Indeed, ETFs are fairly unique among exchange-listed products in this regard; with the exception of custom, over-the-counter derivatives traded between professional money managers and Wall Street institutions, nothing else comes close. Perhaps this is one reason (and maybe the major one) why ETFs continue to command more and more assets.

The discussion didn’t focus on ETFs per se, but on strategic concerns facing investors, particularly U.S. ones. And there is no shortage of them – the inexorable march of China and all that it represents, the debt hangover that is still in the early innings of what will be a very long game, rampant currency devaluations (both visible and otherwise), a very fluid situation in the Middle East, rising commodity prices, repression of interest rates in developed economies, etc.

On the more positive side of the ledger, companies are as lean as they’ve been in generations, with high cash balances and very efficient operations. If there is growth to be had, the majority of blue-chips will bring a larger proportion to their bottom lines than at any time in recent memory. In fact, the “jobless recovery” is due in very large part to the ability of companies to absorb additional orders without additional workers. While not good for the workers, this is very good for the companies (and their shareholders). But we digress:

All of these issues were debated during dinner, some more vehemently than others. And there was a healthy amount of prognostication – where things will end up if left on course, etc. None of it was very optimistic, given the current state of things, but there was no shortage of passion about the need to prepare adequately in the face of some serious strategic concerns and the opportunities that will come along with them.

On the topic of global economic trends, the impact of China continues to be the elephant in the room. Every market, every sector or industry in which China treads will see the conventional wisdom tossed on its ear. And note that this does not necessarily mean a rising tide lifts all boats; depending on the industry, China’s involvement may mean tough sledding for some companies. Take solar – despite record demand for solar components, the vast majority of solar equipment providers have seen their share prices decimated as Chinese companies compete higher and higher up the cost curve.

It reminds us of something we read ten years ago from a very prescient NY money manager who went on to form one of the most successful Asian-themed hedge funds in the country – don’t make what China makes if you want to survive. Make what China needs and you will prosper in the new world order. Good words, all.

The obvious issue with much of the above is the extremely broad brush it takes, and this is where ETFs come in. Fortuitously, the issues and trends facing investors are paired with precisely the kind of instrument they need to make lemonade out of lemons whenever possible. The very serious concern with which we view some of these issues is balanced to a large degree with the knowledge that significant profits can be made via ETFs by astute investors as things develop over time. Markets, currencies, sectors, industries, interest rates and even market volatility, as we discussed last issue, can be easily and cheaply accessed by individual investors via ETFs. As little as ten years ago, this would have been impossible, or at least improbable, for most of us given the cost and complexity of engaging anything that wasn’t traded on Wall Street.

Commodities – oil, gold, silver, copper, aluminum, agricultural products, etc. – take center stage, primarily because we can’t envision a world in which they do not go higher from here over a multi-year period. Ditto for emerging markets. Currencies, too, are important avenues for potential profits, and tie into both of these trends – note that China’s currency reserves are estimated to be 30% backed by gold, and growing.

ETFs have been criticized for being difficult to incorporate into the average investor’s portfolio. The charge is often paired with the statement that most of us think in terms of either mutual funds or individual stocks, and the challenges and opportunities of big-picture macro trends (and thus many ETFs) are lost on the majority of investors. But we think this is too simplistic, given that ETFs provide the only cheap and liquid way to hedge, speculate and take advantage of these trends and financial survival is at stake.

And depending on what particular theme we were talking about last night, it could be.

The market has received a nice boost in the last few days on comments out of Europe and economic data from China.

Unexpectedly, China’s exports beat estimates, further calming down fears of a hard landing there. As far as Europe, the news that European Central Bank President Mario Draghi expects an economic rebound later in the year also had a calming effect.

In the meantime, following the latest round of quantitative easing here in the U.S., which theoretically should have driven interest rates even lower, the opposite occurred and rates actually moved higher.  The benchmark 10-year Treasury now yields 1.9 percent, up from 1.63 percent at the beginning of December —which is still lower than the 1.97 percent yield at the beginning of 2012. Yes, rates are still extremely low by historical standards, but they are indeed trending up.

With cash still paying next to nothing and climbing interest rates endangering their bond positions, investors who need income are increasingly turning their attention to stocks. Though enthusiasm for equities is still muted, their potential for providing a growing income stream remains unmatched and, therefore, holds some appeal. The market’s year-to-date advance of 3.2 percent in the Standard & Poor’s 500 and 2.8 percent for the Dow Industrials both reflects and provides support to this trend.

This year’s move comes on the heels of last year’s strong performance. The improving wealth effect that higher stock prices have on US consumers’ collective balance sheets bodes well for better growth in consumer spending, which accounts for more than two-thirds of the total economy.

As is typical for this time of the year, the beginning of the earnings reporting season is the time when investors look at their individual holdings and try to assess what the market has in store for them in the longer term.

‘So far, so good,’ is the way things could be characterized at present. Only a handful of companies have reported yet, but for the ones which did, beating estimates was the prevailing theme. However, one potential trouble spot has emerged: the guidance provided by those companies which have reported thus far has generally been rather cautious.

Of course, the sample is still small, and it may be too early to draw any conclusions as to where the market is going to move next, as more companies release their results and guidance data. Certainly more in-depth analysis will follow as more information comes out.

Out of our recommendations, we want to highlight one notable pre-release: Seagate Technology PLC (STX), a leading maker of hard drives, said yesterday in an earnings pre-announcement that its fourth quarter results will likely be better than the prior guidance had indicated.

Not only was this a cause for a big jump in the stock’s price (year-to-date it’s now up approximately 5 percent), but it also made us more confident in the company’s dividend. With a yield of 4.6 percent after the latest dividend increase, Seagate is a buy.

Relief. That was the word of the day – for investors and traders alike – as Congress finally approved a 12^th hour fiscal cliff deal last week. All the agreement’s warts aside, on Jan. 2 the market responded to the last minute cliff-aversion feat with the best rally in a year. Moreover, the 2.4% New Year’s rally topped a Dec. 31 that proved to be the best annual market closing day in decades, as a result of investors’ hopeful anticipation.

Market optimism is not entirely without merit right now. While the fiscal cliff deal has removed a major uncertainty overhanging the markets, signs that the U.S. economy is already on a recovery track have also fueled traders’ optimism. Just today we learned that U.S. companies added more workers than originally expected. Private companies hired 215,000 new employees, the most since February.

But even good economic news pales in comparison to the intensive coverage the dramatic fiscal cliff resolution has been getting. No surprise there, as the immediate impact of the portion of the deal affecting taxes, to cite just one aspect, is readily apparent.

For one, tax rates on dividends will remain in line with the rate on long-term capital gains. Plus, unless you are a single taxpayer earning more than $400,000 a year or married couple making more than $450,000, you won’t see an increase in the tax rate for either dividends or long-term capital gains. A 20% tax rate on dividends and long-term capital gains is going to apply only to those individuals in the high net worth category.

And here’s reason number two why we remain optimistic looking ahead to 2013: we expect to see pent-up buying interest for dividend stocks, which, as a group, were laggards last year with some investors delaying their purchases, to come to the surface this year. If yesterday, the first day of trading after the deal was reached, is any indication, demand for dividend-focused stocks is on the rise. Dividend-payers rallied strongly.

And don’t underestimate the value of certainty that we now have regarding some of the important issues. While Congress will be revisiting the debt ceiling and the subject of spending cuts very shortly, the clarity we now have on tax issues makes planning – and income investing – much easier.

Although the tax on dividends was set to increase to the same level as on investors' ordinary income starting in 2013, the new law will keep taxes on dividends and long-term capital gains linked. Most taxpayers will continue to pay a 15% rate on both dividends and long-term capital gains, the same level in place since 2003.

Meanwhile, the Standard & Poor’s 500 index is approaching a five-year high, and the market’s mood has lightened. Whether it will stay this way remains to be seen. For growth and income investors, especially those who rely on stocks to provide for some of their daily needs, clarity in the tax rate on dividends is a big positive.

With a sigh of relief we repeat our familiar but still valid refrain: stay the course. It won’t be all that easy, and the market’s unpredictability is notorious. But until more signs of inflation start to appear (and we do expect that inflation will eventually result from all the monetary easing taking place across the globe), you should be OK with equities, especially if you have a long-term view. That said, investors should also be ready for an inflation spike by taking positions in gold and gold stocks, which will help hedge their equity-income portfolios.

2012 was fraught with uncertainty regarding the U.S. fiscal outlook, making companies cautious about new investments and hiring, and causing investors to be concerned about the prospect of imminent tax increases that could decimate their capital gains and dividends.

The year began with hopeful signs in the U.S., while warning lights flashed in Europe. As the months progressed, China’s economy – if not Chinese stocks – outperformed all expectations. Bonds showed frothiness, while REITs and MLPs performed moderately well. (If taxes on dividends rise, moreover, REITs and MLPs could hold up best, as their income streams are technically not dividends.) U.S. stocks, meanwhile, did well despite the sell-off and jitters over the last week or so of the year.

In the first half of 2012 expectations of more U.S. and European monetary easing lifted gold, and many gold stocks. While neither the metal nor gold stocks did as well in the second half, looking forward it appears that gold and silver alike should benefit from inflation – which will inevitably follow further easing or, in the worst-case scenario, deflation.

Expecting a likely end to the favorable tax rate on dividends in effect since 2003, companies in most sectors reviewed their policies; more than 100 of them turned to special dividends in the fourth quarter, vs. only 31 that did so in 2011. Such payouts may provide good-size one-time payments, but require and hold no future promise regarding regular dividends.

Investors warily surveyed the situation and tended at year end to sell, but not to buy. Investors also sold in order to book gains in advance of a higher capital gains tax. Neither one-time dividends nor dividend accelerations attracted too many buyers to stocks, despite attractive average P/E ratios. But to the extent that investors chose to abandon the equities ship altogether, it will likely prove dangerous to their financial health.

Companies typically pay or raise dividends if they think that is the best use for their cash; so with new business investments and hiring at low levels, companies with strong cash flow can be expected to continue to pay and raise their dividends as a means of returning funds to shareholders. 

Eventually some compromise will be reached. Moreover, since many investors will always have a need for income and there are few viable alternatives, dividend stocks will remain alive and well. Plus, dividend stocks in tax-sheltered accounts will continue to provide a good source of income going forward. IRAs and other tax-deferred accounts are now generally more attractive, too.

Thus we expect dividend paying stocks to remain in demand. Due to historically low bond yields, fixed-income investments no longer offer the same – or even similar – current income compared with their historical yields.  Without a suitable alternative, dividend stocks remain the only attractive option for both current income and long term growth. 

As for the overall investment course, for income and growth high quality stocks remain the best choice. QE4 will bolster equities further. It will also help gold. With a near-zero interest rate environment and monetary easing likely for at least another two years, stocks are the place to be.

If we see any signs that our market assessment is too optimistic, we will change our recommendations immediately. But for now, the best course of action is… to stay the course!

Two market-moving (or potentially market-moving) events have been in focus over the past week. While the fiscal cliff remains front and center of the market’s waiting game, the Federal Reserve’s policy meeting, as always, was the event that had both a longer-term and an immediate impact for both traders and investors.

As its Operation Twist program expires at the end of the month, it was widely expected that the Fed would expand its bond-buying program. And the Fed did just that: the FOMC voted to supplement its $40 billion-a-month in mortgage-bonds purchases with the monthly buying of $45 billion in U.S. Treasurys.  

In response, Treasury bonds fell. Mortgage rates continued to decline, and are again near record low levels. We also learned something new about the Fed’s policies: the FOMC has incorporated employment and inflation targets in its policies.

What does this mean? Theoretically, once unemployment falls to the target level of 6.5 percent the central bank will consider raising short-term interest rates again. When can we expect that to happen? Not until 2015, according to current forecasts from the majority of Federal Reserve officials. Therefore, at least until then we should expect to continue to have the near-zero rate policies in place. The Fed used the “at least as long” phraseology here – so it’s even possible that we will see the continuation of current policies for a while longer, even as the unemployment numbers improve. Another deciding factor will be expectations about the rate of inflation “between one and two years ahead.” Until inflation is projected to be no more than 2.5 percent, the current easing policies will remain in place.

What about the rate of growth in the economy? The Federal Open Market Committee’s forecast is that next year GDP will expand 2.3 - 3 percent, compared with the 2.5 - 3 percent increase forecast in September. In 2014, they expect it to grow at a 3 - 3.5 percent rate.  

Stocks are under pressure because the record easing means, in the long run, higher inflation. By replacing its expiring Operation Twist with new Treasury purchases, the Fed is moving to expand its balance sheet. As noted by more than one commentator, the unlimited money printing cannot fail to result in higher inflationary pressures as one of its side effects.

How to play the Fed’s new policies? One good income-oriented solution is the Australian dollar, via the CurrencyShares Australian Dollar ETF (FXA), which yields 2.3 percent and remains a strong recommendation at its current level. 

The contrast is clear:  the U.S. dollar will naturally be debased by the Fed’s continuing expansionary monetary policy, but the Australian dollar, on the other hand, traded near its highest level in almost three months yesterday before giving up some of the gains in today’s trading.

The Australian dollar is also being helped by better reports from China, as fears of a hard landing there have proved to be exaggerated. As China is Australia’s largest trading partner, any improvement in economic data coming from that emerging economy behemoth will inevitably help the Australian economy and its currency.

While the reelection of President Obama was greeted by increased market volatility, we don’t think this immediate post-election market action is a sign that investors need to sharply change course.

Although the conventional wisdom proclaims that a Republican win – seen as more pro-business – would be more favorable to the markets, the facts still indicate that the economy is on the mend, despite dangers from Europe and a general growth slowdown all around the world.

Yes, the economy is improving, albeit slowly. Moreover, most economists seem to agree that the US economy would be on a course of recovery regardless of who would have won the election. The arithmetic of the business cycle is strong, and the big issues ahead of us would still loom, regardless.

That said, the likelihood that the recipe of monetary easing will continue to be applied in propping up the US economy is higher under President Obama. And don’t forget that the entire world is now easing, too.

For example, although the European Central Bank in yesterday’s meeting decided to hold interest rates at their current level, they did that in a context of inflation that is expected to stay above 2 percent for the remainder of the year. Moreover, the ECB stands ready to begin purchases of Spanish and Italian bonds. And Greece is on its way to pass austerity measures needed for the next tranche of bailout funds, despite violent protests in the streets of Athens.

So the sell-off of the last few days has done nothing to change our mind on the longer-term outlook for the economy and, by extension, the markets.

One more thing to keep in mind when reviewing the post-election stock market action is that corrections are a big a part of a healthy market. Plus, look at the strong year-to-date market advance. Even after a few unfavorable days, the S&P 500 is up around 10 percent, and the Dow is up more than 5 percent. Add in dividends and total returns year-to-date look even better. Of course, some investors have decided to take gains before year-end; this is only natural in any market environment, and is to be expected in light of the impending tax hikes.

Also, don’t forget about gold, which is up today. Why? Because gold and gold miners remain direct beneficiaries of currency debasement – which is likely to continue across the developed countries.

Finally, stay with stocks that are positioned for growth. In this near-zero interest rate and monetary easing environment that can be expected to continue for at least two more years, these stocks are the place to be. And the Fed’s balance sheet expansion is helping economic activity by improving lending and creating a more optimistic consumer.

The dust hadn’t settled on the Fed’s decision to move ahead with the open-ended version of quantitative easing – QE3 – when the Bank of Japan made a similar move. Last week, it joined the chorus of other central bankers as Japan’s Central Bank unexpectedly increased its own asset-purchase target, expanding it by 10 trillion yen ($126 billion), to 80 trillion yen. The objective is the same as the main goal of the US Fed, the European Central Bank, the Bank of England and others: to stimulate the economy. 

Stocks rallied sharply after the US Federal Reserve’s announcement, and, despite some backtracking this week, remain near levels last seen in 2007. To break higher, they needed a strong catalyst, which has been provided by QE3. Without the FOMC’s pledge to keep the easy money flowing, the markets would not have kept acting well, especially in light of the rather negative economic news that keeps coming in. Because the US central bank is essentially promising that its new policies will continue indefinitely, stocks are seen as a more attractive proposition, even despite the gains they have already raked in.

Of course, the underlying nature of equities as an asset class has not changed as a result of the new policies. The unfortunate fact remains that the zero-rate approach, now extended well into the future, has brought the income potential of fixed-income investments – i.e., bonds – almost to a halt. And the high likelihood that current dividend tax rates, which have created an after-tax advantage to owning income equities vs. similarly yielding bonds, will expire is causing new investor uncertainty. 

One important fact we need to face is that the potential expiration of the dividend tax cuts is a negative for income investors, whose effective returns from dividends will then be lower. 

The change in tax rates can also be a negative factor for specific companies that pay dividends. That’s because dividend-payers retain equity ownership and therefore access to capital. 

And indeed, the utility companies, which have long been in the fight against a dividend-tax hike, have based their arguments on this negative impact to their access to capital. About a month ago, the Congressional Budget Office joined the chorus. In its alternative fiscal scenario (which assumes the planned tax hikes – including the dividend one – don’t go into effect), the US economy would be stronger in 2013 (indeed their projection also estimates that the US budget deficit for 2013 would also be higher under that scenario, by almost $400 billion or a whopping 2.5 percent of GDP). 

On the other hand, from the point of view of the overall economy, the fact that we are operating in a low bond yield environment remains a big positive. Borrowing costs are moving lower, and companies continue to issue new debt and refinance old borrowings at rock-bottom rates. And cheap debt equals another source of cheap capital – thus these companies can continue to invest in their future growth for less. 

Therefore, at this point in the market cycle we advise staying invested. We believe it’s important to remain focused on the quality of your investments, and your dividends – regardless of the ultimate outcome of the current dividend tax hike discussion. Remember: Dividends remain a good thermometer of a company’s financial well-being. 

While non-dividend payers have outperformed this year – at least partially because of the uncertainly with the dividend tax rate – going forward the shares of the companies that can grow their earnings and payouts will remain in demand and should prove to be good investments. These are typically companies with higher-quality businesses and better-than-average financial health, and the overall risk of investing in companies like this is lower than it is with the approach of investing with only price appreciation in mind. 

Stocks with a strong record of dividend growth should be at the top of income investors’ buying lists; regardless of what happens come January 1st, the low interest-rate environment will remain conducive to this type of investment. 

If you would like to learn more and/or let your voice be heard, you can visit a website dedicated to the dividend-tax hike issue, run by the Edison Electric Institute: www.defendmydividend.org.

The four-year anniversary of the Lehman Brothers collapse has come and gone, but the memories of the financial crisis and its economic impact are still fresh in our collective consciousness; in many ways, the impact is still being felt in our everyday lives. And we are sure that the memories are likewise still fresh in the minds of the members of Federal Open Market Committee – the policy decision making board of the Federal Reserve – who decided to embark on a new, open-ended stage of quantitative easing earlier in the month.

While the US market has staged a remarkable recovery since then – up roughly 21 percent from its September 15, 2008 levels and more than doubling off the lows of March 2009 – investors clearly still remain quite reluctant to invest in stocks, judging by mutual funds inflows.
 
These past few days, global stocks were hit by growth worries once again. But the overall action can still be viewed in a positive light, especially if you consider that historically, on average, September has been the worst month for stocks (followed by October). Overall, stocks held their ground, up 2.4 percent in September.
 
The record-low borrowing costs are helping many companies – just look at how actively US corporations are issuing new debt. Last week, United Parcel Service (UPS) raised $1.75 billion; the rates they were able to borrow at were 1.125 percent for a five year note, 2.45 percent for a 10-year bond and 3.625 percent for 30 years. Digital Realty (DLR), whose credit quality is lower, was able to obtain 10-year bond financing at a 3.625 coupon last month.

These are just a few examples as to how cheap the money can be for US companies. Demand for commercial and industrial loans, as can be seen from the Federal Reserve’s Senior Loan Officer Opinion Survey on Bank Lending Practices, has also increased – due to low rates and easing lending standards. This is encouraging. Lowering interest payments is one way to improve free cash flow, and companies with significant free cash flow can now increase dividends or repurchase stock.  

Another encouraging sign is the improved housing picture. Though we are far from the point where we could proclaim that the housing crisis is fully over, in recent days several signs of the housing recovery have strengthened. New home demand is picking up, and US home prices are climbing more than forecast. (Here, tight lending standards remain the major obstacle.) Also, new homes sales for August declined 0.3 percent, but that followed an increase for the month of July that was the strongest in more than 2 years.
 
We are sitting at record low levels for mortgage rates – the direct result of the Fed’s monetary policy – creating further hope for this battered sector of the economy. On the one hand, lower mortgage rates help consumers save money on refinancing; on the other, they help improve sales and prices. We learned last week that the S&P/Case-Shiller index of property values in 20 cities made its biggest year-on-year advance since August 2010, increasing 1.2 percent. And while the seasonally adjusted index for pending sales decreased 2.6% in August compared to a month before, this was the highest number since April 2010. As a result, consumer confidence keeps improving, another good sign.
 
And speaking of new records – another record, also directly related to the sea of liquidity unleashed by the world’s central banks, was set recently. Gold, the asset class that is a direct beneficiary of zero-interest rate policies, has set a new record when measured in euros and Swiss francs. And even in US dollars, gold is now trading near its highs of 2012 and not far below its all-time high set last September.
 
We remain big proponents of the yellow metal and continue to recommend that income investors have exposure to the price of gold. One direct way is via the SPDR Gold Shares (GLD), a popular ETF that tracks the spot price of gold.

Fed’s Operation Twist: Is It Good or Bad for the Economy?

The Federal Reserve’s Operation Twist was extended through the end of the year, meaning the Fed will continue to purchase Treasury securities with remaining maturities of 6 years to 30 years at the current pace.  They will also sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less.
 
Why bother selling one type of Treasury and buying the other? Because the Fed does not directly control longer rates, but those rates are important for the economy. As a result of Operation Twist, the yield curve has flattened, with longer-term interest rates are down compared to just a year ago.

Helping the housing sector recover is one of the Fed’s goals. To do so, keeping mortgage rates down is one tactic. Mortgage rates, which are generally benchmarked against Treasury yields, have fallen as a result of Operation Twist, as intended. The average rate on a 30-year loan was 3.6 percent at the end of August, compared with about 4.2 percent a year ago.

And near-record-low mortgage rates seem to be working their way through the system, already reflected in better pricing and increases in the number of contracts to buy existing homes.

Home prices notched their first year-over-year increase since September 2010 in June. Pending home sales are at the highest level since April 2010, when the home purchase tax credit – which inflated data – expired. If this artificial demand boost was ignored, the pending sales figure was the best since mid-2007.

This may be a great time to buy a home. But even if you aren’t in the market for one, signs of price stabilization and better overall housing activity are good for the economy. The next housing boom may be years and years away, but with the help of the Fed’s rate policies we could well be past the bottom.

Social Media Stocks: Revenues and Earnings Growth May Not Be Up to Par

Over the past year a slew of highly publicized IPOs—some of them touted as “the next big thing” in the hot social media arena—have hit the market. The companies that went public differ in the services and/or information they offer, ranging from telling you real estate prices in your area (Zillow), to getting you a discount at local stores and restaurants (Groupon). The escalation of social media IPOs reached its zenith on May 18th with the Facebook IPO, which priced this company at a record-setting valuation of $104 billion dollars.

Facebook’s IPO turned into the highly publicized fiasco and was one of the factors that soured the market’s mood. But overall, other social media companies’ IPOs haven’t fared too well either.

The chart compares the two indices we’ve created, “Social Media” and “All Other” (the companies that went public recently sans the social media firms). We tracked the daily closing price of each security for the first 150 trading days following their initial offering date, and indexed the returns to the constituents’ initial offering price. An equal weighting of the constituents guaranteed that one large company would not skew the results.
 
The divergent performance between the two groups is astounding.
 
Driven by strong pre-offering publicity and increased investor demand, social media stocks on average performed extremely well during the initial days following their IPOs.  However, as the buzz diminished and investor scrutiny increased, the index began to decline. Due to a failure to keep up with investors’ lofty expectations, all the gains in our index were erased after only one hundred trading days.  
 
For comparison, the All Other index was stronger and its performance more stable. While the first day “pop” was considerably less for the All Other index, it continued to perform well in the following weeks, never falling below its initial value.

The explosion of social media is clearly a major, and real, phenomenon now, but it doesn’t necessarily mean social media companies can turn the popularity of their services into what matters to investors: revenues and earnings growth. And given the hype surrounding these IPOs, investors will be expecting explosive growth. Once realization sets in that the sailing isn’t so smooth, the shares get punished.

“Don’t buy into the hype” may be a phrase used so much that it’s become a platitude, but in the case of social media IPOs, it certainly applies. Let the hype die down first, and then reevaluate.

One of the most popular types of investment over the past few years is a category of hybrid mutual funds known as target-date or mixed-assets funds. These are essentially funds targeted to investors who expect to retire at a certain date.
 
If you own a 401(k)—an employer-sponsored defined-contribution plan—you are most likely invested in one or more of these mutual funds.
 
The structure of these funds is flexible enough to appeal to different types of investors: income investors, investors approaching retirement and investors just beginning to save for their future retirement. This explains the tremendous success these funds have had over the past few years. At the end of last year, these funds held about $370 billion in assets, up from $117 billion in 2006. There are now hundreds of target date funds in existence, belonging to roughly 50 distinct fund series. Each series has its own strategy for meeting its investment goal.  
 
Yet there’s some concern whether these funds are well understood by investors. A recent SEC survey confirmed that some of these worries have not been unfounded. For example, only 36 percent of survey respondents indicated correctly that a target-date fund does not provide guaranteed income in retirement. Many investors have also thought these funds to be safer than they actually are.
 
The SEC is also concerned with whether information presented in marketing materials properly describes the funds in question. It’s likely that the result of ongoing discussions between the SEC and the fund families will be an improvement in the clarity and understandability of disclosures presented to investors. But regardless of what this new disclosure will cover, investors should generally approach a target-date fund the way they approach any other investment, i.e.,  refrain from buying it unless they understand it.

Therefore, it should be helpful to be aware of several important features of these popular funds.

The funds are intended to be a “buy and forget” investment and will automatically reset the asset mix, consisting of stocks, bonds and cash or cash equivalents, in their portfolios as they move toward the landing date. 

The landing date, by definition, is the date after which the asset mix will no longer change. But note that some funds will still change their asset mix after the landing date. Therefore, it’s a good idea to review your investments even after the target date is reached.

Another investment metric important to these funds is their glide path. The glide path of a target-date fund is simply the way it changes its asset allocation as it approaches its landing date. A typical glide path for a target-date fund would involve a higher allocation to bonds with time and lower allocation to stocks, though the exact path will vary. Moreover, as noted by Morningstar, it’s possible for the entire glide path to actually shift up or down; as the result, an investor who is 25 today may not have the same allocation in stocks—or bonds—as a 25-year old a few years ago.

Always look at the fund’s asset allocation and the way it invests in various asset classes; two different approaches could be a “fund of funds” methodology (Vanguard is a good example of this passive approach), on the one hand, or investment in a mix of stocks and bonds on the other (AllianceBernstein is a typical active manager in this space.) Typically, funds that employ a more active approach are more expensive; also check whether the fund manager has the discretion to change its asset mix.

And of course understanding what the current asset allocation of your target-date fund will be extremely important in properly making your own allocations within your entire portfolio as far as stocks, bonds and cash, according to your own targets.

One of the most basic yet least appreciated tenets on Wall Street is compounding.

Over the long term, compounding is a simple yet extraordinarily effective way to enhance wealth; as income is generated by an investment, it is plowed back into the same investment, which increases the principal amount, which increases the income generated, which increases the principal, and so on. Over time, this investment-on-autopilot approach can develop into a major nest egg.

But as powerful as fixed-rate compounding can be with investments such as bonds, dividend-paying stocks have it beat hands down. In fact, reinvesting dividends is one of the smartest things you can do as an investor.

Dividend-paying stocks have been all the rage lately because they represent one of the few places where investors can generate an appreciable amount of income at the moment (at least when compared to savings accounts, U.S. Treasury bonds, etc.). Dividend income is a key component in investment return, especially for those living on fixed incomes or retired. But for those able to reinvest dividends back into the stocks that are paying them, things can get really interesting. This is because unlike most bonds and virtually any kind of deposit yield, dividends can go up. The recent trend of increasing payout, coupled with a rising stock market, mean reinvesting dividends essentially turbo-charges your returns.\

The most efficient way to accomplish this goal is a Dividend Reinvestment Plan, commonly referred to as a DRIP. Most broker-dealers offer them to their clients. But we think an even better alternative comes from the companies themselves —most major corporations offer DRIP plans to their shareholders by way of a direct stock purchase plan, or DSP. The combination means that, in most cases, investors can purchase both principal positions in a company’s stock, plus reinvest dividends, without the use of an intermediary. Also, DRIPs usually allow fractional shares to be bought —a DRIP will generally purchase as much stock as possible given the dividend amount. Currently, more than 1,300 companies offer DRIP plans.

In many cases, DRIPs and DSPs are administered by the company’s transfer agent, the entity charged with keeping track of who owns what. However, not all of these plans are created equal; some charge a small set-up fee (usually $25 or $50), and some will allow the additional purchase of stock beyond the dividend reinvestment on regular intervals. In some cases, these additional purchases can be made at a slight discount to the current market price.

Note that while companies that offer a DRIP plan will typically also offer a DSP, the opposite is not always true; a company can offer a direct stock purchase plan without a corresponding DRIP.

A key advantage of these plans is that you do not pay a brokerage commission when you buy and sell the shares in question. Even at the cutthroat rates of modern online brokerage houses, the fees involved in DRIP/DSP plans are generally lower. Moreover, by reinvesting dividends an investor is effectively using a dollar-cost-average approach, which can be very useful when good stocks dip down for short-term reasons. On the flip side, the calculation of cost basis for taxes can be more complicated, since each individual dividend reinvestment is effectively its own tax lot. But we think the benefits are worth the slight tax complication.

Contact the companies directly to see if they offer the DSP or DRIP.

Europe’s ongoing financial crisis has wreaked havoc in global markets, but it also has created fertile ground for bargain hunters. As European banks aggressively sell assets to deleverage and increase their liquidity, Kennedy-Wilson (KW), an international real estate investment and services company, is finding opportunities galore to scoop up real estate properties and real estate-backed debt at big discounts.

The company’s European operations, launched only a year or so ago, are concentrated mainly within the U.K. Last year the company bought $2.1 billion worth of loans backed by properties in the U.K., whose real estate market remains liquid despite that economy’s problems. Some analysts estimate that in the next few years, European banks could sell $3 trillion or more worth of assets, creating numerous investment opportunities to choose among. Kennedy-Wilson has secured a 250 million euro commitment from Fairfax Financial to co-invest in real estate in both the U.K. and Ireland, and we look for it to make strong inroads in those countries.

Moreover, its acquisition of U.K. real estate-backed debt opens the door to future real estate purchases in Europe, because—having gone through the credit underwriting and appraisal process for the properties underlying the loans—the company has gained valuable first-hand knowledge of a long list of properties it might want to acquire.

Other positives for Kennedy-Wilson include signs of bottoming in the U.S. commercial real estate market and continued decline in home ownership. The former should boost selling prices for its properties, while rising demand for rentals will benefit its sizable portfolio of multifamily properties. Management points to the lack of significant new construction in California—where most of its U.S. apartment buildings are located—as a telling portent of positive trends for its rental business.

In addition, the company’s investment business benefits from Kennedy-Wilson’s involvement in other real estate areas, including auction marketing, brokering, and asset and property management. These create relationships and generate information that can lead to investment opportunities and streamline the closing of deals.

Kennedy-Wilson has produced a heartening year-over-year 44 percent gain in the company’s investment account, made up of its equity in real estate assets, loan assets, and marketable securities. It climbed from $582 million in 2011 to $626 million at the end of second quarter 2012. The company also ended June with nearly $97 million in cash, a $100 million credit line, and the ability to raise additional cash by selling assets, giving it the wherewithal to pursue investment opportunities without turning to capital markets.

Kennedy-Wilson’s largely fee-based business gives the company some downside protection against any deterioration in the real estate and stock markets. And when the real estate market rebounds in earnest, the company’s aggressive buy-low strategy should pay off handsomely.

Inflation has long been known as the bane of income investors. Although in the last few years we’ve had to contend with deflationary fears rather than inflation, we believe inflationary forces are just bubbling beneath the surface and investors should always be prepared for what may come very quickly.

We performed an exercise to study the increases in dividend payments by each of the companies in the S&P 500 over the last 23 years (the earliest date for which we have data). The goal was to see whether the average stock investor who relied on income from his/her shares had gained or lost purchasing power over this period when adjusted for inflation.
 
Even though the S&P 500 is not considered a representative dividend index since more than 100 constituent companies do not make payouts, it does provide information about broad trends in the market. We believed if the S&P 500’s dividends have demonstrably outpaced inflation, then there is a reasonable expectation that a well-selected portfolio of dividend-paying stocks will excel in that goal as well.

The graph above shows the compound “real” (inflation-adjusted) dividend growth rate for all of the S&P 500’s stocks. Dividend growth is measured as the year-on-year change in the total amount of dividends paid by the companies of the S&P 500 compounded annually over the 23 years. The second line is the rate adjusted for inflation to provide the real dividend growth.

During this period, there was only one time that the total amount of dividends decreased (in 2009 during the recession, when dividends paid by the S&P 500 companies fell by 20%). Dividend growth was greater than inflation in 18 of those years. Thus had you used dividends as an income stream, you would had seen a significant increase in your purchasing power. Since 1988, dividends paid by the companies in the S&P 500 index have seen real growth of about 70%. It may not seem as such a big number, but remember these are real returns, on top of inflation.

A one-stop way to capitalize on this, without having to pick and choose among individual stocks, is via dividend ETFs that specifically seek to take advantage of dividend growth. Consider the SPDR S&P Dividend ETF (SDY). To be considered for inclusion in this ETF, a company must have increased dividends for the past 25 consecutive years. As you would imagine, SDY follows the S&P 500, but thanks to its income focus, it has outperformed the benchmark in both up and down markets.

U.S. investors may have excess cash on the sidelines because of fear of the financial markets. Unfortunately, yields on money-market vehicles and other cash equivalents are almost nothing. So holding onto too much cash is not a great idea because factoring in inflation, you are actually earning a negative real return on your money.

So it’s only prudent that you put at least some of that money to better use. Here are some suggestions:

#1: Pay down consumer debt. Interest rates on credit-card debt often run much higher. Worse, interest payments aren’t tax-deductible. Rates on auto loans often are low, but well above today’s savings yields.

Paying off debt effectively gives you a risk-free, tax-free return at that rate. In other words, if you save future 5 percent interest payments by paying off debt, that’s as good as earning a 5 percent return on the cash you used to pay off the debt. This is better than sitting on idle cash that’s earning next to nothing anyway.

#2: Pay off some or all of your home-related debt. Here, the effective return is lower, maybe 5-7 percent. And your mortgage interest may or may not be fully deductible, considering that everyone gets a standard deduction on their tax return. But it’s still a good deal in this economic and savings environment.

Start with any home-equity loan debt. Just keep the credit line open so you can draw it down again.

#3: Put some cash to work in low-risk investments. Vanguard GNMA (VFIIX) is a good option. So is a proven balanced fund, which invests in both dividend stocks and bonds. We like Vanguard Wellington (VWELX), a fund for all seasons. Dollar-cost averaging is a good approach here: Invest regularly, such as every month, quarter or six months. 

This way, you make better use of your cash rather than having it sit idle.

Lastly, you don’t want to leave yourself short on cash either. Keep enough available to cover at least a year’s worth of expenses, particularly if you’re retired.

It is a good idea to take an active approach to your investments. Do your homework before investing, whether by yourself or with the guidance of professionals.

The late Benjamin Graham was an economist and professional investor whose ideas have been highly influential. His many followers include the legendary investor Warren Buffett. Graham is credited, first and foremost, for pioneering and promoting the concept of value investing: buying stocks at bargain prices. In other words, value investing can be defined as finding and buying stocks whose market prices are lower than their intrinsic values, or what the price of the stock should be, as determined by the investor’s calculation.

Graham also coined the term “margin of safety,” which refers to the difference between the intrinsic value and market price of a stock. The idea is that if one purchased a stock at a price far below what he believes the intrinsic value of the stock is, even if he overestimated the worth of the stock, he will still turn a profit because he bought the stock at such a low valuation. On the other hand, if a stock was purchased with a small margin of safety, even a small overestimation of the stock’s intrinsic value could result in a loss. Thus, it is preferable to have as large a margin of safety as possible, and one should try to buy a stock when its market value is as far below its intrinsic values as possible.

The problem, of course, is that there is no objective measure of stocks’ intrinsic values. There are a large number of calculation methods available, and variables and intangible factors inject more guesswork into the valuation process. Thus, if the intrinsic value is difficult to determine, so too is the margin of safety.

Graham himself favored one simple calculation method. He favored taking the difference between a company’s earnings yield and the return on long-term riskless bonds. The difference, or spread, he called the margin of safety. The larger the margin, the more undervalued the stock is.

For example, if stock XYZ had an earnings yield (earnings per share divided by price) of 5 percent, and the 10-Year Treasury yield (typically used as the riskless benchmark) was 3 percent, then the margin of safety is 2 percent. What this means is that company earnings could be overestimated by as much as 2 percentage points and the stock would still be a likely better investment than the 10-Year Treasury note.    

Thanks in part to ultra-low Treasury yields today, the margin of safety is one silver lining we can take away from what otherwise has been a sideways market and shaky economic backdrop; stocks are now in one of their most undervalued periods in recent years, when compared to Treasury notes.

As you can see from the graph, which charts the margin of safety for the S&P 500 (as measured by its earnings yield compared to the 10-Year Treasury yield) since 1990, the spread of 5.6 percent between earnings yield as of the end of the June quarter, was one of the widest in the last two decades. This means that, according to the calculation used, stocks are now at their most undervalued point in recent memory compared to Treasurys. This is a combination of investor pessimism in equities plus the unusually low Treasury yields. 

What’s also interesting in the graph is that the spread has become larger over time, suggesting investor preference for stocks over bonds has waned. This is understandable because the 1990s was a strong period for the U.S. economy, with solid growth coupled with tepid inflation. Optimism was high. It was a time for buy, hold, and watch the investments grow. After the dot com bubble burst, 9/11, and the recession of the early 2000s, investors demanded better bargains before investing in equities. Then of course, we had the housing bubble burst, financial crisis and global recession in recent years, from which we have not fully recovered. Meanwhile, the European debt crisis, China’s slower growth, and an uncertain economic outlook in the U.S. remain major overhanging clouds today.     

Current low valuations may be the saving grace to the weak market as it may encourage bargain hunting investors to step in and provide some lift to the market. Even if that doesn’t happen, with stock earnings yields now at significantly more attractive levels than Treasurys, stocks are offering investors higher reward for taking on risk than at most times in recent years. Bargains can be had if chosen carefully.

For investors, maximizing returns while minimizing risk is one of the most important challenges you will face. One area all too often overlooked is where to stash “cash.” Despite the paltry yields being offered in today’s world, it pays to give careful consideration to how you invest your most liquid assets.

Cash is a collective term for several types of traditional bank accounts, all of which are insured by the Federal Deposit Insurance Corporation (FDIC). These include checking, savings, and certificates of deposit (CDs).

A money market deposit account, offered by the bank, is typically also insured by the FDIC. The legal limit of such insurance is currently set at $250,000. You can find more information on how these limits are set and when (for special kinds of accounts or ownership categories) this $250,000 limit can be exceeded at www.fdic.gov.

While all three types of cash accounts—checking, savings and certificates of deposit—generally generate some income, in today’s environment of ultra-low interest rates income from checking (if it satisfies your bank requirements for generating income),and even savings, is negligible. CDs generally offer higher rates in exchange for committing your funds for a pre-determined period of time.

Typically, CDs are offered in the lengths beginning from 3 months, 6 months, 9 months, a year—and up to 5 years. Typically, the longer the term, the better the rate. In case of a withdrawal until maturity, or early withdrawal, a penalty will be assessed. While in most cases the penalty will be paid out of your earnings, in some cases the principal may suffer.

You can protect your liquidity and receive better rates on at least some of your money by using a technique known as laddering. With laddering, your money is distributed among the available CD maturities so that some of it is allocated to the shortest spectrum of maturity, and some—to the longest. When the first tranche matures, it is reinvested to CDs with longer maturity. This way, some money will always be close to maturity—and you’ll be taking advantage of better rates all the time.

The advantage of laddering is that it takes guessing out of the equation. Like dollar-cost averaging for stocks, it allows the saver to benefit from market forces which, in case of CDs, work towards higher long-term rates.

Of course, the specifics of today’s environment are such that longer-term rates may not be that different than shorter-term rates. For those investors/savers who don’t think the rate differential compensates enough for the longer time periods, we recommend staying on the shorter side of the time spectrum, and with that in mind select the best rates available every time you roll your CD into another one.

Options are often dismissed outright by some investors who believe that all option trades must be high-risk endeavors best left to the day-trading crowd. This is unfortunate, since equity options are among the most versatile of financial instruments and can be extremely useful when used properly.

One instance in which options can be used effectively and conservatively is via covered calls. A call option is a right (but not an obligation) to purchase a certain number of shares (typically 100 shares per contract) at a certain price at some point in the future. Obviously, if the stock is above the price (known as the strike price) at the time the option expires, the option holder will benefit from exercising the contract and taking delivery of (or call) the stock. Conversely, if it is below the strike price, the option will expire worthless, and no stock changes hands. A “covered” call is merely a call option sold, or written, on stock you already own.

This strategy is useful for equity holders, especially those in liquid stocks, in two related but distinct ways. First, the sale of the option results in a premium paid to the equity holder, his to keep no matter what happens. Some investors continually sell covered calls on their stock positions, especially relatively sleepy ones not prone to sharp moves in either direction, by rolling them following each position’s expiration (options expire on the third Friday of every month) and pocketing the ongoing premium income.

Generally speaking, the farther away the expiration date of the call, the greater the premium. Additionally, those calls whose strike prices are less than the underlying stock’s price (such options are said to be “in-the-money”) generate more income, but the position will get called away frequently. For those calls whose strike prices are above the stock price (“out-of-the-money”), the premium is lower but the likelihood of the stock being called away is smaller. If the options expire without being exercised, you can continue to write new ones to continue to boost portfolio return. This is particularly effective with dividend-paying stocks, since you earn both the call premiums when the options are written in addition to any dividends paid. Cashing in the call premium as well as the dividends can turn a decent annual yield into an excellent one.

Moreover, covered calls can be used to generate income in instruments that do not generally pay regular distributions or dividends. For instance, exchange-traded funds (ETFs) concentrating on physical metals like gold do not typically pay dividends.
The second use for covered calls is as a hedge against price declines in the underlying stock. This strategy works well when you believe in the long-term prospects for a stock, but think it may go through a rough quarter or two in the meantime.

Although the S&P 500 Index finished 2011 at break-even in terms of simple price appreciation, it was anything but an uneventful year. Fundamentals did not seem to matter anymore as the markets became news-driven, ebbing and flowing with every major update and speculation from Europe and the U.S. debt ceiling fiasco. The volatility has continued into 2012. An unusually warm winter inflated economic readings and drove U.S. stocks to the best first quarter in more than a decade. But as reality set in for the U.S., China’s growth slowed, and Europe’s crisis escalated, most of the early gains have been wiped out.  
 
In a recent Leeb’s Market Forecast, we charted how defensive stocks outperformed when market anxiety is high. In fact, the same logic extends to funds too. This month, we take a look at how some funds tracking generous dividend paying stocks performed vis-à-vis SPDR S&P 500 (SPY), an ETF tracking the S&P 500, a good proxy for the broader market.  

The graphs below compares SPY’s total return performance against SPDR S&P Dividend ETF (SDY), iShares Dow Jones Select Dividend Index ETF (DVY), and ELEMENTS Dow Jones High Yield Select 10 Total Return Index ETN (DOD) from 2010 through 2011. All three convincingly outperformed in 2011, evidence of the increased popularity of dividend payers last year. And as the graph below illustrates, even when the general market was strong in 2010, they still all beat SPY, albeit by smaller margins than in 2011.

SDY seeks to replicate the returns of an index of the 60 highest-yielding stocks from the S&P Composite 1500 Index, which covers approximately 90 percent of total U.S. market capitalization. Members of the index have increased dividends every year for at least 25 consecutive years and are subject to minimum market cap and trading volume requirements. Current yield: 3.1 percent.

DVY is linked to a Dow Jones index of 100 of the highest-yield U.S. stocks selected from the Dow Jones U.S. Total Stock Market Index, which covers nearly the entire U.S. stock market capitalization. Besides requiring attractive yields, the index screens stocks by other metrics like dividend growth rate and payout ratio. Current yield: 3.4 percent.

DOD is an exchange-traded note, or ETN, debt instruments whose returns are predicated on the performance of a particular index. In DOD’s case, it tracks the eponymous index, comprised of the top ten yielding companies in the blue chip Dow Jones Industrial Average.
 
Blue chip stocks, deemed to be safer than most, offer an extra layer of protection when market risk is high. Plus, risk is mitigated through sector diversification, not to mention the Dow's periodic rebalancing, which forces out underperforming companies and replaces them with faster-growing, more stable blue chips. Therefore, it’s not surprising that in the post-financial crisis era, this ETN was the top performer in our exercise. Note that DOD itself does not pay a dividend but its return reflects the gains in the stocks tracked.

As stocks got off to a very strong start this year and risk appetite ran high, SPY built an early lead, but over the last three months the dividend funds have once again proved their mettle, outperforming SPY. Over the upcoming months, if policymakers around the world unleash new rounds of stimulus, the dividend funds may underperform somewhat on the upside, but the underlying global risks make them prudent holdings to have for protection on the downside.  

Real Estate Investment Trusts, or REITs, are one of our favorite investments for income. They pool investor funds together and invest in real estate properties and/mortgages. By law, in return for tax breaks, REITs must distribute at least 90 percent of their taxable income to shareholders as dividend, resulting in very attractive yields.

There are three main types of REITs: equity, mortgage, and hybrid (just a combination of the first two). Equity REITs own and manage physical real estate properties. Some may specialize in certain segments such as residential, industrial, or commercial while others hold a diversified mix.

Mortgage REITs primarily invest in mortgage-backed securities (MBS). Thus, they own loans that have properties as collateral, but don’t directly own any real estate themselves.

The current rock-bottom interest rate environment has been very favorable for mortgage REITs because it has enabled them to borrow money at low cost and then invest in high-yielding collateralized debt and pocket the sizeable spread. To boost returns, they tend to use the MBS as collateral to borrow more in order to buy additional loans that can be further used as collateral. The end result is a highly leveraged company, but one that offers lucrative yields to investors — often in double digits.

But the downside is that they are more vulnerable to interest rate hikes than equity REITs. When short-term rates rise, mortgage REITs will see their financing costs go higher without a corresponding rise in revenue. This results in shrinking margins and less cash available to distribute to shareholders, decreasing their appeal. However, given that the Federal Reserve has pledged to maintain benchmark rates at essentially zero through at least late 2014, the environment for mortgage REITs should remain favorable for quite a while.

Mortgage REITs are also subject to prepayment risk: When borrowers pay off their loans sooner than scheduled, future interest payments are lost. Since current mortgage rates are low, mortgage REITs will likely have to reinvest in new MBS with lower coupons than the paid-off securities. If prepayment rates increase, that too could threaten the ability of mortgage REITs to sustain their generous dividend levels. Rising long-term rates will likely lower the number of prepayments, which is a positive, but may also result in the book value of properties coming under pressure.

Another drawback is that the leverage employed by mortgage REITs is typically very high, with debt exceeding equity by a factor of 5 to 10. And mortgage REITs that own non-agency MBS (i.e., those that aren’t backed by government agencies such as Fannie Mae) face credit risks.

Lastly, unlike equity REITs, they do not participate in the appreciation of collateralized assets because they don’t actually own the properties.

Despite these risks, carefully selected mortgage REITs shouldn’t be shunned altogether. But because mortgage REITs involve much higher potential volatility than their equity counterparts, they should generally be treated and monitored as higher-risk investments.

One of the very best investment guidelines anybody can follow is probably the easiest one: There is no such thing as free lunch.

Consider the so-called “Dividend Capture” strategies. In a nutshell, these strategies entail buying a stock just before it will pay the dividend, holding it just long enough for the stock to move back to the original purchase price in order to collect the dividend without cost, then selling the stock and capturing the dividend.

The strategy has some following among dividend-hungry investors and has gained in favor in recent years. There is nothing that indicates—fundamentally, at least—that this sort of strategy should generate a superior yield when compared to a buy-and-hold portfolio, let alone a superior total return. The quick rotation in and out of a stock—collecting dividend in a process—may work in a bull market, when a rising tide lifts all boats and buying/selling a stock is a profitable endeavor just because some time has passed. If you look under the hood of the potential for profits, you’ll see that the strategy relies on the stock price increase more than on anything else.

The closed-end funds that tout the strategy and promise higher-than-sky dividends should be avoided. While their current yields might seem tempting, we suggest a quick look at their price charts before making a decision. When high dividend comes at expense of a decline in price, that’s not something you want.

Finally, buy-and-hold is cheaper in terms of trading costs. Prudent dividend investing should not be a wild ride downhill. Stay away from Dividend Capture strategies if you need dividends—these approached are, in fact, trading strategies and not worth the risk.