How to Get Income AND Momentum

With the 10-year T-note yielding only 3.21%, investors interested in getting income from their investments are in sort of a tough place. Dividend-paying stocks are a very good place to look for a replacement.

One thing you know for sure is that the coupon payment on a 10-year note is not going to rise. A yield of 3.21% does not offer much of a cushion against inflation. What is inflation likely to average over the next 10 years? I have no idea, but based on the spread between the regular 10-year note, and the 10-year TIPS, the market is implicitly expecting a rate of about 2.50%, which is pretty much in line with the historical experience (headline CPI) over the last 20 years of 2.57%.

While core inflation is the thing to keep an eye on when judging if monetary policy is too tight or too easy, it is headline inflation that investors — particularly fixed-income investors — have to be concerned about. After all, the whole point of buying a bond is to defer consumption of a basket of good and services from today, in order to be able to consume a bigger basket of goods and services in the future.

Both of those baskets are going to contain food and energy. An expected real return of 0.75% is not a very big payoff for that long a period of delayed gratification.

Forecast on Inflation

I do not think that inflation is currently a huge threat, and I agree with Ben Bernanke that the recent commodity price spike fueled increase in headline CPI is likely to be short lived. On the other hand, it seems quite plausible to me that we could see much higher inflation a year or two from now, particularly if the economy manages to get back on track and unemployment falls to more normal levels. I’m not talking about a trip to Zimbabwe, or even a return to the 1970’s, but inflation rising to around 4% would not shock me.

If that proves to be the case, then your real return on the T-note will be negative. The yield will rise, and the price of the bond will fall. You are simply not being paid very much for taking that risk. Of course, if we don’t increase the debt ceiling — and it looks like there is a real possibility that the government could even be a few days late in making an interest payment — the rise in T-note yields could happen much sooner than that.

I expect that the increase in the debt ceiling will happen, but that it will probably fail at least once before it happens. That could make the markets very nervous. Not raising it would be the absolute height of fiscal irresponsibility and incompetence in Congress, but before it happens there will be a lot of interesting political theater.

If you want to directly play a rise in T-note yields, a short treasury ETF like TBT is a good call. Most investors though will probably just want to find potential shelter from the storm. A basket of high-yielding stocks is a very good safe harbor.

What Else to Consider

It is, however, a mistake to only look at the dividend. Buying a stock because it yields 4.0% and seeing the stock fall by 5.0% right after you buy it is not going to make you either happy or wealthy. You want to find both a good steady income, and some potential for near-term appreciation. Therefore, I looked for stocks that are currently rated either Zacks #1 Rank (Strong Buy) or Zacks #2 Rank (Buy).

Dividend investing is a long-term strategy, and the Zacks Rank is mostly for shorter-term traders, but even long-term investors should not ignore it entirely. It is still a good timing tool for them.

If you are buying a stock for income, the last thing you want to see is a cut in the dividend. The best defense against that is a low payout ration. Managements generally will try to avoid dividend cuts, but paying out more than you earn each year is not sustainable.

A company needs to retain at least some of its earnings to grow, not just earnings, but the dividend as well. I therefore required that the company pay out no more than 60% of its earnings so there is a very strong cushion against dividend cuts.

Check the History

While I did not specifically screen for dividend growth, a company that has a long history of dividend growth is more likely to increase its dividends in the future than companies that have gone for years without an increase in the checks they send to shareholders. Some of the firms on the list below have extremely high dividend growth histories over the last five years. I would not expect those rates to continue.

However, those with historical growth rates of less than 15% can probably sustain that sort of growth. I did not eliminate them, but I would be inclined to avoid those with a history of dividend cuts over the last five years. All things being equal, I would also rather have a company where the yield today is higher than it has averaged over the last five years. Reversion to the mean can be a powerful force, and you want to be on the right side of it.

International Stocks In Play

Don’t be afraid to look outside the U.S. for income stocks. The dollar has been declining, and I think it will probably continue to do so. That would mean that a dividend paid in euros or yen would be translated into even more dollars. I think that the decline of the dollar is a good thing, in that it should help promote growth and reign in our massive and unsustainable trade deficit.

One group that is very heavily represented on the list below are the Canadian banks. In the financial meltdown, Canadian bank regulators proved themselves to be far more competent than their U.S. counterparts, and none of the major Canadian banks got into trouble or had to cut their dividends.

The Canadian economy, with its heavy natural resource base, is likely to outperform the U.S. economy this year. Five banks from north of the border make the list, fully 20% of all the names. Bank of Montreal (BMO) has the highest current yield of the five, but also the highest payout ratio, and a relatively low historical growth rate. At the other end of the spectrum, Toronto Dominion (TD) has the lowest current yield, but also the highest growth rate. It also has the most room to increase its dividend with a payout ratio of just 41%.

Other Places to Find Stocks

While foreign banks are heavily represented on the list, it is possible to develop a very well diversified portfolio of high yielding firms that are currently experiencing solid earnings estimate momentum. Telecommunications firms are also well represented. Telefonica (TEF), for example, is based in Spain, but has extensive telecommunications holdings in Latin America.

In Technology, Intel (INTC) makes the list, and is only paying out one third of its earnings, even as it yields more than 3%. It could easily sustain its historical 12.06% growth rate. If so, five years from now your yield on cost will be 5.53%.

French oil giant Total (TOT) also makes the list. It, too, can probably maintain its historical growth rate of 15.05% that in five years would leave you with a yield on cost of 7.80%.

Publisher R.R. Donelley (RRD) might not be the most exciting company in the world, but its current yield of 5.51% is still mighty attractive relative to T-notes.

There are two Chemical companies to chose from, one relatively small and domestic — Olin (OLN) — and one large and European — Akzo Nobel (AKZOY).

Historically dividend paying companies have far outperformed non-dividend paying stocks, and dividends account for about 40% of the total return from owning S&P 500 stocks over the long term. The combination of high dividends plus short-term estimate momentum just could lead to long-term success in the market.

This is not a flashy strategy, but a solidly profitable one. It focuses on both sides of total return — income plus capital appreciation.

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