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These are bountiful times for Corporate America, but when it comes to dividends, shareholders may feel left out of the profit party.
Companies in the S&P 500 are on track to earn more than $1 trillion this year. Yet even with companies paying 32% of their profits in dividends — 37% above the average for the last 10 years — the yield on the S&P 500 (.SPX) has been stuck at roughly 2%, less than half its historical yield of 4.4%.
The low yield reflects rising stock prices in the past year. But if you're investing for income, a 2% dividend won't take you very far, especially after accounting for inflation and taxes, assuming you hold the stock in a taxable account.
Still, there are some higher-yielding stocks that — in moderation — may help boost your returns and improve your portfolio's diversification.
Some money managers suggest energy master limited partnerships (MLPs) as a supplement to a traditional portfolio of stocks and bonds. Other investing pros like technology and financial stocks — two sectors with low payout ratios and strong potential for dividend growth.
Most advisers don't recommend stretching for yield: Taking more risk in return for more income. An attractive yield may not be the best way to generate total returns. And dividend payers tend to be more defensive names, which aren't always good bets.
Indeed, high-yield stocks — notably utilities and REITs — tumbled recently as interest rates spiked, making bonds and other fixed-income investments more competitive.
"It's a challenging environment, and not just for people who want higher yields," says David Wright, managing director at Sierra Investment Management in Santa Monica, Calif.
Overall, your portfolio should be tailored to your long-term investing objectives, and you should focus on total returns: a mix of capital gains and income from a wide variety of sources.
Here are some ideas from fund managers we interviewed, along with our own research. As always, you should consult an adviser or do your own research before investing.
MLPs make money off fees charged for moving oil and gas through their pipelines or storage facilities. They're required to pay out more than 90% of their cash flows as distributions to investors, and they currently yield 6%, on average, according to the Alerian MLP Index.
With domestic oil-and-gas production booming, MLPs should generate solid long-term returns, says Curt Pabst, managing director with Eagle Global Advisors, an advisory firm based in Houston that uses MLPs for clients. Many MLPs have hiked their distributions more than 10% this year, he adds, a sign that the industry is "fundamentally healthy."
"They're making more money than most people expected and they're passing that on to investors," he says.
MLP valuations remain reasonable compared to REITs and other "yield investments," adds Pabst. And MLPs usually don't move closely in tandem with traditional stocks and bonds, providing some diversification.
MLPs do have drawbacks. They're sensitive to interest rates and energy demand, and their tax treatment is very complicated. You should consult an adviser to see how they fit with your other investments and whether to hold them in a taxable or tax-deferred account.
One way to capture much of the market is to buy the five biggest MLPs in the Alerian Index: Enterprise Products Partners (EPD), Kinder Morgan Energy Partners (KMP), Plains All American Pipeline (PAA), Energy Transfer Partners (ETP) and Magellan Midstream Partners (MMP). Combined, they make up more than 45% of the index, driving a large share of its returns.
Another option is the Credit Suisse Equal Weight MLP Index ETN (MLPN). The ETN holds 30 MLPs, weighted equally, and it avoids the highly energy-sensitive MLPs in favor of "midstream" MLPs, which are less sensitive to commodity price swings.
The downsides: The ETN isn't as tax-efficient as owning individual MLPs, and it could be more volatile than a basket of large MLPs. The annual expense ratio is 0.85%. As a debt product backed by Credit Suisse, the ETN poses credit risk.
A few years ago, dividends were a rarity in Silicon Valley. Today, most large-cap tech stocks pay a dividend and tech companies in the S&P 500 are expected to grow dividends 17.4% in the next 12 months, the highest rate of any sector, according to FactSet, a financial software and research firm.
Four big names to consider: Apple (AAPL), Microsoft (MSFT), Cisco (CSCO) and Intel (INTC). Yields range from 2.5% at the low end (Apple) to 3.5% for Intel.
Perhaps more compelling is their potential for dividend growth. Apple paid out 27% of its profits in dividends in its last fiscal year. Microsoft and Cisco paid out 35% and 33%, and Intel paid 39%. Those payout ratios are considered low, providing plenty of potential for dividend growth.
"You have to think about dividend growth as well as a high yield, and that's an attractive thing in tech," says Scott Offen, manager of the Fidelity Equity Dividend Income Fund (FEQTX), which has 12% of its investments in tech stocks, including these companies.
Key risks: Volatility is a hallmark of technology stocks. They can rapidly lose their edge in the marketplace, and hardware companies, in particular, are economically sensitive.
Profits for banks and other financial companies have rebounded sharply, yet they're still paying out a meager share of their earnings as dividends — just 21.6% in the second quarter, according to FactSet. That's the lowest payout ratio of any sector and could bode well for future dividend increases.
One stock with an attractive yield and strong business is CME Group (CME), according to Jack Leslie, a portfolio manager with Miller/Howard Investments in Woodstock, N.Y., who recommends CME for his clients.
Based in Chicago, CME is the largest U.S. operator of options and futures exchanges. Revenues have been rising, in part thanks to heightened volatility around interest rates, and the company's clearing business is gaining market share, says Leslie.
The stock currently yields 2.4% but the company has a policy of paying out 50% of cash earnings, usually as a special dividend in December, which could double the current yield.
Key risks: Weaker trading volumes could pressure the stock.
Another stock Leslie likes is REIT Digital Realty Group (DLR). Based in San Francisco, the firm owns and manages data centers in the U.S. and abroad — a growth business benefiting from rising Internet traffic and demand for data facilities. The firm has a lot of debt and faces stiff competition in the data center space, factors that have weighed on the stock.
Yet the stock is now "very inexpensive" relative to its historic average, says Leslie. Projects under development should provide ample cash for the dividend to grow 7% to 10% annually, he adds, while occupancy rates remain high.
Key risks: Higher interest rates could pressure DLR's profitability and dividend. Most REIT distributions are considered ordinary income which may be taxed at high marginal rates, making REITs best held in a tax-deferred account.
Among bank stocks, companies with above-average yields include PNC Financial Services (PNC), Wells Fargo (WFC) and U.S. Bancorp (USB). Valuations for these banks are at the low end of their historical range, says David Ellison, lead manager of the Hennessy Large Cap Financial Fund (HLFNX), which owns the stocks.
"You have an industry that's gone through a once-in-a-lifetime downturn and it's pulling out," he says. "The stocks don't fully reflect the amount of potential for these companies to get better."
These banks are conservatively managed, he adds, and their stocks could get a lift from improvements in their balance sheets and stronger loan demand if the housing market and broader economy continue to recover. Steeper interest rates could also help them earn higher profits on loans.
Key risks: The banks may have to pass stress tests before being allowed to raise dividends. A downturn in the economy would likely impact loan demand and could pressure their profits and stock prices.
|Enterprise Products Partners (EPD)||20||4.5%|
|Kinder Morgan Energy Partners (KMP)||28||6.7%|
|Plains All American Pipeline (PAA)||19||4.5%|
|Energy Transfer Partners (ETP)||21||6.9%|
|Magellan Midstream Partners (MMP)||20||3.8%|
|Credit Suisse Equal Weight MLP Index ETN (MLPN)||N/A||4.6%|
|CME Group (CME)||20||2.5%|
|Digital Realty Group (DLR)||32||5.6%|
|PNC Financial Services (PNC)||11||2.4%|
|Wells Fargo (WFC)||10||2.9%|
|U.S. Bancorp (USB)||12||2.5%|
Source: Thomson Reuters Datastream, Credit Suisse. P/E ratios based on forward consensus estimates. As of 9/27/2013.Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He owns shares in Enterprise Products Partners, Kinder Morgan Energy Partners and Energy Transfer Partners in a passive index account.
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