Break Out the Barbell, Part I

 | Feb 28, 2013 | 2:00 PM EST  | Comments
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I played hooky much of the day Wednesday. At the invitation of a longtime Real Money reader, I attended a spring training baseball game, taking in the sunshine and baseball-related conversations, though we did touch on the markets in the aftermath of Ben Bernanke's testimony on Capitol Hill. The Federal Reserve chairman consoled markets, saying that the majority of Fed governors favored continued quantitative easing and that the practice would continue for the foreseeable future. He said that the need to support the economy outweighed the risk of creating asset bubbles down the road. He sees no such bubble at this point, apparently.

This is a hard blow for traditional income investors. Rates are going to remain low for an extended period. Low-risk, interest-paying instruments such as Treasuries, CDs, municipal and even corporate bonds are not going to pay a high enough rate to provide the income needed to support a pre- or post-retirement lifestyle for many people. I am amazed that seniors groups have not stormed the Hill to protest the changes wrought upon them by the Fed's Zero Interest Rate Policy. Money is basically forced into riskier assets, and this can put principal -- even basic financial security -- at risk.

We have to play the hand we are dealt in life, so absent an ability to change Fed policy, income-oriented investors are being forced to embrace riskier assets. Wall Street's massive marketing machine has geared up for these easy pickings, creating products aimed at income and retirement investors, and pushing blue-chip stocks that have already doubled or more. Income and dividends are the flavor of the day on Wall Street and I have never seen marketing favorites become performance leaders in my career.

Again, we have to accept the reality that doing what everyone else is doing is probably not going to provide the income and long-term growth needed to fund a retirement or income portfolio. Even income investors need to be driven by valuation and basic value investment principles. If you have a friend or relative who needs to become an income investor as retirement approaches, the best gift you could possibly give them is a copy of Benjamin Graham's The Intelligent Investor to prepare them for the challenges ahead.

In today's market, the best approach for income investors is to adopt a barbell-style portfolio. The first end of the barbell is the higher-yielding alternative income investments such as real estate investment trusts, business development companies, and select high-yielding issues that are not currently darlings of Wall Street. Although I am always a fan of "stay small and move slowly," I will modify this belief for income investors and encourage them to "stay smaller and move slower." Markets will be volatile going forward, and there will be ample opportunities to scale into income positions.

This is particularly true of one of my favorite alternative income arenas. Mortgage REITs will react to every interest rate pronouncement and piece of housing-related news. Spread compression because of lower net interest margins could spur a few dividends cuts. Mortgage REITs take advantage of market conditions to issue new equity on a regular basis, and this frequently creates short-term selling pressure in the shares. It is very important that investors never pay a premium for mortgage REITs and only buy when the shares are down.

Look at a current favorite. ARMOUR Residential REIT (ARR) has cut its dividend and recently conducted an equity offering to provide further pressure on the stock price. The shares yield 14% now and I would not fall out of my chair if ARMOUR reduced the dividend further. I would buy a little here, and if it cuts the dividend, buy a few more shares on the selloff. Over a long period, careful buying should allow for solid, double-digit, long-term returns.

Another example of buy-on-the-way-down income stocks is Pengrowth Energy (PGH). The Canadian oil and gas company is in the process of a painful transition, moving away from traditional oil and gas to thermal production. Management believes this will provide a stable, long-lasting, low-cost supply of oil and gas for the future. More importantly, from our perspective, it has committed to funding the dividend via asset sales during the transition. Trading at less than 60% of book value with an 11% dividend yield, it makes sense to buy a little and scale in on further weakness.

The keys to winning with alternative income are to always pay less than asset value, scale in on news-related selloffs, and own lots of them. I was asked how many of these high-yielding vehicles investors should own and my answer was simply as many as you can find. If you spread the risk, stay really small and move really slowly, this approach can provide some of the cash flow income investors need.

I'll address the other end of the income-investing barbell in my next column.

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