Diary of a Dividend Diva: A Teachable Moment

 | Jun 07, 2013 | 9:30 AM EDT  | Comments
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Dividend investors are worried after the recent backup in rates caused important income sectors to get crushed. Utility stocks, real-estate investment trusts (REITs) and master limited partnerships (MLPs) were all hit as investors adjusted prices on securities in order to sustain the spread between the yields and fixed income rates of return.

In case you missed it, these charts illustrate the carnage:

Source: Yahoo! Finance

 

Source: Yahoo! Finance

 

Source: Yahoo! Finance

This is a perfect teachable moment for us to look at the dividend capture strategy and why it avoids some (but not all) of the risk associated with the current yield environment.

The target "yield" for the dividend capture strategy does not move with rates or the general level of yields for the stock market. In my partnership portfolio, I target 8% of income generation a year (although I have done 10% in each of the last three years), and that target is rather invariant. The ease or difficulty of achieving the goal is a function of two variables: yields on offer by the market and velocity of trading. I typically achieve the 8% using stocks yielding the 3%-4% range with two to three turns of the capital. Therefore, higher yields actually make it easier on the margin to achieve our goals.

Large changes in the yield environment mostly affect the strategy from a marketing perspective. If this were 1982 with long-term rates at 20%, clearly few would be interested in a strategy paying out 10%, and I would have to adjust accordingly.

Having said that, this is an equity strategy, so the risk comes from general stock market exposure. For instance, due to this nascent correction, my open trades over the past couple weeks are below my purchase price, so I may have to take some capital losses to keep my capital utilization. The strategy runs this risk often -- not only in a rising rate environment -- and I suggest regularly how you should "make hay while the sun shines" by collecting a lot of dividends in bull market phases, but throttle back activity in bear market phases. Since the current risk of capital loss is higher, my activity level is much lower now.

A key risk mitigator for the strategy, and one of the reasons it works in general, is that we avoid stocks that are owned for the dividend. The groups noted above are income stocks and the owners care deeply about the dividend, such that they trade very efficiently around going ex. Dividend capture utilizes names for which the owners care less about the income. For example, we have great success capturing dividends in technology stocks, which most people own for the growth. These non-income names are more likely to bounce back quickly to your purchase price, and may not even drop on the ex-dividend date. Similarly, they are less likely to get sold off for yield reasons during a period when the yield stocks are getting crushed.

Another risk mitigator is that we do not use the full portfolio for income generation. I allocate about 40% of the capital to dividend trades, and the remaining is invested longer-term in a "foundation" set of names that mimics my growth strategy. (For home-gamers, you could also leave the 60% in the SPDR S&P 500 (SPY) or even in cash) This foundation will have equity volatility of course, but it will not react in the same fashion to rate increases as will the dividend plays.

Finally, as I noted earlier I generate income using 3% to 4% yielders, which also react less violently to yield repricing than do the pure income names.

Those of you executing dividend capture trades should be following these guidelines to reduce your risks. No strategy is risk-free, including this one, but by paying attention to the types of names you use, the structure of your portfolio, and the pace of trading given the market environment, you should be able to sustain attractive income generation and maintain a positive total return over time.

Since I am cutting back on trading, I will not offer any dividend ideas at the moment. I have a few in mind, but they are in tough to play sectors such as mining. I'll be back with more as safer dividends are declared in the days ahead.

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