Stay Small and Move Slowly

 | Jul 24, 2013 | 4:00 PM EDT  | Comments
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Stock quotes in this article:

ivr

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nly

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efc

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arr

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kfn

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ainv

One question I am asked with some consistency is about how and where to find investments that can provide some measure of income. The world is yield starved after a few years of quantitative easing (QE) and zero-interest rate policy (ZIRP) programs and that is not going to change anytime soon.

I generally favor a mix of higher yielding alternative income securities such, as real estate investment trusts (REITs), business development companies (BDCs) and Mortgage Real Estate Investment Trusts (mREITs), as well as companies that have the potential for very high dividend growth over the next five to 10 years. Generally speaking, this has provided a portfolio income well above what is available from bank instruments, bonds, municipal funds and even blue-chip dividend stocks. Right now, I am having the same problem everyone else is: Yield chasing has pushed prices to unsustainable levels.

I have a presence in the mReit market and have not sold any of my holdings in Invesco Mortgage (IVR), Annaly Capital Management (NLY), Ellington Financial (EFC) or Armour Residential (ARR). I am wiling to take the ride with these even as they become increasingly volatile with the yield on longer-dated bonds rising. I think these mREITs will be among the survivors no matter what happens in the industry, and I am willing to ride along and collect the dividends. I would hold off on any new purchases until second-quarter earnings are reported to see how they respond to the rate rise and how well their hedges did -- or did not -- protect book value in the second quarter.

For new money right now, I am being pretty cautious. I favor the BDCs and specialty finance companies that are associated with a major private equity player. I find that they tend to benefit from the expertise and guidance of the private equity side of the business and have access to better lending and investing opportunities. KKR Financial (KFN) is a great example of this type of investment. KKR Financial is a specialty finance company managed by a wholly owned subsidiary of Kohlberg Kravis Roberts (KKR) and does not have the same investment and dividend restrictions as regular BDCs. They can invest in a wide range of industries and also have both a REIT and master limited partnership (MLP) subsidiary to take advantage of income opportunities in these sectors.

A look at the latest earnings report shows that the firm was able to grow its book value in the quarter from $10.16 to $10.41 at the close of the first quarter. Net income was up by 11%, year-over-year, and the company declared a quarterly dividend of $0.21 a share. At today's price, the company trades at a slight premium to asset value and yield 7.64%. Management's long-term goal is to deliver annual returns 1,000 basis points over the 10-year Treasury note. If it even comes close to that goal, income investors should be very satisfied with a long-term position in the stock.

I still own and would be a buyer with new money of Apollo Investment (AINV). The BDC is affiliated with Apollo Global Management (APO), the private equity and buyout firm founded by Leon Black, and has access to their research and expertise. Their relationships in the LBO and PE industries have given them access to a decent range of sponsors across a wide range of industries. In 2012, the company was shirting away from unsecured debt toward secured debt opportunities to better protect their assets in a still weak economy. At the end of March, the company had more than $2.85 billion invested in 81 different companies.

Both of these should be outstanding long-term holdings for income oriented investors. As the market has been still moving in its "all steam ahead" fashion, it makes sense to be a scale buyer of both stocks. The shares trade at a very small discount to net asset value and yield 9.67% at the current price. This experienced management team has a solid track record and the BDC should do very well in an improving economy over the next several years.

You can buy a little now to start enjoying the cash flows from dividends and use periods of market weakness to increase your holdings over time. It is a difficult time to invest for income, but some digging, research and a policy of staying small and moving slow should prove rewarding with higher yielding alternative income investments.

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