Instead of Piling Up REITs and ETFs

 | Oct 08, 2013 | 3:00 PM EDT
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On Monday I addressed some specific question for a longtime reader who was interested in monthly income securities. Today, I want to expound on the subject of income-oriented investors and take the discussion a little further.

I am of the opinion that, in the last few years, we have seen an awful lot of money make it into the stock market that would have never turned heavily toward equities if it weren't for the Federal Reserve's current zero-interest-rate-policy. We can argue all day about whether that should be the case, or whether these are optimal asset-allocation mixes in the context of history -- but the simple fact is that these folks are here in the stock market, they are not very experienced at it and they need income.

More to the point, I think these market players need some help from the pros who have been around a while and have a few scars and bruises. The inexperienced income investor is highly susceptible to the Wall Street sales machine, and can be easily steered in the wrong direction. It is no accident that, even as we are seeing individual investors desperately search for yield, we've once again seen a sales-volume explosion among unlisted real estate investment trusts, as well as in closed-end funds and new REIT offerings.

With that in mind, today I will share some of my thoughts on income investing and maybe challenge my fellow contributors to do the same over the next few days or weeks. It always fun to talk about the trade of the day, but I suspect we have a lot of readers who are looking for income or have parents and other relatives in need of advice on their income portfolios.

My advice is probably different from most of what you will hear these days. If you have new money to put to work, then you have missed your chance to buy most of the dividend-paying blue-chip stocks. These shares have tripled or more off the market bottom, and without any serious improvements in revenue or profit beyond that provided by cost-cutting and share buybacks. Stocks like McDonald's (MCD) and Coca-Cola (KO), and big drug stocks like Merck (MRK) and Pfizer (PFE), look extremely overvalued to me -- and, from a price standpoint, they are currently too risky for income accounts.

I think you need to own a wide variety of alternative income investments, such as business-development companies, asset managers and REITs. Be patient and buy them when they are trading below their asset value, and own a lot of them.

I myself like the names associated with the established private-equity firms and hedge-fund managers -- such names as KKR Financial (KFN), Apollo Investment (AINV) and Avenue Income Credit Strategies (ACP). You can also own KKR & Co. (KKR) common shares, which have a solid yield of more than 8% right now. It doesn't matter whether these firms pay out monthly or quarterly as much as it does that they pay regularly. Buy these shares when they are down below net asset value, and do not buy too much of any of them. Stay small, move slowly and own lots of names.

Do not ignore the preferred stocks, either. We haven't heard a lot of people talking about these hybrid securities, but they can add a lot of yield to your portfolio. Although you'd concurrently be taking on interest-rate risk, if you buy carefully these stocks won't be subject to the day-to-day fluctuations of the income markets. Right now I like higher-yield preferred shares that are trading for a decent price, such as International Shipholding (ISH), Tsakos Energy Navigation (TNP), FelCor Lodging (FCH) and Northstar Realty (NRF). Again, it pays to be patient and buy on down days, and to avoid paying above par value or the next call price.

This approach -- buying small amounts of many higher-yield investments, purchased at a discount to net asset value or below par value -- should be used for about one-half of your portfolio. The other half needs to be devoted to dividend-growth names. We want to apply some of the valuation principles developed by Ben Graham and put together a portfolio of reasonably valued stocks for which the dividend payout can be expected to grow at a very high rate for the foreseeable future. I ran a screen for these types of stocks, and I found a very interesting list -- which we'll explore in Wednesday's column.

This barbell approach of gathering higher-yielding investments, and reasonably priced dividend-growth stocks, requires more work than if you just buy a couple of closed-end funds from your broker or if you pick up a collection of ETFs that look OK. You have to be patient and buy these names when you they are cheap, and you need to spend a bit of time doing the required homework to find the right ideas at the right price.

So, yes, it's labor-intensive -- but I wonder how hard you worked to make the money in the first place, and how hard you need it to work for you now. Anyone who tells you this is easy is a fool or a liar, and I am not a big fan of investing with either kind of person.

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