Why I’m revamping our “Income” Holdings

I’ve been reworking the stock holdings within the income allocation of portfolios all year.  To offer some background, I break portfolio allocations into two segments, Growth and Income, and fit clients based on the amount of volatility that’s appropriate for their retirement/financial plan.  These days, “Income” oriented investments don’t offer much in the way of annual income (unless you’re taking a lot of risk, which defeats the purpose of “safe” income investments) so to me it’s more about stability and having a reserve available when better opportunities arise.

Over the past few years, holding high yielding, dividend paying stocks has been a great way to boost returns within our Income portfolio.  However, I’ve been getting the feeling that most of these stocks have run their course and now offer a slanted risk/reward relationship.  Similar to high yield bonds (a.k.a. junk bonds), some of the highest yielding stocks are now richly valued, offering very low prospective returns.  Investors have been blindly chasing yield for a few years now and I think this has created some distortions in asset prices.  To me, there’s no point chasing a 4% – 5% yield if you face a strong risk of losing 10%+ in principle on a drop in prices.

The biggest issue I’ve been seeing with high dividend paying companies is that most are maxed out, meaning they’re currently paying the vast majority of annual net income out to shareholders in the form of dividends.  This leaves little room for future dividend increases without growing the business (revenues, profits, etc.) which might be a tough task moving forward.  Additionally, many companies are now paying more than 100% of their free cash flow as dividends!  This means that they’re funding the dividend payments with either cash on the balance sheet, or more commonly these days, taking on additional debt to make the payments.  We can call this the government business model, which clearly isn’t sustainable.

So here is my biggest concern regarding dividend paying stocks: the economy is showing signs of slowing, many companies have spent the past few years leveraging up with a lot of debt, they’ve boosted the dividend so much in attempt to make their stock look attractive that they’re “overpaying” and eventually credit markets are going to tighten (as they always do) making it very difficult to rollover the debt.  If the economy slows, if the stock market falls, or if long-term interest rates continue to rise, these companies will most certainly get hit the hardest and eventually could be forced to cut the dividend payouts.  That’s not what I’m looking for in a stable “Income” holding.

The new companies that I’ve been picking up in our Income model all seem to have lower yields (most in the 1.5% to 2.5% range), but have plenty of free cash flow to boost future payouts, even after taking into consideration the current dividend payments.  While the yield is less, I view these stocks as facing far less downside risk and higher potential total returns (dividend plus appreciation).  Again, in this low interest rate world I’m not expecting huge inflows of income.  Some income is nice but stability is the key on which I’m focusing.  We’ve made nice gains and now it’s time to preserve some of them.  See this previous post for a quick recap on why free cash flow is so important.

I completely sold out of Utilities at the beginning of the year and significantly reduced exposure to energy companies during the bounce this spring.  Throughout the first half of the year, I’ve already sold or am in the process of selling: ITC Holdings (ITC), Chevron (CVX), Spectra Energy (SE), Dupont (DD), Waste Management (WM), and General Electric (GE).

New buys on the Income side include: Travelers Insurance (TRV), Oracle (ORCL) and General Dynamics (GD)

I’ve also added to: Johnson & Johnson (JNJ), Amgen (AMGN), Church & Dwight (CHD) and Lincoln Electric (LECO)

Travelers Insurance (TRV) – 1 year

Oracle (ORCL) – 1 year

General Dynamics (GD) – 1 year

Thanks for following!

-Nick