There's a simple way to make sure your income stocks are performing up to snuff, and that's to make sure their payouts are either rock-solid or rising for the right reasons, notes Ari Charney of Personal Finance.
After an incredible run amid the market tumult of 2011, dividend-paying stocks were due for a breather in 2012. As such, our holdings gained 7% last year versus a 16% return for the S&P 500.
Aside from the global economic malaise, our stocks faced the additional headwind of Congress’ contentious negotiations to avert the so-called fiscal cliff. The deal that was finally struck at the outset of the New Year came too late as far as the market’s fourth-quarter performance was concerned.
Although our stocks suffered in sympathy with the broad market, they once again demonstrated their ability to preserve wealth when the market drops. That’s despite the fact that dividend stocks sold off as income investors fretted over a possible change in dividend taxes that largely failed to materialize. While the market lost 0.4% during the fourth quarter, our stocks gained 0.4%.
Over the long term, safe businesses coupled with growing dividend payouts result in a portfolio that beats the market while incurring less risk.
That gulf in performance may not sound like much, but thanks to the magic and power of compounding, it means a difference of almost 54 percentage points—for a total return of 146.5%. Almost as important, our portfolio achieved this outperformance with significantly less volatility than the market. That’s the sweet spot of successful investing.
While we’re perfectly happy to watch our stocks rise in value, a substantial portion of these returns is due to the reinvestment of dividends. Over time, a growing payout will entice investors and push share prices even higher. To that end, the 16 stocks that have been in our portfolio for a year or longer enjoyed an average growth in payout of 4% over the past year.
One of the best examples of the relationship between payout growth and capital gains also happens to be our top performer for the year: Genesis Energy (GEL). The midstream master limited partnership (MLP) posted a total return of 35.2% along with distribution growth of 10.5%.
The MLP generates mostly fee-based income from storing and transporting crude oil, which largely insulates it from the vagaries of commodity prices. Genesis boosted its most recent quarterly distribution to 48.5 cents, the 30th consecutive quarter in which its payout has risen and the 25th time it’s done so at an annualized rate of at least 10%.
Even so, the MLP tends to conservatively cover its payout with a ratio of cash flow to distribution of 1.2 to 1. Management intends to continue the MLP’s record of double-digit distribution growth in 2013. Genesis Energy LP is a buy.
APA Group
Over the short term, a stock’s payout doesn’t necessarily have to rise for it to produce outstanding gains, as evidenced by our second-best performer of the year, APA Group (APAJF).
Australia’s leading natural gas infrastructure company produced a total return of 31.7%, with much of that gain coming during the fourth quarter, following improved guidance for 2013 due to its acquisition of Hastings Diversified Utilities Fund. Meanwhile, its dividend rose just 0.3% year over year.
Similar to Genesis, APA Group specializes in the distribution and transmission of a key energy commodity. The company’s expansive footprint of 14,000 kilometers of gas pipelines in the Land Down Under, along with government forecasts of a doubling in gas volumes over the next 20 years bode well for further gains.
The company also benefits from Australia’s enactment of a carbon tax, which favors natural gas over coal for power generation. APA Group is a buy.
Windstream
Our worst performer for the year was telecommunications company Windstream (WIN), which dropped 22%, with much of that fall occurring during the fourth quarter.
Windstream’s shares have been beaten down by investor skepticism over the company’s ability to maintain its 25-cent quarterly dividend. Nevertheless, management has repeatedly affirmed its dividend guidance, and free cash flow continues to cover the payout by a comfortable margin.
We suspect Windstream is largely suffering from guilt by association with other rural telecoms that have stumbled in repositioning their businesses. The company’s management team has pursued an aggressive acquisition strategy to transform the company from a rural wireline telecom with a limited footprint into a company that provides advanced business communications services on a national scale.
For now, the dividend appears to be safe, so Windstream Corp remains a buy.
Exelon
Although we only just added Exelon (EXC) in mid-August, it managed to drop 19.9% by year-end, earning it the distinction of our second-worst performer.
Exelon’s acquisition of the former Constellation Energy means that it’s now the premier play on US nuclear power generation. However, the company still derives roughly half its revenue from wholesale power generation, an unregulated market where pricing can be volatile.
The company attempts to hedge its exposure to electricity prices, but now faces an “earnings cliff” as its hedges come off the books and wholesale pricing remains weak. Barring an improvement in the next few months, management has warned that a dividend cut could soon be in the offing. Exelon is rated hold.
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