The Income Investments You Need to Focus On Right Now

The yield on 10-year Treasuries dipped sharply below 2% again last week. Meanwhile, inflation, even on the official figures, is running at 3.4%.

For someone trying to preserve their capital in real terms, those two figures show a real problem - with bond investments, it's impossible.

Capital gains are out - the Dow Jones Industrial Average is below its level of five years ago and, adjusted for inflation, below its level of 10 years ago. Today, the only way you stand to get a decent deal out of your investments is through income stocks.

Not all income stocks are ideal. At one extreme, there are the blue chips that pay 3% to 4% in dividends and are referred to as "income stocks" because they don't show a great deal of growth. These include McDonalds Corp. (NYSE: MCD), The Procter & Gamble Co. (NYSE: PG) and the like.

Individually, some of these may be good "Buys" sometimes. But collectively, they are overpriced. Everybody has heard of them and the most optimistic assumptions about their steady growth are built into their stock price.

Even with all the analysts on Wall Street crawling over them, stuff can still go wrong - at which point their stock price will tank. While they may not be very risky, at their current prices there's all risk and little reward. Dividend yield of 3% to 4% is not much more than Treasuries and certainly doesn't pay you if something goes wrong. At $57 (equivalent to $570 today) in 2006-07, Citigroup Inc. (NYSE: C) was one of these stocks - within two years it was trading at $1.

At the opposite extreme, there are stocks that appear to have very high yields, but won't pay their dividend. Often, this is because the quoted yields are based on historical dividends, and hard times have hit the stock - Citigroup quoted some very fancy yields indeed on the way down! However, there are other snares in this area, which may be more difficult to spot:

  • Some companies are running along fine, but consistently pay out more in dividends than they take in through earnings. After a few years of this, the cash runs out and they have to cut or eliminate the dividend - which makes the stock drop, normally by much more than the extra dividends you've earned. Frontier Communications Corp. (NYSE: FTR) for example was paying $1 per year, which it claimed it could meet out of cash flow even though earnings did not meet it. Then after a big acquisition, it cut the dividend to 75 cents. In the last four quarters it has earned 16 cents, so I'd bet that the dividend will have to be cut again. Perfectly good business, but with profits and thus value in steady decline.
  • Then there are the companies whose earnings cover their dividends, but whose life is limited. Some of the Master Limited Partnerships (MLPs), which own a finite pool of oil or gas wells, are in this category. An extreme case is Great Northern Iron (NYSE: GNI). Nice company, 14% dividend yield, almost covered by earnings. But it depends on an iron ore mining concession that runs out in 2015 - so you only get four years of 14% plus 5% to 10% in extra assets in 2015 before the company disappears altogether. That doesn't add up to 100%, to put it bluntly.

By and large, yields above 12% are not that common, and yields below 6% are not especially worth going for. Still, that leaves you quite a big universe of companies with yields in the 6% to 12% range.

All you have to do then is determine whether the companies are going to be able to continue paying their dividends. Of course, the possibility of increasing earnings and dividends does not hurt. Look for earnings that are well in excess of dividends, with a business model that seems sustainable in the long run. Ideally, if the shares are selling below book value, that's a plus too.

As you can see, income investing is a bit more difficult than just looking for the highest dividends, or picking the blue chips whose yields have inched above 3%. But it is also highly rewarding, giving you yields close to double digits in stocks with solid values.

As far as specific investments go, I have an excellent suggestion in today's edition of Money Morning Private Briefing. It is undervalued in today's market and has a strong chance of appreciating in value and increasing its dividend. If you're already a Private Briefing subscriber you can read all about it in today's issue. If not, you can sign up by clicking here.

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