Dividend stocks have been bid up in 2013, and many investors believe the yawn-inducing dividends of 3-4% generally available now aren't worth the risks involved in an overheated income sector.
Many stocks paying higher dividends, in the tantalizing 8-10% range, are paying them out of capital, which is hardly a good thing. A number of companies are paying a fixed dividend where it's mathematically impossible for investors to get their money back just because so many unwary investors are craving big, easy income.
And while there's need to beware, there's also no need to despair.
There's a unique class of dividend paying companies that kick off big dividends but aren't going to sell their investors down the river. And Wall Street doesn't talk about them because they're a bit more complicated than your average income stock because their dividend yields fluctuate.
In some cases, you can get a very good deal in spite of the complexities involved.
What's more, if you're willing to put up with a few peculiarities, this asset class is tax-advantaged, to boot.
Their variable dividends arise directly because these master limited partnerships (MLPs) can avoid paying corporate tax provided more than 90% of their income is distributed to shareholders.
Increasingly, companies have used this provision to spin off parts of their operations to separate entities, relying on the receptive market for dividend stocks to pay an attractive price for them.
Steady but Variable
Most spin-offs of this kind pay fixed dividends. First, the operation concerned may have an income that is effectively fixed; for example the spinoff of a pipeline may ship a fixed amount of product through the pipeline and pay a fixed charge per ton, giving a fixed annual income.
Second, if the income from an operation varies only moderately, and cash flow exceeds income, then dividends can be paid at roughly the highest annual income figure, which then allows the company not to pay tax while still having only a small chance of running out of cash.
But not all MLPs and REITs work the same way.
There are a substantial number of MLPs or equivalent structures that pay out quarterly the actual income earned, and allow that income to fluctuate. That gives investors a fluctuating dividend, which the market generally values lower than a fixed dividend of equal average amount.
And this is where the opportunity arises.
If the market values something lower because it's simply variable, smart investors can buy it cheaper, and earn a superior return.
That's what I'm talking about here.
Shop Wisely
But not all variable yield MLPs are created equal.
Most MLPs, especially those with fluctuating dividends, rely on a finite pool of assets with a finite lifespan. If an oilfield is expected to last 20 years for example (or if as in some cases only 20 years of the field's production accrues to the MLP), the 5% should be deducted from the yield to reflect that part which is a true return of capital.
In some cases, the calculation is more difficult.
One oil MLP is expected to pay high dividends until 2016, as new wells are drilled, then gradually declining dividends until 2031, when the concession ends. That one has an expected life of somewhere between 3 years and 18 years, depending on what shape you think the decline slope will be.
Just as the market tends to undervalue fluctuating dividends, it tends to overvalue assets with a finite life, not accounting properly for the depletion of capital. Great Northern Iron Ore Properties (NYSE:GNI) owns the rights to earnings from iron ore properties, but only until April 2015, at which point the properties revert to another company.
Needless to say, its apparent 12.5% yield isn't very exciting when that's taken into account.
But I have found a trio of these unique income creatures that are worth your capital and should provide solid income over the long term.
One MLP I like owns the rights to the sale proceeds of 11.5 million barrels of oil equivalent, of which 5 million had already been sold by March 31, 2013. Hence 6.5 million barrels remain to be sold, and are expected to be sold between now and 2026.
At the $45 per barrel of oil equivalent received from sales in September-November 2012 (based on an $83 oil price) that's worth $297 million, but at today's $95 oil price, it's worth the current $341 million market capital.
MVO gives a return linked to the oil price, so it's equivalent to buying oil at today's spot price and selling it at market price over the next 13 years. Currently MVO's running yield is 12.2%.
Another that is working well for subscribers pays out the proceeds of drilling the oil from oil and gas properties in the Permian Basin. It currently has 3.2 million barrels of oil reserves and 484 producing oil wells, with another 404 to be drilled by March 31, 2016.
The Trust will receive royalties from oil sales until 2027, but dividends are expected to decline after 2016. Based on the last 12 months dividend of $2.05, Sandridge Permian yields 13.6%, but if you assume a 10-year average life for the dividends, 10% of that can be considered a return of capital.
On the other hand, today's oil price is significantly higher than the last 12 months average, and the yield should increase with the oil price.
A third is VOC Energy Trust (NYSE:VOC), which owns a term net profits interest of the proceeds from 80% interests in 881 oil and gas properties in Kansas and Texas, with about 90% of its production coming from oil.
Its interest terminates on the later of two dates, December 31, 2030 or when the underlying fields have produced 10.6 million barrels of oil equivalent output.
In the first quarter the dividend paid was 48 cents, and we can expect similar payouts going forward. Based on the 48-cent dividend, VOC's yield is about 14.7%, of which, based on a 17-year life about 5.9%, should be regarded as return of principal, giving a net yield of 8.8%.