Where Income Investors Should Look

Monday, 23 May 2011 09:03 AM

By Tom Hutchinson

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Investing for income has seldom been trickier. The safest investments are paying almost nothing while higher yielding investments are vulnerable to rising interest rates which loom in the near future.

So, it appears that income investors have a choice — earn nothing or risk losing your shirt.

Today's historically low interest rates have almost nowhere to go but up. Last week, even the Fed has suggested that it may raise rates in the not-too-distant future as inflation becomes more of a risk. In fact, interest rates are already on the rise in China, Brazil and Europe.

Adding to the current dilemma is an extremely uncertain long term direction of the economy. Strong possibilities of both slow growth and inflation lurk and each requires different investment strategies. While inflation would crush bonds, slow growth would hurt MLPs (Master limited partnerships) and REITs (real-estate investment trusts) snd other high yielding stocks. Much about the longer term economy will depend on the results to the upcoming presidential election, which is impossible to predict at this point.

Where can investors find reliable and reasonably safe income?

One possibility is high dividend-paying stocks in defensive industries.

Defensive sectors (healthcare, telecom, utilities, consumer staples) make sense now because these companies are generally able to generate consistent earnings in good times and bad, making them viable in a slow-growth economy.

After all, while people may cut back on meals out and home entertainment systems in a tough economy they still continue to get sick, turn on the heat and buy soap.

These companies are ideal for income investors because their reliable cash flow enables them to pay strong dividends.

In addition to providing income, dividend stocks have been solid performers in rotten economies. While dividends have accounted for about 40 percent of the market's total return for the past 80 years, the contribution has been greater in tough markets.

From 1974 to 1982, a period marred by slow economic growth and inflation, dividends accounted for 56 percent of the S&P's total return. In fact, total return (including dividends) over this period was an annualized 9.4 percent, compared to just 4.1 percent without dividends.

Here are a few defensive dividend payers.

Eli Lilly and Co. (NYSE: LLY) is a global pharmaceutical powerhouse with sales in 143 countries. The company currently sells at less than nine times earnings, nearly half the current S&P 500 multiple. Lilly yields over 5 percent and the dividend, which has increased 75 percent over the past decade, is strongly supported by a 41 percent payout ratio.

AT&T (NYSE: T) is one of the largest telecommunications providers in the world. The company is the second largest wireless provider in the country, the dominant local phone company in 22 states, and a wireless services provider in more than 220 countries. The stock currently yields 5.5 percent and the dividend has been raised every year since 1998.

Founded in 1837, Proctor and Gamble (NYSE: PG) is the world's largest consumer products company, with operations in more than 180 countries.

The company estimates that about 65 percent of the people alive on the planet use its products. While the stock currently yields just 3.1 percent, it has raised the dividend every year for the past 56 years.

These companies also protect against inflation. As prices increase, they can raise prices and increase the dividend, unlike bonds which pay a fixed rate of interest. As well, the companies mentioned are multinational and revenues generated in other currencies protect investors from a falling dollar.

With the S&P 500 nearly 100 percent above the lows of 2009 and GDP growth projections being scaled back for the rest of 2011, investors have begun to flock toward defensive stocks.

So far this year, the top performing sectors have been healthcare (16 percent), utilities (9.5 percent) and consumer staples (9.4 percent). These sectors were among the worst performing in the bull market of 2009 and 2010 but the momentum appears to be shifting.

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