– Tim Plaehn, Editor, The Dividend Hunter

When you start looking for stocks to generate income, it’s easy to focus on yields, and your temptation might be to believe that higher yields are always better.

I too am a fan of high-yields, but only when the dividends come from a sustainable business model and the market is mispricing the quality of the company which leads to the higher yield.

However, to build an income stock portfolio that is not subject to large swings in the stock market, you need to employ some portfolio management strategies beyond just investing in a handful of high-yield stocks.

When I speak with investors, either at investment conferences or through my newsletter or email, I focus on how we really can’t foresee when the market will correct or go into a bear market. These events are part of investing in stocks and happen on a regular basis, but the one thing I do know is that the market always recovers from a downturn. This is a key fact to remember when investing.

For income-focused investors specifically, investing in stocks that will keep the dividends coming through all stock market conditions is an utmost necessity. As you build an income stock portfolio, take the necessary steps to make sure you earn a stable and growing income stream through any market conditions.

Before I jump into a specific stock discussion to make the point and provide an attractive stock opportunity, here are a couple of basic portfolio strategies you should always have in mind as you research for stocks to add to your portfolio.

1. Plan to reinvest a portion of your dividends, even if you are investing for income to pay your living expenses. The nice thing is you can still have a relatively high take-home yield even if you reinvest a portion of the dividends you earn. For example, Starwood Property Trust, Inc. (NYSE: STWD) currently yields about 8%. Taking 5% as income still leaves you 3% to reinvest. That reinvestment will buy more shares, giving you higher dividend payments the next time around and in the future.
   
2. Diversify across a number of stocks you own and by economic sectors. I recommend that about 20 stocks will give an adequate amount of diversification. This number needs to be spread across different market sectors such as equity REITs, financial companies (REIT or otherwise), energy, telecom, and transportation.
   
3. Look for dividend growth. Invest a portion of your portfolio – at least a quarter and up to half – in income stocks that are more focused on dividend growth than current yield. I like to call investments like these “Accelerating Dividend Stocks” because of their commitment to regularly increasing their dividends. The power of an accelerating dividend for driving total returns is why I recommend stocks like these.

This last point is important. Income focused investors tend to go for higher yields but do not spend a lot of time looking at dividend growth prospects.

There are a couple of reasons why dividend-focused investors need some growth prospects in their portfolios.

1. High-yield stocks which do not have much dividend growth tend to have more volatile share prices. During the first two months of 2016, we all felt the pain of share prices that were down 20% or more even though the businesses behind the share prices were doing fine. You will find that by owning some stocks that generate higher dividend growth rates, you will get more price stability when the markets get volatile.
   
2. With some dividend-growth focus, you will also see share prices increase, generating greater wealth along with a higher income.
   

And with that, let’s get into those five stocks…

Rock-Solid Dividend Stock #1:
A Retail REIT Consistently Raising Dividends

Our first example of a stock price charting an upward trajectory with increasing dividends is Tanger Factory Outlet Centers (NYSE: SKT). The chart below shows this clearly.

Tanger Factory Outlet Centers Inc. is the type of dividend growth stock you should own in your income-focused portfolio. While SKT shares currently yield just 5%, you need to look at the long-term potential from a company that grows its dividends like Tanger Factory Outlet Centers.

Here are some of the numbers:

• SKT has increased its dividend every year since going public in 1993.

• The company currently pays out about 60% of free cash flow, called funds from operations or FFO in the REIT world, as dividends with the rest staying in the company and used to grow future cash flow and dividends.

• The SKT dividend has grown by 7.4% per year compounded over the last 10 years and 10.5% annually over the last five years. This is a company that is accelerating its cash flow growth.

Let’s look at what your investment results would have been if you invested in Tanger 20 years ago. Remember, there have been two major bear markets in that period.

On February 13, 1996, SKT closed at $26.25 per share. To buy 500 shares would have cost $13,125. Based on the last dividend before the purchase date, SKT was yielding 1.9%, resulting in $250 a year of dividend income.

Now we jump ahead 21 years to the present. There have been a pair of 2-for-1 share splits, so the position is now 2,000 shares. As of this writing the share price is $26.61, giving a share value of $53,600. The current annual dividend rate is $1.37 per share, giving an annual dividend amount of $2,740.

To break it down, the SKT share value has increased by 405% and the dividend cash flow has grown by 1,096%. The $2,740 of annual dividends also represents a 20.9% annual yield on the initial investment amount.

Rock-Solid Dividend Stock #2:
A Gaming Company that’s Not a Gamble at All

It is hard to beat both the personal satisfaction and the gains in your brokerage account from finding and investing in a good, quality income stock before the rest of the investing public discovers the company. Since income stocks typically do not hit the market with a widely publicized IPO, it can take up to two years for the investing public to catch on that the new company is a great dividend paying stock that also has the cash to start growing its dividend.

MGM Growth Properties LLC (NYSE: MGP) was spun out by casino owner MGM Resorts International (NYSE: MGM) with an April 2016 IPO. With the spin-off, MGP became the owner of 10 MGM operated properties, including seven located on the Las Vegas Strip. MGM Growth Properties is organized as a real estate investment trust (REIT) which means it must pay out at least 90% of net income as dividends to share owners. MGM has structured the new REIT to provide an attractive combination of safety and dividend growth potential.

Safety Factors

All owned properties will be leased by subsidiaries of MGM under a single, triple-net Master Lease. Instead of 10 different leases, MGM pays a single rental payment to MGP. With the master lease, MGM cannot stop or renegotiate payments on a single property if it has financial problems at that property. The Master Lease has an initial lease term of ten years with the potential to extend the term for four additional five-year terms at the option of the tenant.

The Master Lease states that any extension of its term must apply to all the properties under the Master Lease at the time of the extension. The lease has a triple-net structure, which requires the tenant MGM subsidiary to pay substantially all costs associated with each property, including real estate taxes, insurance, utilities and routine maintenance.

MGM also covers the internal management expenses of MGP. In 2016 MGM generated corporate EBITDA that was 4.1 times the rent. That is very strong cash flow coverage of the rental payments from MGM to MGP. For its worst year in the past decade, EBITDA was 2.2 times the rental rate.

Growth Factors

There are three ways that MGP can and will generate revenue growth. That growth will lead to growing dividend payments.

• The Master Lease includes built-in annual rent increases. The rental payments are scheduled to grow by 2% per year through 2020.
  
• After 2021, the rent will be adjusted upward based on the average revenue generated by the owned properties over the previous five-year period.
• MGP has the right of first offer ­(ROFO) on all MGM property currently owned and developed or acquired in the future. The company has already purchased one additional MGM managed property since the IPO.
• Potential for acquisitions outside of the MGM assets. The traditional net lease REIT companies have built their companies using sell-lease back contracts. MGP has the potential to do the same with non-MGM owned gaming properties.

Since its IPO, MGP has provided superior performance compared to its net-lease REIT peers. That performance is based on dividend increases totaling over 10% since the IPO and compared to the initial dividend rate declared in the prospectus.

I first recommended this new REIT to my Dividend Hunter subscribers in July 2016 and the stock has produced a 13.4% total return since. MGP currently yields 5.3% and investors can expect continued dividend growth to produce double-digit total returns in this under-the-radar dividend superstar.

(Note: My Monthly Dividend Paycheck Calendar gives you every ex-dividend and payment date for MGP and over 20 other safe high-yield stocks so you can build an income stream that pays you multiple times per month.)

Rock-Solid Dividend Stock #3:
The Largest Public BDC

A close look at a business development company (BDC) reveals a company or stock that combines the features of a finance company, an income fund, and a venture capital fund. BDCs operate under special tax rules and laws that were written to provide debt and equity capital to corporations that are too small to access the public stock and bond markets. The business of a BDC is to make loans and/or equity investments to mid-sized corporations.

Legally, a BDC is a closed-end investment company, similar to closed-end mutual funds (CEF). The difference is that a CEF owns publicly traded stock shares and bonds, while a BDC makes direct investments into its client companies. A BDC will have up to hundreds of outstanding investments to spread the risk across many small companies. The client companies of a BDC will be corporations that are too small or too new to be able to issue stock or bonds into the publicly traded markets.

As a risk control factor, BDCs are limited to no more than one times its equity in leverage. This means that if a BDC has $500 million of equity raised from selling shares, it can borrow another $500 million. The company can then make $1 billion of loans or equity investments. This helps avoid many of the problems we saw from other firms during the 2008 financial crisis.

Again by law, a BDC must operate as a pass-through entity, paying at least 90% of net income out as dividends to shareholders. There are several consequences of a pass-through business structure. First, and very importantly, these companies do not pay corporate income taxes. (Real estate investment trusts (REITs), mutual funds, and exchange traded funds (ETFs) are other types of pass through business entities.)

No income taxes and the 90% payout rule place BDCs squarely into the high-yield income stock category. Typical BDC yields range from high single digits up to low double digits. A company operating on a pass-through model grows by issuing more shares and/or debt and then uses the new capital to make more investments.

As investors we want to see the companies behind our high-yield stocks to be able to make “accretive” investments when they sell more shares into the market. Accretive means that the company will earn a higher yield on the investments it makes than the current yield on the stock shares. The extra earnings will help the company grow the dividend: the importance of this cannot be understated to investors planning to live off investment income. In the BDC universe, a stock price that is above its net asset value (NAV) is a good indicator that the company can grow distributable cash flow when it issues new stock shares.

Management fees are a big deal with BDCs and you’ll want to pay close attention to them when evaluating any BDC for your own portfolio. Most of the companies in the sector have external management agreements, where a larger financial firm provides the management services for the BDC. The typical management agreement pays a percentage of assets and a cut of profits after the portfolio yield exceeds a certain level. The costs on an externally managed BDC are usually higher than the average management expenses of the handful of internally managed business development companies. It is not uncommon for the management fee to scrape off 3% of assets, which is a direct reduction of the income yield available to pay dividends to investors.

It is important to keep in mind that, to a great extent, BDCs are companies with low to medium credit ratings borrowing money and selling shares so they can lend to smaller companies with worse credit metrics. The result is that the major risk to BDCs is a negative economic credit event that would prevent BDCs from borrowing or refinancing and at the same time, causes the portfolio clients to default on their obligations to pay the BDCs. Such an event occurred in the form of the 2008-2009 financial crisis and the surviving BDCs claim to have learned the lesson.

A large portion – about half – of the 40 public BDCs are mostly indistinguishable from each other. Venture capital and leveraged buyout firms are a major source of BDC client companies. These firms feed debt financing business to the BDCs to get the loans necessary to grow or buyout the medium sized companies stalked by the venture capital types. This group of BDCs will do fine as long as the economy remains stable and the individual companies to not reach too deep into the junk credit drawer in a stretch for portfolio yield.

Reviewing individual BDCs by scrutinizing the negative factors leaves a very small number of companies that meet my standards for yield, dividend growth, and safety.

Ares Capital Corporation (Nasdaq: ARCC) with a $7 billion market cap is the largest business development company.

Ares Capital Corp. has a 12-year history of paying regular and mostly steady dividends. Since its IPO, ARCC has produced a 13% average annual return, without including any dividend reinvestment. The stock currently yields 9.2%.

Rock-Solid Dividend Stock #4:
High Yield from the High Flying Tech Sector

My research focuses on recommending higher yielding stocks with safe payments. While history shows us that a dividend-focused investment strategy can provide attractive long-term returns, some market sectors do not include the types of dividend paying stocks I follow.

Currently, the hottest stocks in the market are the big tech companies like Amazon.com, Inc. (NASDAQ: AMZN), Alphabet Inc (NASDAQ: GOOG) and Facebook Inc (NASDAQ: FB), which do not pay dividends but are building a lot of wealth for investors. For dividend-focused investors who would like a piece of the tech stock share price action look at the Nuveen Nasdaq 100 Dynamic Overwrite Fund (Nasdaq: QQQX).

Fund manager Nuveen has developed a range of index tracking closed-end funds that use covered call writing to generate a cash income while capturing much of the upside of the broader market indexes. These are the funds and the indexes they track:

• Nuveen S&P 500 Buy-Write Income Fund (NYSE: BXMX) replicates the S&P 500 stock index and then sells call option against 100% of the portfolio. BXMX currently yields 6.5%.
  
• Nuveen Dow 30 Dynamic Overwrite Fund (NYSE: DIAX) tracks the Dow Jones Industrial Average and writes call options covering between 35% and 75% of the value of the fund’s equity portfolio, with a long-run target of 55%. DIAX yields 6.2%.
  
• Nuveen S&P 500 Dynamic Overwrite Fund (NYSE: SPXX) is another S&P 500 fund, with the same dynamic call option strategy of covering 35% to 75% of the portfolio. SPXX yields 6.1%.
  
• Nuveen Nasdaq 100 Dynamic Overwrite Fund (NASDAQ: QQQX) has a portfolio that matches the Nasdaq 100 stock index. QQQX uses the same dynamic strategy to sell call options covering between 35% and 75% of the value of the funds equity portfolio, with a long-run target of 55%.

The Nasdaq 100 index covers the largest stocks listed on the Nasdaq stock exchange. As a result, the index and QQQX are heavily weighted to the large cap technology stocks. The five largest holdings are Apple Inc. (Nasdaq: AAPL,) Alphabet Inc., Microsoft Corp. (Nasdaq: MSFT), Amazon.com Inc., and Facebook Inc. These five stocks account for 42.5% of the portfolio.

The call writing strategy uses short-term options, with a weighted average 13 to 16 days to expiration. The short expiration allows the fund’s share value to keep up with the gains of the Nasdaq 100 index. The sold call options provide extra income and some downside cushion. Dividends paid have varied over the life of the fund. The current $0.35 quarterly dividend has been in effect since the second quarter of 2015. That dividend gives QQQX a current 6.5% yield.

As I noted, QQQX gives exposure to the Nasdaq 100 index and investors should look for a total return that parallels the tech stock-heavy Nasdaq. For the last five years, QQQX has produced an average annual 16.1% total return. For comparison, the PowerShares QQQ Trust ETF (Nasdaq: QQQ), which is designed to directly track the Nasdaq 100 index has a five-year average annual 19.3% return. QQQX investors give up some share price gain in exchange for an attractive dividend yield. I recommended QQQX to my Dividend Hunter subscribers as a holding to add diversification to a list that includes the usual finance, REIT, and infrastructure stocks in a high-yield portfolio.

Turning your retirement savings into a consistent stream of income is no easy task. You might spend hours researching what stocks to buy, only to end up with three seemingly attractive stocks like the three above.

There are thousands of stocks to choose from, but only a small percentage of that group is the right stocks for you to own. The best high-yield stocks need to have safe long-term businesses that print money every year no matter what the market does. Those are the only companies that can pay consistent dividends.

Rock-Solid Dividend Stock #5:
Get Paid Every Time a Traveler Goes to Sleep

There are few things as useful for a stock market researcher as getting out and talking to a lot of investors. Recently I gave two presentations at the Las Vegas MoneyShow and was a moderator on two dividend stock investing panels.

Through these events and having individual investors come talk to me, I learn a lot about what dividend-focused investors are concerned about. I also pick up the occasional stock idea.

One investor asked me about lodging/hotel REITs and a specific stock, which I will cover below. The lodging REITs own portfolios of hotels.

The typical REIT will specialize in a specific type, such as full-service hotels, select service hotels or extended stay. The REITs are the property owners. They sign contracts with management companies to market and manage the hotels.

The REITs collect the revenue and pay a portion as management fees. With rentals as short as one night, the hotel business is the commercial property sector that reacts the quickest to changes in economic conditions.

A hotel REIT strives to increase percentage room occupancy and the average daily room rate it charges. If those two metrics can be increased, profits will grow at a significant rate. Here are some of the pro and con factors about hotel/lodging REITs

Pros

• Hotel results tend to mirror economic growth. If the economy is growing, so will profit for a hotel company. The current 2% GDP growth rate puts the sector in neutral for most of the hotel REITs. If economic growth were to increase, the returns from these REITs will be excellent.
  
• Since room rates can be changed on a daily basis, the hotel sector can react quickly to factors that increase expenses, such as rising interest rates. Hotel REITs generally have lower debt levels compared to other REIT sectors, but if interest rates do move up sharply, the hotel industry can respond by charging more.

Cons

• Hotel results tend to mirror economic growth. If the economy goes into a recession, hotel sector profits can disappear until the economy again starts to grow. In the current slow economic growth environment, hotel REITs have in general not increased dividend rates for the past several years.
  
• Hotel room rates can be threatened by over building of hotels, which has not been a factor in most markets during the current economic expansion. Hotels are also facing competition from technology-driven competitors such as AirBnB.

Here is a hotel REIT that is well managed, has a conservative dividend payout ratio and pays monthly dividends. Current yield is very attractive.

Apple Hospitality REIT Inc. (NYSE:APLE) is a hotel REIT that launched in the public market with a May 2015 IPO. The company was the roll-up of several private hotel REITs under the same manager. Apple Hospitality’s portfolio is exclusively branded as either Hilton (50%) or Marriott (50%). This is one of the largest hotel REITs, with 236 hotels in 33 states and a $4.2 billion market cap. The company has paid a 10 cent monthly dividend since the IPO. The current dividend rate is a conservative 68% of funds from operations (FFO) per share. APLE yields 6.4%.

Hotel operators use a couple of industry specific metrics to track performance. EBITDA Margin is the percentage of revenue remaining after the company pays all of its regular business expenses. A higher margin is better. For 2016, APLE reported a margin of 38%, tied for second out of all lodging REITs.

RevPAR is average daily revenue per room. This amount varies significantly from company to company. You should watch RevPAR to make sure a hotel company continues to rent a high percentage of rooms at the best possible rate.

For the first five months of 2017, APLE’s RevPAR was up 1.4% compared to a year earlier. Not burning things up, but steady growth in a flat economy. Financially, this REIT is among the more conservative. Debt is just 25% of total capitalization. The $1.20 per share annualized dividend is less than of modified funds from operations (FFO).

Bonus Research

In the entire stock universe, there is a small sub-sector that has been consistently handing out double digit returns to investors regardless of market conditions.

I want to spend some time here discussing a different way to analyze stock investments and an investment strategy that does not involve trying to find stocks that will go up more in value than the market averages.

While I find it very difficult to find stocks that will consistently generate above average capital gains, I find it an easier task to build a portfolio of stocks that will provide me with a cash flow pay raise every quarter.

The strategy I use is to focus my search on finding higher yield stocks with histories and future potential for regular and growing dividend payments. Most stock market analysts, advisors, and investors themselves focus on new products, revenues, earnings per share, and share prices and what effects the latest economic news will have on the individual company metrics. The result is a blizzard of information that is often contradictory and share prices that end up moving up and down together, no matter how good the prospects of an individual company might be.

Recently the “experts” were proven right when the market corrections they had been predicting since 2013 finally happened. Yet most investors had been buying shares on the ride up from the last correction in 2011 and many, many sold out when prices of a large number of stocks dropped in the January to February market correction of 2016. These investors let their worries about share prices push them to sell low, after buying high.

A dividend-focused approach to stock market investing takes out the part where investors have to try to figure out whether share prices are going to go up or down, and which stocks will do better or be able to buck the trend if the market is falling in general. With a dividend-centric investing strategy, you work to find stocks with attractive yields and growing dividends. These stocks will produce a growing cash flow stream and also, in the longer term, generate high share prices. Let’s look at a couple of examples:

Realty Income Corp (NYSE:O) is the poster child stock for this cash flow focused investing strategy.

This conservatively managed REIT has increased its dividend rate 85 times in the last 20 years, with zero dividend reductions. There have been 76 consecutive quarterly increases or six straight years of quarter over quarter dividend growth. During the last decade, the yield on O has ranged from about 4.5% to around 7.5%. The dividend growth rate has averaged 5% per year. The regular dividend payments with steady growth in those dividends has produced an average total return of over 15% per year from Realty Income.

And as a bonus, the company pays monthly dividends.

While Realty Income is an awfully good investment choice, I like to use O as my benchmark and look to find income stocks that can produce a better return than the stock’s current 4% yield combined with 5% annual dividend growth.

Using this approach, you can find those stocks where the market has severely mispriced companies that focus on making high and steady cash payouts to investors.

Then, build a diversified portfolio of dividend paying stocks. You will want to own companies from different sectors including finance and equity REITs like O above and business development companies (BDCs) like ARCC. These are the sectors that allow a company to generate steady and growing cash flows to support the dividend stream you want to earn.

The goal is to buy these stocks for the long term, and you will own many of them for years collecting dividends along the way, just as Warren Buffett has famously done with Coca-Cola.

However, you must be ready to drop those companies that fail to live up to your cash flow forecasts and add new candidates that offer better combinations of yield and dividend growth potential. If you are investing for the growth of an investment account, use the dividend earnings to buy new holdings or to pick up more shares of companies that have fallen out of favor with the market.

With this type of stock market portfolio, you should see your dividend earnings grow every single quarter no matter the market conditions. That’s a great feeling and one that can help you sleep at night.

Finding stable companies that regularly increase their dividends is the strategy that I use myself to produce superior results, no matter if the market moves up or down in the shorter term.

And companies like Tanger Factory Outlet Centers and Realty Income that won’t cut their dividends, pay a high current yield and have the potential for dividend growth is an integral part of the income strategy for my newsletter, The Dividend Hunter. In it I recommend 20 of the market’s strongest, most stable high-yield dividend payers that are currently available to you through my Monthly Dividend Paycheck Calendar.

Tim Plaehn
Editor
The Dividend Hunter

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