A lot of people talk about “income stocks” and “growth stocks” as if they were two different things … but they don’t necessarily have to be. When putting together a portfolio of dividend stocks that can pay off for the long haul, my biggest priority is to find both high income and the potential for significant capital gains.
That’s the best recipe for success in terms of maximizing your total return for years to come.
It also means thinking outside the box. You’re not always going to get the best income and growth by sticking with the same old blue-chips like Johnson & Johnson (JNJ) and Procter & Gamble (PG); sometimes it’s the smaller names that are the most promising.
Small-caps tend to be better-known as growth plays, but a number of them also offer hefty dividends as well. The trick is to make sure that the company has strong enough fundamentals to support that high yield — and several of my favorite dividend stocks fit that bill exactly.
Opportunity in Junior MLPs
One small-cap dividend stock that is a great buy at current levels is Memorial Production Partners LP (MEMP). Investors are hungry for tax-advantaged income that can take advantage of higher energy prices — so energy MLPs like Memorial Production Partners are very attractive. MEMP is a proven winner, and its distribution growth is trending much faster than most of its peers. MEMP pays a hefty 9.9% yield, while most of the more mature MLPs pay less than 6% to 6.5%.
These junior MLPs have really been a good theme for income investors. They have what I call a “mother ship” — an owner (usually a private energy company) that carves out a portion of its oil-and-gas assets, starts an MLP, and continues to feed that MLP with proven reserves. As a result, you’re able to get very good yields from names like MEMP, while a lot of the bigger, more known names like Kinder Morgan Energy Partners (KMP) and Plains All American Pipeline (PAA) are not carrying the ball as they used to.
In general, I think that the real opportunity in MLPs is the junior-sized or small-cap ones like Memorial Production Partners, and that’s where my focus is right now. MEMP has come down a bit following an 8.6 million share secondary offering priced at $22.50; the units are trading right around that level now and sport a yield of nearly 10%. I recommend that you take advantage and buy the dip while you can.
Not Your Average REIT
Another great aspect of some of these lesser-known, small-cap dividend stocks is that their share prices don’t get jerked around as much by institutional trading. They’re fit for individual investors — but the Leon Coopermans of the world, who are looking to come in and buy 40 million shares, are not going to be looking at these types of names, because the trading volume’s not there to support a big purchase like that.
And I do want to avoid dividend stocks that tend to have large hedge funds coming in and out of them, because their main goal is just to capture the dividend and blow it out. When you’re in it for the longer term, as I am, you don’t want to see that kind of volatility. So instead of an Annaly Mortgage (NLY), which has a lot of fast money running in and out, I’d recommend a more under-the-radar name like New York Mortgage Trust (NYMT).
There are other points in NYMT’s favor, too: It has a phenomenal 14% yield and much stronger fundamentals. The more “vanilla” REITs like Annaly have really gotten hit hard because of their focus on fixed-rate mortgages. Once the Fed inevitably takes interest rates higher, more well-rounded REITs like NYMT will be much better positioned, thanks to their emphasis on adjustable-rate mortgages.
Profit from Higher Interest Rates
This hunt for floating-rate debt leads me to my final small-cap dividend stock pick today: PennantPark Floating Rate Capital (PFLT). Ever since 2008, many of the bigger banks have been hesitant to loan money to small- to medium-sized businesses … but demand in this area is booming. That’s where the business development companies (BDCs) come in. Companies like PFLT are filling the gap and lending money to up-and-coming private companies at rates that are tied to Libor or some other fixed-income yield.
Therefore, if rates move up, then the interest coming in from those loans also is raised — and that makes for substantial profits for these BDCs. It also leads to hefty dividends for investors like us, because BDCs are structured to pay out 90% of what they bring in, similar to REITs. So it’s a beautiful thing to own floating-rate BDCs because, again, we’re laying the groundwork for higher interest rates.
You’re definitely going to want to be in those asset classes that are going to be sensitive to higher rates going forward. And if you can do so via stocks like PFLT — a lesser-known name that offers a great 8% yield and room for significant growth — all the better.
As you can see, income is my biggest priority, followed by growth in the share price. If a dividend stock is making steady payouts while increasing its dividend, that’s the sweet spot — but make sure to avoid names whose yields are going up only because the share price is plummeting.
The name of the game is finding dividend stocks that you can own safely for the proverbial “year and a day” and keep earning high yields all the while because of their strong fundamentals.
Bryan Perry is the editor of Cash Machine, a newsletter focused on high-yield income investing with the goal of maintaining a blended total yield of 10% across two portfolios. Bryan is also the editor of Extreme Income, which uses the power of historically cheap money to create a leveraged “baby hedge fund” strategy that paves the way to massive profits and 4x greater income.