Great Value Sectors for Dividend Growth Investors

After the recent spate of market volatility, I thought it might be a good time to do a quick review of our strategies and how the volatility affects us.

To start, I would say that the best way to defend against a bear market is to simply buy stocks at good prices. The market will fluctuate, and there is nothing we can do about that. But in buying quality stocks at good prices, we dramatically reduce our risk of long-term or permanent losses. And along those lines, remember that every stock in our firm's Dividend Growth model (opens in new tab) pays a strong and growing dividend. And the large majority have continuously raised their dividends every year for more than 10 years, including the crisis years of 2008-2009.

My ideal holding period is one to two years, but I also take Warren Buffett’s (opens in new tab) advice seriously. Mr. Buffett says that any stock we own is one that we’d be comfortable holding if they were to close the market for five years. Again, I don’t necessarily plan to hold any stock in our portfolio that long. But I like to think that the stocks I buy are suitable to be held for five years or even longer.

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Currently, our portfolio is allocated to sectors of the market that I believe have the best value pricing. A little more than a third of the portfolio is allocated to real estate investment trusts (REITs) and midstream master limited partnerships (MLPs), essentially “toll roads” that transport oil and gas with very little sensitivity to oil or gas prices. These sectors performed poorly from February through July, as worries over the Federal Reserve’s pending rate hike led investors to reduce their exposure to income-focused assets.

Yet I believe these fears are vastly overdone. My research has shown that REIT and MLP prices often move independently of the Federal Reserve’s actions (opens in new tab), and in any event the coming Fed tightening cycle will likely be the mildest in decades. With much of the broader market looking very expensive today, I consider both sectors to be excellent values at today’s prices.

I also have about 20% of the portfolio allocated to what I consider “special situations,” or unique value opportunities that might be slightly out of the mainstream. These would include mortgage REITs, closed-end bond funds and business development companies.

All of these “special situation” sectors have several attributes in common. All pay very high dividends at today’s prices, all are trading cheaply by historical standards, and across all three asset classes it is very common today to find stocks trading at deep discounts to net asset value (NAV).

I tend to discount NAV, or book value, when looking at traditional common stocks as I believe it tends to get distorted by inflation and by accounting conventions. Yet in the case of mortgage REITs, closed-end bond funds, and business development companies, the discount or premium to NAV is generally a very good barometer of value. Because the underlying portfolios are revalued at least quarterly, book value is a good measure of the real, market value of the assets. And buying these securities at discounts to NAV is the equivalent of buying a dollar for 75 cents.

The remainder of the Dividend Growth portfolio is invested in solid, dividend-paying stocks that might be considered more mainstream. And in every case, I am buying stocks with improving fundamentals and a strong recent history of dividend growth.

There are never guarantees when it comes to the market. But I’m confident that the Dividend Growth portfolio is diversified and well-built for the road in front of us.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights (opens in new tab) blog. As of this writing, he was long MCD, O and UL.