Yield to the Rescue

When the markets take a licking, it's small consolation when your investment losses are less than the next guy's. In that bittersweet spirit, I can report that a strategy of investing in high-income stocks retains its defensive backbone.

High yield wasn’t a perfect defense to the recent flash bear market and its indiscriminate trashing of virtually all investments, save gold, cash and Treasury bonds. But my favorite alternative high-yielding categories -- real estate investment trusts, pipeline master limited partnerships, gas and electric utility stocks, and the high-dividend phone duo of AT&T (symbol T) and Verizon Communications (VZ) -- have been relatively calm. It helps that companies haven’t been cutting dividends left and right, as was the case during the 2007-09 bear market and recession. Remember how a mess of REITs paid dividends in stock instead of cash? That was rough. It’s not that bad now.

I call the recent unpleasantness a flash bear market because, like a “flash mob,” it gathered without much warning, took over the territory and refused to disperse. The trouble began July 22, when Caterpillar (CAT) issued disappointing earnings results and suggested that the outlook for its business wasn’t so hot, either. As investors started to focus on the U.S. debt-ceiling fiasco, the European debt crisis, negligible economic growth and high unemployment, they began to sell in droves. From July 22 through August 22, Standard & Poor’s 500-stock index, a measure of the broad U.S. stock market, lost 16.3%. The losses came not in drips but in terrifying torrents of 3% and 4% a day, interrupted by some dramatic but fleeting rebounds. (Stocks rallied sharply on August 23 and 24 in anticipation of new steps by the Federal Reserve Board to goose economic growth.)

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For the most part, dividend-paying stocks in the S&P 500 fared better than the index as a whole. The index includes 41 utilities and 14 REITs. All told, it holds 72 stocks that, as of August 24, yielded at least 4%.

You would assume that REITs, to take them as an example, would fall out of favor when investors begin to anticipate a new recession (a fair possibility). That’s because real estate income and dividends, and thus REIT asset values and share prices, vary with rents, occupancy, consumer spending, the financial health of developers and the value of office buildings, warehouses, apartments and retail space. None of these are recession-proof.

Yet REIT results are reassuring. Over the past month, the largest property-owning U.S. REITs have generally done much better than the broad stock market. From July 22 through August 22, Simon Property (SPG), a national operator of shopping malls and the nation’s biggest REIT, lost 8.7%. Public Storage (PSA) -- which sounds recession-resistant because people who sell or lose their houses, as well as businesses, need storage space -- lost just 6.4%. The typical apartment and health care REITs gave up 10% or so, and the largest exchange-traded REIT fund, Vanguard REIT ETF (VNQ), dropped 15.8%. I wouldn’t call all this great, but there’s no reason to run from high-dividend REITs, especially if a sale results in a tax bill, just because hedge fund managers are angry at Italian bankers or Ben Bernanke or whoever else is the punching bag du jour and high-frequency traders are making things worse with their mindless activities (see VALUE ADDED: Could Computerized Trading Cause Another Market Crash?).

Utilities have performed even better than REITs over the summer. Popular blue chips, such as Southern Company (SO), Exelon (EXC), Dominion Resources (D), Duke Energy (DUK) and American Electric Power (AEP), were about even between July 22 and August 22.

The sector’s strength isn’t just in the giants. If you explore small to midsize U.S. electrics, you’ll find plenty that have recorded only trivial losses (if any) since July and that yield 4% or better. Small, regulated utilities are an unappreciated sub-sector because they usually offer good yields and a chance for a windfall if they get taken over, something that happens regularly. A few small utilities with excellent dividend records and good recent performance that fit this pattern are Black Hills Corp.(BKH), DPL (DPL), Empire District Electric (EDE), Hawaiian Electric Industries (HE) and Pepco Holdings (POM).

I once called master limited partnerships that own and operate pipelines the best investment you’ve never heard of. They do great in good times, and, once again, the pipeline sector is proving to be a fine refuge in troubled times. Over the past month, such favorites as El Paso Pipeline Partners (EPB), Energy Transfer Partners (ETP), Magellan Midstream Partners (MMP) and Plains All American Pipeline (PAA) lost no more than 11% each; El Paso surrendered 9.1% and Magellan lost 5.6%. This group’s long-term record is so splendid and the cash distributions so hefty that to sell any of these investments is foolish. If you’re an income-oriented investor and you insist on sticking with CDs or Treasury bonds, you’re just lazy. Remember, pipelines are regulated utilities -- toll roads for the movement of crude oil, gasoline and natural gas -- and not speculative drilling or exploration businesses. Like REITs, MLPs have to pass along most of what they earn. And like publicly traded REITs, they are totally liquid and make detailed public disclosures. My one reservation is that you should own shares in a bunch of pipelines because there’s always the potential for an accident that shuts a facility down for repairs and can harm an operator’s earnings and dividends for a quarter or two.

Pipelines are a critical element of my common-stock-free Tofurky income portfolio, which is almost ready for a once-over. If the stock market doesn’t settle down by Thanksgiving, when I serve this financial tofu, investors will, I predict, add plenty of income alternatives to their menus.