Investment Consult

How to profit in today's market

You might think of them as boring, but the old reliables—bonds and dividend-paying stocks—will steady your portfolio.

Lewis J. Altfest, PhD, CFA, CFP

The meltdown of several large corporations—including Adelphia Communications, Enron, Tyco International, WorldCom, and Xerox—has been a cold slap in the face to investors.

The new outlook on investing that emerges from the scandals will probably be more practical. The old environment rewarded companies that boasted of exciting concepts and the promise of boundless future growth. Now, investors are concerned with strong cash flow and reasonable stock valuations. They're not as willing to pay a premium for a company's, or an idea's, potential.

Your portfolio doesn't have to languish while the stock market recovers. One way to boost your returns is to look for stocks that pay healthy dividends. Lots of companies assigned a lower priority to dividend payouts in the 1990s, choosing to reinvest more of their profits in the business. Few people complained about this because it caused stock prices to increase. Moreover, wealthy investors got a tax break when they sold their shares: They paid the lower capital gains rates on their profits from price appreciation, rather than the ordinary income tax rates dividends are subject to.

But now dividends have regained their appeal; they indicate real earnings and returns that don't depend entirely on share-price appreciation. Two types of stocks that pay strong dividends are real estate investment trusts (REITs) and those of utility companies.

Bonds are another reliable vehicle. Three types have the potential to deliver good returns over the next several years: inflation-indexed, municipal, and high-yield (also called "junk") bonds.

As usual, I encourage you to invest through mutual funds, which are managed by professionals who limit your risk by researching and buying dozens—perhaps hundreds—of issues.

Here are my favorites for each category.

Utility company funds are hardly new. Franklin Utilities Fund—Class A shares (800-342-5236) is one of the country's oldest mutual funds, dating back to 1948. It's a plain vanilla fund that favors dividend-yielding electric and natural gas utilities, rather than the telecommunications services stocks and unregulated utilities found in many of its peers' portfolios. Aggressive investors would consider Franklin Utilities boring, but I'll take a boring fund that pays a current yield of 5.1 percent and has earned 8.0 percent annually over the past 15 years.* (The A shares carry a 4.25 percent load, which is waived if you purchase them through a fee-only financial adviser.)

If you're willing to accept a bit more risk, consider the no-load Fidelity Utilities Fund (800-544-8888). It tends to hold more telecom services stocks, which are typically more volatile than stocks of regulated utilities. But the fund's low expense ratio (less than 1 percent) and Fidelity's talented analysts make it less of a risk than it might seem. Its average annualized return since its 1987 inception is a shade under 9 percent.

REITs are another smart way to play the dividends game, because of their tax structure. REITs get huge corporate tax breaks if they distribute at least 90 percent of their taxable income to shareholders annually.

I particularly like a small fund called Stratton Monthly Dividend REIT Shares (800-634-5726), which has just $126 million in assets. James W. Stratton, who holds an MBA from Harvard, has been at the helm for 22 years. He screens for high-yielding REITs first, then winnows out the ones he feels have underlying problems that may not allow them to sustain their strong dividends. The fund's three- and five-year average annualized returns—14.4 and 7.9 percent, respectively—place it in the top quartile of its peers. (For advice on choosing individual REITs, see "REITs: solid dividends and gains," Sept. 9, 2002.)

Inflation-indexed bonds provide protection if inflation picks up. They pay a fixed rate—currently 2 percent for bonds issued before Nov. 1—plus an inflation rate that's adjusted every six months, based on the percentage change in the Consumer Price Index over a recent six-month period. Bonds purchased before Nov. 1 will pay a total of 2.57 percent for the first six months.

Known as "Series I" bonds or simply "I Bonds," inflation-indexed bonds can be purchased directly from the US Treasury ( www.publicdebt.treas.gov ). But if you'd rather avoid the hassle of tracking maturity dates and reinvesting your earnings, buy shares of a mutual fund that specializes in inflation-indexed bonds. Two that I recommend are Pimco Real Return Bond Fund (888-877-4626) and Vanguard Inflation-Protected Securities Fund (800-662-7447). Vanguard's fund is no-load; Pimco's carries a 3 percent load for amounts under $50,000, but you can purchase it without a load through a discount broker like Charles Schwab & Co.

Long-term municipal bonds also pay good yields these days—around 5 percent. Earnings on many types of munis are free from federal income tax, which means you'd have to earn several percentage points more on a taxable investment to get an equivalent return. Check first for bonds from your home state, which are usually exempt from state and local income taxes, too. Vanguard offers state-specific muni funds for California, Florida, Massachusetts, New Jersey, New York, Ohio, and Pennsylvania.

High-yield, or junk, bonds are issued by small and speculative companies and those based in emerging markets outside the US. Junk bonds offer higher yields as an enticement for taking on much greater risk and a greater likelihood of default. Not surprisingly, issuers of high-yield bonds default about 10 percent of the time compared with 4 percent for bonds overall, according to the Income Securities Advisor, a research organization specializing in fixed-income investments.

Because high-yield bonds are especially volatile and difficult to evaluate, I'd suggest owning them only through mutual funds. My favorite high-yield fund is the $1.7 billion Northeast Investors Trust (800-225-6704). This no-load, created in 1950, has returned 5.8 percent annually since inception and 7.9 percent a year over the past decade.

*Unless otherwise noted, all performance figures are through July 31.

The author, a fee-only financial planner, is president of L.J. Altfest & Co. ( www.altfest.com ), a financial and investment advisory firm in New York City. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics magazine, 5 Paragon Drive, Montvale, NJ 07645-1742. You may also send a fax to 201-722-2688 or e-mail to meinvestment@medec.com.

 

Lewis Altfest. Investment Consult: How to profit in today's market. Medical Economics 2002;18:17.