How To Add 6% Income To Your Portfolio Without Sacrificing Growth

Until the last year or so, I haven't been a fan of preferred stocks, unless they were convertible or had a good chance of being redeemed with a capital gain. Yields available on well-chosen common stocks, real estate investment trusts (REITs) and master limited partnerships (MLPs) were high enough to beat preferred returns, factoring in modest growth in the price of the non-preferreds.

That's not the case anymore. Yields on utilities, REITs, etc., are mostly down in the 4%-5% range, and MLPs also have tax-related inconveniences. Hence, I've revisited preferreds lately and am finding some good buys. I don't expect to get rich from them, but I do expect not to end up in the poorhouse.

The problem with most preferred stocks is the specter of inflation. The dividends that seem high now won't seem so high if we can get 7% on a one-year CD five years from now. That is always a possibility that has to be taken into consideration.

However, with the Fed's interest-rate suppression still in force, we just need to own some gold as a hedge, and we can be covered on both ends of the deflation-inflation spectrum. I think it's much wiser to position ourselves that way than to try to make a bet on one outcome or the other. Will we get a Japan-like several-decades-long period of no growth, or a Weimar Republic decent into the chaos of hyperinflation? Your guess is as good as mine.

Warren Buffett and Jeremy Grantham both think total market returns for the rest of the decade will be in the mid-single digits, albeit with a lot of ups and downs. Today we with discuss a strategy with which we should get a good combination of growth and above-average income, plus the added benefit of low volatility in our personal cash flow.

Numbers Don't Lie (government numbers excluded)

We often hear that buying stocks with dividends that grow is more important than buying stocks with dividends that are high, but don't grow. In principle, I agree with that. We are also told that the big multinationals in the S&P 500 continually grow their dividends. The statistics show that's true. But being a math kind of guy I ran some numbers to see how long it takes for lower dividends to catch up to the total returns for stocks with higher ones, such as the preferreds I'll recommend today. To say I was shocked at the results is an understatement.

The S&P 500 has had an average dividend of 2.66% for the last 10-years. (The median is lower at 2.38%.) The historical average dividend growth rate is about 5.1%.

Of the preferred stocks I'll recommend, the lowest current yield at today's price is 6.36%. In terms of just dividends, it would take a typical S&P stock 32 years to return the same amount of total dividends if it grow at the historical 5.1% average. This, of course, ignores the present value of money, which is highly unlikely to maintain value over those decades. In terms of present value, you could probably tack on another five or so years to recover.

Hot Growth Stocks For 2014

In addition, I looked at the total return of the S&P over 10 and 20 years with dividends reinvested. In this scenario, after 10 years the index returns finally break even with the lowest paying of the preferreds recommended here, and outperforms it at a widening margin after that. However, returning to the present value issue again, we should note that the dollar has lost 13.8% of its value over the last 10 ten years. This again boosts the relative real (inflation adjusted) returns of the preferred shares.

If you're planning on living longer than 10 or 15 years, this presents a dilemma. Take the money now while its present value is assured, or take it later and hope dividend growth keeps up with inflation?

My solution to this conundrum is a kind of barbell approach. On one side of the bar you have the higher-paying preferred stock. On the other you have the common stock that is likely to overtake the preferred in 10 years or so—maybe sooner if you've picked a stock with above-average growth prospects. The result is a pair of stocks that will provide higher, surer current income than the common stock alone, and a higher total return over 15 or 20 years than the preferred alone.

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Three Great Barbell Buys

First up today is a preferred stock from one of my favorite companies. We've owned the common and two classes of the preferred stock in our portfolios for quite some time and we're very happy with the results. The preferred is Seaspan Corp. 7.95% Series D Cumulative Redeemable Perpetual Preferred Shares (SSW-PD). At its recent price of $25.30 it yields 7.86% (simple rate of return). The shares are redeemable by the company on January 30, 2018. If they are redeemed on that date, the compounded annualized rate of return will be 6.8%. Ex-dividend dates are: January 30, April 30, July 30 and October 30.

The common stock, Seaspan Corp. (SSW) recently sold for $24.87 and yields slightly more than 5%. The dividend has grown nicely over the last few years.