Hedging against uncertainty through growth and income

The uncertainty in today’s stock market makes it difficult for investors to achieve their financial goals using traditional investment strategies. On any given day, terrorism, war, oil prices, interest rates, employment, inflation or a natural disaster can have a major impact on the stock market. Today’s global economy has contributed to market volatility, as an event that happens in another part of the world can have a major impact here.

Investors can respond to this uncertainty by investing for both growth and income, which can increase total returns and reduce downside risk.

Many investors need growth from rising stock prices to meet their long-term financial objectives. Unfortunately, investing for growth means taking risks. The greater the potential for growth, the more money you can lose when the market falls.

Those who believe they cannot tolerate the risk of loss generally seek the relative safety and income associated with bonds. They may take less risk, but typically have lower gains. And bonds are not always safe, either; as interest rates rise, bond prices fall. In addition, low total returns recently have not even kept pace with inflation. As a result, those who are heavily invested in bonds have experienced some erosion in their purchasing power.

Financial advisors typically suggest that investors compromise, balancing stocks with bonds. That means taking more risk or sacrificing some growth - and understanding how to put together a portfolio of either individual stocks and bonds, or mutual funds. But investors don’t have to compromise and they don’t have to make complex portfolio management decisions. There are simpler ways to achieve both growth and income with a portfolio of convertible securities, Real Estate Investment Trusts (REITs) and dividend-paying stocks.

These asset classes give investors dividend or interest income, along with potential growth. Adding dividend or interest income to a portfolio can provide an extra boost, while reducing risk. What if, for example, you receive annual interest income or a dividend worth 5 percent of your investment? If the investment gained 10 percent, you would gain the equivalent of 15 percent, before taxes. But if your investment dropped 10 percent, you would lose only 5 percent, before taxes. Long term, this income can contribute significantly to total returns.

Balancing risk and reward

Convertible securities, REITs and dividend-paying stocks offer other advantages, too.

Convertibles. Convertibles are corporate bonds or preferred stocks that can be converted to common stock. Companies issue them to make either their equity or debt securities more attractive. In addition to providing income and growth, advantages include:

• High current income. Convertibles typically provide higher current income than the dividend yield of the underlying stock.
• Equity participation. If the value of the stock rises, the value of the convertible often does as well. The convertible will generally rise and fall less than the underlying stock.
• Diversification. Convertibles are issued by companies in a broad mix of industry sectors, with varying market caps and a wide range of credit quality.
• Total return. Achieving both growth and income can add to total returns.

Examples of convertibles that are providing both growth and income include Washington Mutual (WAHCU) and Texas Industries Capital Trust I Convertible Preferred S (TXI/PS).

While much of the banking industry is suffering from the flat interest rate yield curve and from the downturn in the real estate industry, Washington Mutual is adjusting well. The chief attraction of Washington Mutual’s convertible security is its 5 percent yield. At the same time, based on management’s current strategy, it would be reasonable to expect the underlying common stock to appreciate by 7 percent to 10 percent over the next 12 months. That would translate to a return of about 5 percent to 7 percent for the convertible security, resulting in a total return of 10 percent to 12 percent over the next year.

The convertible of Texas Industries, which makes cement, concrete and aggregate products, has a current yield of 5.3 percent. Its stock is up 4.4 percent year to date and has the potential for further growth. Texas Industries works primarily in Texas and California, where it is benefiting from strong population growth and highway construction.

REITs. REITs, which enable investors to pool capital to invest in all types of real estate, offer both capital gains and income. The potential for stock price appreciation is similar to that of common stock issued by other companies, but is specifically tied to the benefits of owning real estate (i.e., increases in lease or rental income, or benefits of other supply and demand characteristics). REITs earn income from rent and interest on loans and typically must pass on at least 90 percent of income as dividends to shareholders, to avoid taxes on the income.

Other advantages include:

• Liquidity. Shares are traded daily on a national exchange, so they can be bought and sold anytime.
• Diversification. REITs add diversification and can decrease portfolio risk.
• Tax advantages. Like common stock, no tax is payable on REITs until they are sold. At that point, profits are taxed as capital gains.
• Inflation hedge. As an investment in tangible hard assets, REITs can provide an inflation hedge.

REITs have been performing especially well so far this year. Examples of REITs that are currently performing well include Ashford Hospitality Trust (AHT) and Host Marriott (HST). Shares of Ashford, which focuses on the lodging industry, are up 20 percent year-to-date (through 9/28), plus the REIT offers a 6.7 percent dividend. Ashford claims to be the only publicly traded REIT "focused on investing in hotels at all levels of the capital structure and across all segments."

Host Marriott (HST), which builds upscale, luxury, full-service hotels, is another successful REIT. Its yield is lower at 3.6 percent, but its shares are up 21 percent year-to-date (through 9/28).

Dividend-Paying Stocks. During the past 30 years, dividends have accounted for nearly a third of the total return of the S&P 500, according to Standard & Poor’s.

Dividends can produce ongoing income, or, when reinvested, can significantly increase total returns. If $10,000 were invested in the S&P 500 in 1972, today it would be worth $208,972 if all dividends were reinvested and only $74,547 if dividends were not reinvested. It’s important to note that past performance is no guarantee of future return.

Also, because of changes in the Federal tax code, instead of paying taxes on dividends at their income tax rate, most investors can now pay at a rate of only 15 percent.

Dividends are often paid by mature, large-cap companies, such as Chevron Corporation (ChevronTexaco) (CVX), whose common stock pays a dividend yielding 3.3 percent and whose stock is up 13.5 percent year to date (through Sept. 28). While oil prices are coming down, Chevron’s investment in the exploration of new oil fields and alternative fuels make it a good long-term investment.

There are no guarantees in investing. The key is to find an acceptable level of risk that, long-term, also provides a level of return high enough to achieve your financial goals. A portfolio invested for growth and income can help.

David N. Grenier is president of Cutler Capital Management of Worcester. He can be reached at dgrenier@cutlercapital.com