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John D. Rockefeller once quipped that the only thing that gave him pleasure was to see his dividend come in. The famous oil tycoon made that statement in the early 20th century, and for some investors during the tech boom of the late 1990s, it may well have seemed hopelessly anachronistic. After all, the S&P 500’s dividend yield sank to multi-decade lows in 1999. At that point in time, no one seemed to care about a 1% or 2% yield when the market was rallying 15% or 20% annually, offering capital gains galore. But the truth is that the bull market of the 1990s was an anomaly and dividends have historically formed a key component of stock market returns, at least over the long haul. British economist Andrew Smithers of Smithers & Co. has studied long-term stock market returns in several countries using rolling return calculations--he looks at returns in rolling 15 and 30-year periods. He calculates the very long-term average return at between 6.5% and 7%. And while the S&P 500 has been yielding around 2% in recent years, historically the yield has been closer to double that level. That means that for an investor holding a basket of stocks over a 20-year or longer time frame, dividends make up, on average, about 50% of overall returns. That’s hardly a trivial figure. After more than a decade of playing second fiddle to capital gains, dividends are once again in style. As my staff and have I pointed out on numerous occasions in recent issues, periods of extremely large stock market gains are normally followed by a long period of below-average returns. For example, the huge bull run in the Dow Industrials from the late 1940s to the mid-1960s gave way to a flat market from 1965 to 1980 -- over this period the Dow actually returned less than 1% annually (excluding dividends). The same basic pattern held in Japan after the bull market of the 1980s, as well as in the U.S. after the 1920s bull run. Most likely, we’ll again see a prolonged period of uninspiring trading action in the wake of the big 1990s run. One effective way to make money in a flat -- or even declining -- market is to collect dividends. This strategy works for two major reasons. First, companies that pay dividends tend to have more reliable, stable businesses that hold up better during weak markets. After all, to pay dividends over a significant period of time, a company must have positive cash flows--most firms that pay larger dividends can do so because they sport solid, dependable earnings streams. These are exactly the sort of companies that investors look for in troubled times.
All Income Stocks Are Not
Created Equal -- Choose Wisely Company
#1 -- CharterMac (CHC)
CharterMac's business can be divided into four main segments: portfolio investing, mortgage banking, credit enhancement and fund management. Portfolio investing accounts for the largest chunk of overall revenues. This business is actually rather simple -- CHC buys revenue-backed bonds from state and local governments that are used to finance the construction of multi-family (apartment buildings) housing for lower-income families. In most areas, residents with incomes below 60% of the average can qualify for so-called affordable housing. Customarily, local or state governments finance the building of this housing. As such, the government generally issues bonds to pay for new construction. For the most part, such bonds are exempt from tax because they’re issued by the government. As of the most recent quarter, CHC held about 256 separate revenue bonds worth about $2 billion and covering 25 states. During 2003, about 57% of the firm's total revenues came from interest paid on these bonds. Fund management has also become an extremely important part of CHC’s business in recent years. This business accounted for about a quarter of total revenues in 2003. Basically, CHC raises money from institutional investors (or high net-worth individuals) to form investment funds, and the firm then invests these funds in multi-family housing. This is a fee business -- investors pay CHC to manage their money for them. Mortgage banking accounted for a little under 10% of CharterMac's 2003 revenues. This business is quite simple and familiar to most investors -- the company originates mortgage loans for the likes of Fannie Mae and Freddie Mac, earning a fee for raising the loans. Growth Drivers: Around half of CharterMac's businesses are what’s known as fee-based businesses. Meanwhile, the other half are subject, at least partly, to interest rate swings. With fee-based businesses like fund management, CHC doesn’t actually own bonds or speculate on property. Instead, it simply earns a fee for managing money. As long as institutional investors see promise in the company’s management skills in the specialized area of low-income multi-family housing, they’ll continue to pay fees to CharterMac. The portfolio management business is an interest rate sensitive business. Because the company is buying, holding and investing in bonds, its returns are subject to conditions in the bond market. Essentially what CHC is doing is earning money on the spread -- the difference between how much it costs CHC to raise money (by issuing bonds and stock or taking out bank loans) and how much it receives as interest paid on the bonds it purchases. In recent years, that’s been a very profitable business, as the spread has been very large. However, that hasn't always been the case. When the Fed hikes rates, historically the spread dissipates -- that can potentially hit earnings. However, even if interest rates rise, my staff and I believe CharterMac will continue to fuel future growth thanks to two related catalysts: Increased growth in fee-based business and renewed investment interest in multi-family housing. The multi-family housing market isn’t affected by rising rates in the same way as the rest of the real estate market. In fact, the recent period of low interest rates has actually been bad news for this market and has prompted occupancy rates to fall steadily over the past few years. The reason: Even low-quality borrowers have been able to grab affordable mortgages. As a result, most consumers have opted to buy a house or condo rather than continue to rent. As a result, occupancy rates in the type of low-income housing developments that CHC works with are now at 10-year lows. As rates rise, some low-quality borrowers are likely to switch back to renting as they find themselves unable to borrow money to buy a home. Historically, modestly rising rates have actually helped boost the rental market at the expense of the housing market. Even better, there’s been little or no growth in the amount of affordable housing in the U.S. over the past few years. Therefore, if demand rises, then we're likely to see another profitable round of new construction. This will have two main effects. First, the company’s investing business should benefit from increased issuance of bonds to finance new multi-family housing construction. This raises the potential investing universe for CHC. Second, and more importantly, a firming up in the rental market should cause occupancy rates and rents to rise, making this class of investment increasingly attractive to investors. Management expects demand for its portfolio management services to actually rise in such an environment as institutional investors are attracted to higher rental yields. Dividends: For tax purposes CHC is treated like a partnership. However, because the company’s main business is financing multi-family housing bonds for low-income families, much of its income is tax exempt. In fact, in the most recent quarter about 92% of all income passed through to shareholders was exempt. As a result, a very significant portion of any dividends received can be excluded from federal (though not state or local) income tax -- this boosts the actual value of the dividend yield significantly. My staff and I are also very impressed with CHC’s track record of steadily raising dividends over time. The company has hiked dividends 13 times since going public in 1997 -- equivalent to about an +8% annualized increase in its dividend payout. As of recent trading, the firm's dividend yield stood at roughly 7.5%. Going forward, my staff and I firmly believe that CharterMac will maintain this strong dividend growth. Since its inception, CHC's earnings have been compounding at about 11% annually and analysts expect continued growth over the next few years in the mid to high single digits. That should be more than sufficient to sustain a steady increase in dividends paid.
If the company can maintain a P/E ratio in line with historical averages of around 15X earnings, then the stock should be able to rally towards the $29 area within the next 12 months based on projected earnings of $1.94 in 2005. ---------------------
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