How To Achieve 9% Yield With Lower Volatility: Managing Risk In High-Yield

Co-produced with

Beyond Saving

and

PendragonY

Introduction

Our Service,

High Dividend Opportunities

('HDO'), focuses on finding opportunities that provide a high level of current income- investments that provide a larger than average dividend.

We often target investments with yields over 7%, frequently these investments are immediately labeled as "high-risk", "sucker yields" or are said to be "just returning capital". Often with little more evidence than just pointing at the yield.

There is misunderstanding and a lot that is read into a high-yield. While many high-yield investments are in fact high risk, many low-yield (or zero yielding) investments are also high risk.

Dividend yield alone is not a measure of risk

.

Yields are high for a number of reasons-"Pass-through" entities like REITs, BDCs or MLPs are designed to pass the majority of their profits directly to investors. This results in a much higher than average yield.Capital allocation strategy- when companies have excess capital they have a variety of choices of where to allocate it. Many will buy back shares on the market, increasing share-price, others decide to increase the dividend.The company is trading at a

low price

- yield is the annual dividend divided by the current price, so as price declines the yield goes up. So when a yield is high, it is because the company is cheap. On the other hand, when the yield is low, it is indicative of a company that is expensive.

The first step of buy low/sell high, is buying low

.

We choose to focus on investing in companies that distribute more capital directly to shareholders. This means we invest in a lot of pass-through corporations as well as corporations which make the capital allocation decision to prioritize dividends.

It also means that we are frequently on the lookout for companies that are trading at a low price. Naturally, companies that are "on-sale" often get there for a reason. Maybe performance has been below expectations, there are operational challenges or for some other reason, the market is bearish on the company. Just like the market frequently overcorrects to the high-side, causing "bubbles", it often overcorrects to the low-side.

Stocks and sectors that are out of favor and over-react create a unique buying opportunity!

This provides an opportunity for us to invest in companies when they are priced low and benefit from a high-dividend yield, plus the eventual price appreciation with recovery.

Total Return

Investing is about taking a risk, and earning a return for taking that risk. Every penny you invest in an equity, bond, treasury, or even a bank account is theoretically at risk. If you want to "preserve capital at all costs", we suggest you avoid investing and maybe try putting cash in the freezer. History is rife with investors who invested in a "sure thing" that turned out to be quite uncertain.

When you invest in an equity, your total possible loss from day 1 is 100%. It doesn't matter what rating the company has, whether it is a blue-chip or how great of a history it has, all equities are subject to the risk of unpredictable downswings.

Today, FAANG is all the rage.

(FB),

(AAPL),

(AMZN),

(NFLX) and

(GOOG). These have been fantastic investments for those who bought in the early 2000s. Only one of these companies

even existed

30 years ago.

These stocks have had an amazing run, with their price growing by leaps and bounds, investors who got a good price and have stuck with them, have had great success. All of them also had competitors that didn't turn out to be good investments. They have also been subject to significant volatility, with only FB avoiding a drawdown of greater than 50%-, give it time.

Looking at a lot of green in your account is fun, but until you actually sell, unrealized returns

are unrealized

. A company can go up thousands of percent, to turn around and drop to zero in a scarily short amount of time. Odds are, that if you managed to invest in FAANG when they were cheap, you probably also invested in some of their competitors that didn't make it.

Data by YCharts

Consider

Helios and Matheson

(OTCPK:HMNY) a company that acquired Movie Pass, MP was touted by bulls as the biggest thing since NFLX. It was going to disrupt the movie industry, make boatloads of cash and everyone was going to be rich- just look at the chart!

Many investors had very large unrealized gains, and if they failed to realize them, they saw them evaporate as quickly as they appeared. That is an extreme example, and it is unlikely that any of the FAANG constituents will collapse as far, however, all of the FAANG constituents have experienced 30-50% drawdowns. All of them are certainly capable of having larger drawdowns in the wrong economic environment.

Until you actually sell, you don't know what your total return will be and your theoretical maximum loss is 100%

. (With the exception of AAPL, which does pay a small dividend).

With a dividend investment, you also don't know what your total return will be, but you know that

your maximum downside declines with each dividend payment

. Instead of having to wait to receive your total return,

you get a portion of return with each dividend payment

.

What is higher risk- an investment that pays you every quarter, or is it an investment that you will only be paid if you manage to find someone to buy it at an unknown point in the future? Many analysts will tell you with a completely straight face that the investment that pays little to nothing is lower risk, and that because a stock is paying you a high dividend is proof that it is a high risk... We totally disagree with this view and here is why.

Our Model Portfolio Returns In 2019

Source: Portfolio Visualizer

Here is a look at our current model equity portfolio performance year-to-date with dividends reinvested. For illustration purposes we have named our portfolio

HDO

. Note that our portfolio targets an overall yield of 9-10% and currently yields 10.8%. We compared it to an equally weighted portfolio of "Dividend Kings", a list of companies which have increased their dividends for 50 years or more. Also, we compared it to SPY.

Year to date, our portfolio has outperformed both SPY and the dividend kings. In fact, for the majority of the year, HDO outperformed by even more, giving up ground in July/August as illustrated by the blue line below.

Notably, our max drawdown was significantly lower than the Dividend Kings or SPY. We achieved better performance with a smaller drawdown.

Of course, one of the main reasons we love dividends stocks is because we want to receive the dividends and put them towards things other than equity investments. We want to invest those funds into things that allow us to be happily retired to cover our expenses, and even to supplement our income so we can achieve a happier life. So let’s look at how the portfolio performed without reinvesting dividends.

Even without reinvestment, the HDO equity portfolio has a gain of over 13% in value year-to-date. The return looks to be underachieving on the surface, do we really have $3,000-$4,000 in underperformance?

No, we received it as

income

. Over 6.5% of our portfolio has come back to our pockets and

we still have another quarter of dividends to receive!

Many investors will compare stocks price to price while ignoring the dividends. So they will look at the price and see a 13% return, compared to a 16% return and assume the 16% is better, as if the dividend payments never existed.

While reinvesting dividends will usually maximize your total return for a specific investment, if you choose not to reinvest, that does not mean the cash you received is worthless! In fact, it means that

you found something that is of higher value to you

.

Once you receive dividends, what you spend it on is

your

business. Many of our investors reinvest a portion of their dividends, and we encourage reinvesting enough to ensure your portfolio continues to grow-but what is the point of investing if you are never going to use the money?

Whether it is used for living expenses, traveling, that dream car or supporting your preferred charity, having consistent cash-flow from your portfolio provides the flexibility for you to invest in yourself and your priorities . When you have a portfolio that beats the market, has lower drawdowns, and provides you the flexibility to choose where to allocate cash-flows, you have realized the greatness of High Dividend Opportunities.

Risk Assessment

Our investment strategy includes a mixture of higher-risk/higher return investments, with more stable, lower risk, income producers. Are some of our investments higher risk? Absolutely. Sometimes a little bit higher risk can provide great returns.

When we make a pick, we designate it as low, medium or high risk based on our outlook for the particular pick. We currently have 18 picks that are designated lower risk yielding an average of 7.7%, 20 picks that are designated medium average 9.3% yield and 8 higher risk picks yielding 19.75%. The result is a diversified portfolio of 46 common equities that

yield 10.5%

.

Comparing our 3 risk designations, we can see that our "lower risk" investments have strongly outperformed. While the higher risk investments have proven to be more volatile and have had a stronger drawdown.

While the "higher risk" portion of our portfolio is the smallest portion, it is often the largest topic of discussion. These are investments which tend to be "contrarian" picks and have strong market sentiment against them.

(VET)

with a yield of 14% or

(MAC)

with a yield of 10%, for example, is certain to stimulate a lot of debate, criticism and has been subjected to some very large drawdowns. The very negative investor sentiment towards oil stocks and the mall REIT sector has resulted in a very large pullback, but also creating many opportunities. These are the kind of investment

that offers outsized upside

but could also be subject to an undetermined amount of downside in the short term, while we wait for the investment thesis to play out. In such cases, we usually recommend to our investors a maximum allocation of only 2% while allocating 3% to our lower volatility picks.

By having significant diversity, we can smooth out the volatility we experience with our more aggressive picks. We can benefit from the high-yield, until negative investment sentiment changes, and then we expect to see massive upside potential when our thesis is proven correct and MAC trades above $45/share, and VET above $20/share. Also, by pairing higher volatility stocks with conservative high dividend stocks, an investor can achieve a dividend yield of +9% with a lower price volatility than the S&P 500 index, and this is exactly our objective.

Preferred/Bond Portfolio

Common equity by its very nature is a higher risk/higher reward investment. At the beginning of 2019, we have focused on increasing our exposure to fixed-income investments such as preferred equity, bonds, and baby bonds. As discussed above, our equity portfolio already has many conservative picks that have performed well. By adding in 35%-40% exposure to even more stable fixed-income investments, our investors have been able to enjoy even more stability without sacrificing cash-flow.

While the focus on these investments is on the income, since par value limits upside, we have had some excellent opportunities to take advantage of a fearful market and invest below par. Our preferred portfolio has enjoyed capital gains of

over 10%

year-to-date, while paying a

current yield of 6.7%

(investors who bought with us at lower prices have a higher yield-on-capital). Our bond and baby bond picks currently have an average yield of 6.7% and 6.6%. Our fixed income returns were well over 17% year to date.

By investing 35-40% of our portfolio in fixed income investments, this provides even more stability in portfolio value, lowering risk,

while maintaining a high level of current income

. These are investments that we have a high level of confidence that they will continue paying dividends even in extreme bear markets. Plus, when the market was bleeding red on those rough days in August

and almost all stock indexes were significantly down, our recommended portfolio was mostly green in our fixed-income recommendations.

Even among fixed income, it is best to keep your portfolio highly diversified. For our investors, we call this

the rule of 40

. We have also been recommending that income investors get defensive, allocating 35-40% of their portfolio to fixed income that means you need at least 14-16 preferred stocks, bonds, baby bonds and high quality fixed income CEFs. Currently, our recommended

preferred stock portfolio

includes 50 preferred securities choices for investors to chose from, with a focus on high quality and recession resiliency, and provides an overall yield of 7%. Combined, a 40% allocation in fixed income picks and a 60% allocation in our equity picks would produce

an overall

dividend yield of 9%

.

Another tool for Managing Risk

One great way to make money is to buy stocks on the cheap. This is also a risk management tool because cheap stocks tend to have more upside potential and less downside risk. One of our mission is to seeking high dividend stocks that are currently out of favor, despite strong fundamentals, and buy the pullback. We have many high yield opportunities today with many sectors being out of favor. Most notably, the oil and gas and the Mall REIT sectors. Investors should note that buying into sectors that are out of favor requires a lot of patience to make good money. Some sectors can remain out of favor for months and even years. The beautiful thing about targeting those high yielding stocks that are out of favor today is that income investors can cash a nice dividend to wait. One of our most recent pick, related to the oil and gas sector was Vermilion Energy (VET) with a yield of +14% at the time of our alert. The stock is already up 11%, and has paid a dividend of 1.2% since our buy alert 3 weeks ago. VET pays its dividend on a monthly basis which is a great plus for us income investors! In this case, it seems that timing was perfect as many energy stocks seem to have hit bottom already and ready to rebound.

Conclusion

Yields get high when the price goes down. Prices go down for numerous reasons, sometimes good ones, sometimes bad ones. Dividends will get really high when the market believes a cut is imminent, or when the market believes the fundamentals are deteriorating. Sometimes they are and it is best to avoid.

Other times, the market is reacting to news that is not all that significant. It creates opportunities to invest in quality companies at low prices due to imaginary dangers.

You can invest in companies that are high-priced, maybe the next person looking at all the momentum will pay you more than you paid. Then again, maybe they won't. You'll find out when you need to sell, and whatever dollar value your portfolio portrayed anywhere between when you buy and when you sell is irrelevant.

By focusing on companies that reward shareholders with regular quarterly or even monthly distributions, we experience realized returns on a regular basis. While some individual picks have significant volatility and have had large drawdowns, through diversification we have been able to mitigate that.

The result is a well-balanced portfolio, that is capable of providing a dividend yield of 9%. Is it "higher risk" that our investments are actually paying us in cash and not just promises that we can sell them for more later? Is it "higher risk" to invest when prices are low? Common sense says

NO

.

From time to time, a high-yield can be indicative of a company having financial difficulties, it can be indicative of a dividend that is at risk of being cut, but it can also be indicative of market mispricing and excessive fear. By focusing on the fundamentals, we can capitalize on excessive fear and take advantage of such mispricing. Keep in mind that dividend investing is a defensive investment style that generates regular cash flows for investors and tends to outperform when markets are volatile!

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Join us today and get instant access to our

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"

Disclosure: I am/we are long MAC, VET, WPG.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.