Equities That Get Tough When the Market Gets Rough

All investors have a little Rod Tidwell in them. They just want to yell, "Show me the money!" But it's been hard to make money in this market.

Technology and telecom are certainly not working. Given the difficult business conditions in these industries and the high valuations, these stocks look like dead money for a while.

Health care stocks look awfully tired as well. America may be graying, but the senior citizens are feisty. They want their drugs, and they do not want to be gouged. I expect pricing pressure to be a real problem for pharmaceutical stocks. I continue to love the financial stocks, but admittedly, these stocks have not gone anywhere in a couple years.

Warren Buffett has predicted that equities will generate a 7% annual return for the next decade. After the last two years, 7% probably would feel pretty good. I am actually quite bullish on stocks. I see a recovering economy and a period of sustained low interest rates. However, while I expect equities to be the best-performing asset class, I think that we are heading for a period in which all asset classes will generate lower absolute returns than their historical averages.

Related Stories

Telecom Panic Creates Opportunity in Adelphia

Better Performance in Convertibles

While equity investors have been watching their portfolios shrivel, fixed-income investors have been suffering from "yield shock." Nobody is happy. We have to find a solution for everybody. We need to make some money.

How about a basket of real estate investment trusts (REITs), master limited partnerships (MLPs), utilities, convertible securities and high-dividend stocks? Let's call them high-yielding equities. We can assemble a portfolio of these securities that will generate a blended yield of about 6%.

Moreover, the annual dividends for many of these companies are increased annually. Many REITs and MLPs have tax-favorable dividends in which a portion of the dividend is treated as return of capital. These slow-growth companies also offer the opportunity for capital appreciation, so the total return potential is very interesting. But hold on. These are stocks. They can be volatile, and they do go down.

The best way to control the volatility of these high-yielding equities is to develop a diversified basket. I do not mean a diversified basket of REITs. I mean a diversified basket that incorporates securities from each of the sectors identified above. To appreciate the benefits of diversification (as if the last two years has not been lesson enough), check out the chart below. It presents the annual rates of return for the S&P 500, a REIT index, a utilities index and a convertible securities index. Unfortunately, I am not aware of a reliable, representative index of MLPs.

As you can see, these defensive, cash-flow generating securities move around a bit. While the volatility can be no fun, it is a lot easier to sit tight with a high-yielding stock. In addition to generating income, the yield acts as a cushion, and it is an indication of the financial strength of the underlying company.

With the Masters golf tournament being played at Augusta, Ga., this weekend, I am reminded of my favorite line from Jack Nicklaus. When asked how he has been able to win 20 major championships, Nicklaus responded that the major championships were the easiest to win -- he just waited for everyone else to blow up. The best way to grow money is to avoid big mistakes. Dividend-paying stocks have historically been considerably safer than their nondividend-paying brethren. Moreover, between 1950 and 2001, dividends accounted for about one-third of the S&P 500's compound annual return.

Here are a few suggestions for a higher-yielding portfolio:

Equity Office Properties (EOP - commentary - Cramer's Take) is the largest nationwide office-building REIT in the country. The company is run by the legendary Sam Zell. The stock offers a 6.45% yield, and the dividend has grown 10.9% over the last three years.

Vornado Realty Trust (VNO - commentary - Cramer's Take) is a REIT that owns and manages retail and industrial properties primarily in the Northeast. Steve Roth and Mike Fascitelli are very savvy and opportunistic dealmakers. The stock offers a 5.72% yield, and the dividend has grown 17.4% over the last five years.

Allegheny Energy (AYE - commentary - Cramer's Take) is a utility company serving the mid-Atlantic states. The stock offers a 4.1% yield.

Cinergy (CIN - commentary - Cramer's Take) is a utility previously known as Cincinnati Gas & Electric before it acquired PSI Resources. The stock offers a 5.15% yield.

Kinder Morgan Energy Partners (KMP - commentary - Cramer's Take) is natural gas master limited partnership that was spun off from Enron (yes, Enron) in the early '90s. The stock has been unfairly punished because of its association with Enron. The stock offers a 6.88% yield, and the dividend has grown 27.8% over the last five years.

Northern Border Partners (NBP - commentary - Cramer's Take) owns and operates an interstate pipeline system that transports natural gas from the Canadian border. The stock offers a 7.9% yield, and the dividend has grown 7% over the last five years.

Phillip Morris (MO - commentary - Cramer's Take) is monster. It offers earnings, dividend and cash-flow growth. The company is buying back stock and selling underperforming assets (such as Miller Brewing). Moreover, it is cheap at 10 times 2003 estimated earnings. The stock offers a 4.4% dividend.

DuPont (DD - commentary - Cramer's Take) is a charter member of the Dow Jones Industrial Index. The company is benefiting from the economic recovery, and earnings surprises should be to the upside. The stock offers a 3% yield.

Echostar Communications (DISH - commentary - Cramer's Take) has a convertible bond with a 5.75% coupon, a May 2008 maturity and a $43.29 conversion price. The current yield is 6.2%. I do not know if they will complete the acquisition of Hughes, but I am a big fan of satellite television.

Boise Cascade (BCC - commentary - Cramer's Take) has a convertible preferred with a 7.5% coupon, a December 2004 maturity and a $38.88 conversion price. The current yield is 6.75%. The paper stocks have lagged other economically sensitive stocks. I expect a catch-up rally.

Don't let your eyes glaze over here -- there is nothing boring about making money. We have to get creative. I grew up in hockey country. I am going to go where the puck is.

---

Brett Messing is a managing director at Neuberger Berman LLC. The views expressed are Messing's and do not represent the views of Neuberger Berman LLC, its portfolio managers, employees or affiliates. At time of publication, Neuberger Berman or its clients had no positions in any of the securities mentioned in this column, although positions may change at any time. This material is not intended to be a formal research report or recommendation and should not be construed as an offer to sell or the solicitation of an offer to buy any security. Before acting on any advice or recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Messing appreciates your feedback and invites you to send it along.