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Dividend Edition: Look Abroad for Income

As you may have heard, interest rates in the U.S. are at historical lows. Good if you want to refinance your house, not so good if you want to create a low-risk income-generating portfolio. We’ve already talked about a number of ways for income investors to adjust to the new landscape...

As you may have heard, interest rates in the U.S. are at historical lows. Good if you want to refinance your house, not so good if you want to create a low-risk income-generating portfolio. We’ve already talked about a number of ways for income investors to adjust to the new landscape (last week’s issue provided several alternatives to bond funds), and this week I have one more idea: look abroad.

The advantages vary by country: some, like Australia and New Zealand, have higher interest rates. Others, like Canada, allow businesses to be organized in a variety of income-funneling ways that go beyond the REITs and MLPs available in the U.S.

Below are three international ideas for income investors. The first comes from Dr. Marvin Appel and Gerald Appel, and was published in Systems & Forecasts on July 2 and in the Dividend Digest on July 18.

“In the last issue of Systems & Forecasts, I reported that real government bond yields in Australia far exceeded real yields in other major bond markets around the world. In fact, the only other industrialized economy where long-term government bonds yield more than inflation is in Japan. (In addition, Brazil’s long-term government bond yields, at 6.2%, are 1.2% above the inflation rate.) High real interest rates represent a favorable investment climate for more than just bond investors, because equity returns, by virtue of high dividends or other attractive valuations, have to compete with bonds in order to attract investor capital. That warrants taking a look at Australian equities.

“The immediate attraction is that the dividend yield on the iShares MSCI Australia Index ETF (EWA) is 4.6%. Another attraction is that the sector mix of Australia’s stock market is very different from that of the S&P 500 Index, making EWA a vehicle for portfolio diversification. … EWA is very heavily concentrated in basic materials and financial services, while having very little representation in technology. In contrast, technology is the largest sector in the S&P 500 Index, while basic materials is one of the smallest.

“Even though banking is the largest sector in Australian stocks, their stock market responds mainly to changes in commodity prices and to the economic outlook in the commodity-importing nations that are Australia’s customers, such as China, Japan, India and South Korea. That means that overall, the Australian stock market behaves as a very cyclically-sensitive investment: Any development that represents a threat to worldwide economic growth (more specifically, to commodity demand) depresses their stock market, while any development that bodes well for consumer economies is bullish for Australian stocks.

“As an example, even though Australia’s largest trading partners are in Asia, the credit scares of 2010 and 2011 in Europe caused a much larger decline in Australian stocks than in the S&P 500 Index. In fact, the declines in EWA and in the European Equity ETF (IEV) were about equal to each other, both more than one and a half times the decline in the S&P 500 Index. (EWA had drawdowns of 26% in 2010 and 30% in 2011.) [The bottom line] is that EWA is an indirect bet on the direction of commodity prices, albeit a bet that pays a healthy dividend while you wait. The downside is the high level of volatility that EWA has experienced. The correlation between Australian stocks and commodity prices makes them a good portfolio diversifier. Downside price risk should be $20.50, which would be a good bottom fishing area. The intermediate-term upside objective is $24/ share. [Buy] below $22/share.” — Dr. Marvin Appel and Gerald Appel, Systems & Forecasts, July 2, 2012

Our next idea comes from the opposite side of the world (nearly). The Royal Bank of Scotland (RBS) has had a rough few years. The Scottish bank bought ABN AMRO Group, a Dutch bank, in October 2007, overextending itself right before the global financial crisis hit. The U.K. government stepped in to save the bank in 2008, and now owns about 80% of RBS.

In exchange for being bailed out by the government, RBS was required to suspend dividends on its common stock and many of its preferred shares. However, a few of its preferred shares had shareholder protection clauses that required the bank to continue making distributions regardless (which it did).

One of those preferred shares, the The Royal Bank of Scotland Group Plc Preferred Stock Series F (RBS-F), was chosen as a Dividend Digest Top Pick for 2012 by Vivian Lewis, editor of Global Investing. In January, she recommended buying the preferred around $19. Six months later, when we published our Top Picks update issue, the preferred was one of the best performers, having gained 28% (on top of paying a dividend in March).

Lewis still thinks RBS-F looks good here, despite the appreciation. But, in her update on the stock, she said that if she were buying today, she’d buy the cheaper RBS L-Series Preferred (RBS-L). Despite RBS’s problems, she writes, “I can think of no reason why the payments will not be made on time. ”

Be aware that liquidity is low for the preferred shares, so be careful not to pay more than you want for them. In addition, their symbols vary by brokerage.

Our final foreign finding comes not from overseas, but from our neighbor to the North.

The iShares MSCI Canada Index (EWC) was recommended by Steven Lord, editor of Leeb’s Cash Cow, in the July 18 Dividend Digest. Here’s what he wrote:

“With Canada’s reliance on natural resources, precious metals, energy and the like, it is no surprise that, given what has happened with commodities so far this year, the iShares MSCI Canada Index (EWC) has taken it on the chin. Now oversold at roughly a two-year low, the ETF is uncharacteristically underperforming the S&P 500, despite very solid long-term prospects. In our experience, this is a good set up.

“EWC holds 101 stocks in its market-cap weighted portfolio, which means nearly 90% are either mega- or large-capitalization companies. Appropriately, given the composition of the Canadian economy, fully half of the fund’s considerable assets are dedicated to materials and energy companies, with another 31% allocated to Canada’s financial sector. In fact, the top three positions are banks—Royal Bank of Canada, Toronto Dominion and Bank of Nova Scotia—and they alone command 17% of assets. In resource-reliant emerging markets, this often gives us pause; in this case, we’re encouraged. Unlike in the U.S., Canada’s five major banks are well capitalized, more insulated from Europe’s travails and are not facing real-estate-related trauma to nearly the same extent as their U.S. brethren. ... Note, too that EWC does not hedge its currency exposure—much of its outperformance versus the S&P 500 over the past several years has come from an appreciating Canadian dollar.

“EWC is pegged to the MSCI Canada Index and aims to capture roughly 85% of the Canadian stock market. Its weighting system ensures that there are few of the speculative mining micro-caps listed on Canada’s exchanges included in the portfolio, but all of the large-cap industrial, materials, and financial ones. ... Yielding 2.2% and also rated five stars by Morningstar, EWC is an indirect play on both commodities and emerging markets, but via a liquid market in a developed country with the added diversification of very stable and profitable financial companies. The selloff in commodity-related investments of all kind brought EWC down from $34 in April to strong technical support around $25, and gives the fund some room to run as commodities stabilize. Buy.” — Steven Lord, The Cash Cow, August 2012

Wishing you years of safe income ahead,

Chloe Lutts

Editor, Dick Davis Dividend Digest

Chloe Lutts Jensen is the third generation of the Lutts family to join the family business. Prior to joining Cabot, Chloe worked as a financial reporter covering fixed income markets at Debtwire, a division of the Financial Times, and at Institutional Investor. At Cabot, she is a contributor to Cabot Wealth Daily.