5 Stocks to Protect Your Dividend Portfolio

Kyle is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Dividends can play an important role in boosting the returns of an individual’s portfolio, and can help to stabilize losses during a market downturn. While dividend paying stocks should be included in anyone’s portfolio they are not without their risks; One major factor exists that could force dividend paying stocks to see a decline in value. Individual investors need to protect themselves against this force otherwise they are likely to see significant losses in the near future.

In late 2008 as global markets were beginning to spiral downward the Federal Reserve began a rapid succession of interest rate cuts in an effort to stimulate the economy. Additionally the Fed announced the first round of Quantitative Easing. Essentially the Federal Reserve would borrow money from the Treasury and then use this money to buy Mortgaged Backed Securities and other debt based instruments. This forced the yields down on mortgages, and the lower mortgage rates eventually spilled over to other fixed income securities.

Additionally investors began fleeing the stock market, and other country’s currencies for the safety of U.S. dollars. These investors began rapidly buying up dollar denominated assets including MBS’s, bonds, and other fixed income securities.

The combination of investors fleeing to cash, actions by the Federal Reserve, and a general skepticism surrounding stocks led to downward pressure on interest rates.

This low interest rate environment fueled by a weak economy and Fed action has led many investors to seek yield elsewhere. Today dividend-paying stocks are one of the most popular asset classes. Investors can now find dividend paying stocks that provide yields significantly higher than their bond counterparts. With relatively high yields compared to bonds, and the possibility of price and dividend appreciation it should be no surprise that investors have began taking a sudden interest in dividend stocks.

There is one risk however that could negatively impact the value of these stocks. If interest rates rise substantially, the yields on stocks will begin to appear less and less attractive relative to their bond counterparts.

For example: if an investor has a choice between a company that pays a yield of 4%, and a bond in that company that yields 3%, the investor would generally choose to buy the stock, unless the investor felt that there was a good chance that the company was going to go bankrupt or lower its dividend. If however interest rates rose so that in order for the company to borrow money it had to pay 7% instead of 3%, the investor would likely go the other way and buy the bond unless he/she felt that the companies shares would see price or dividend appreciation in the future.

Because of this the dividend investor needs to be worried about the possibility of a rise in interest rates.

Fortunately there are at least a couple of ways to hedge against this risk. Investors can buy stock in insurance companies, or payroll companies.

Insurance

Most of the money insurance companies make comes not from the premiums they collect, but from the interest paid on the premiums. Insurance companies generally sell policies at near what they expect to eventually pay out in the future, and then invest the float so that by the time the policy does pay out they are able to pay the policy holder and still show a profit.

This strategy works well when interest rates are high, as insurance companies can buy high yielding bonds and profit substantially from the float. When interest rates are low however it becomes substantially more difficult for insurers to make a profit. For this reason many insurance companies have been hurt by the economic crisis. If interest rates return to normalized levels (which they almost certainly will) these insurance companies will likely appreciate substantially, making them a perfect hedge for the dividend investor’s portfolio.

Three Insurance Stocks to Buy

Aflac (NYSE: AFL) –A large percentage of Aflac’s assets are in European debt, and much of their underwriting business comes from Japan. Because of the problems coming out of the EU, as well as the Japanese Tsunami that occurred a couple of years ago Aflac has been hit harder than many other companies in the same industry. Shares may have overdone themselves however as Aflac currently trades at under 9 times trailing twelve month earnings, and 7 times forward earnings.

Fairfax Financial (NASDAQOTH: FRFHF.PK) – Fairfax Financial is essentially a mini-Berkshire Hathaway. The company underwrites insurance policies and then uses the float to invest in various undervalued securities. The company’s underwriting business is not as profitable as Berkshire Hathaway’s underwriting business, but the company has actually outperformed Berkshire in growing book value. Since 1985 the company has seen its book value grow at a compound annual growth rate of 24.7%, and its shares have seen a growth rate of 21.3%. Despite this amazing growth the company’s shares currently trade at less than a 10 percent premium to book value.

While Fairfax Financial is an incredible buy, there is one caveat. Unlike other insurance companies Fairfax Financial holds a large percentage of its portfolio in equities, not just bonds. Because of this factor the company may not provide a complete hedge against a rise in interest rates.

Hartford Financial Services (NYSE: HIG) – Hartford Financial is one of those deep value companies that you hate owning in the short term, but could pay off down the road. The company was trading at over $100 at one point prior to the economic crisis. When the economy and market took a nose-dive in late 2008 shares of Hartford traded below $4. Today the company trades at around $20 ($21.05 as of this writing). The company appears expensive trading at over 16 times last years diluted earnings. Additionally the company has underperformed analyst expectations over the past year. So what makes the stock intriguing? If next years earnings estimates are correct the company trades at around six times forward earnings. Additionally the company has been selling off assets recently to make themselves a leaner company. Trading at less than half of book value this company may be an excellent deep value opportunity.

Payroll Services

Like insurance companies a large percentage of payroll service company’s profits come from collecting interest on the float. When a company hires someone such as ADP to do their payment processing services the company that hires them begins by paying ADP. ADP then invests the money in short-term securities before finally paying the employees of the company that hires them. Because of this, payroll service companies can profit not only from the payment services themselves, but also on the float from these services. When interest rates rise these companies should expect to do substantially better.

Automatic Data Processing (NASDAQ: ADP) – The payroll services behemoth does not look cheap trading at over 20 times trailing twelve month earnings, and over 18 times forward earnings. While it does have strong growth (analysts are pegging the 5 year growth rate at over 9%), making money from this stock may be difficult at current prices. If interest rates go up however, and unemployment rates decrease this company could benefit substantially. For this reason it may be worth looking into ADP, especially if the price goes down from these levels.

Paychex (NASDAQ: PAYX) – Paychex trades similarly to ADP at 21.7 times earnings, and under 20 times next years earnings. Like ADP analysts are also expecting a bit over a 9% growth rate over the next five years. Also like ADP the company does not look very cheap at the moment, but could improve if unemployment rates decrease, and interest rates increase. Paychex could see significantly higher earnings in a few years, and investors could be rewarded for their patience.

An Ironic Twist

While all of these stocks act as a good way to hedge a dividend portfolio from rises in interest rates, each one of the stocks mentioned above also pays a dividend. This might seem a bit like fighting fire with fire, however even if most dividend stocks fall as a result of a rise in rates, the stocks mentioned above should appreciate. As interest rates rise the companies mentioned above will begin to increase their earnings, and many are likely to begin paying out higher dividends. This allows investors to have their cake and eat it too… without getting fat!

Company

PE (TTM)

Yield

Aflac

8.8

2.74%

Fairfax Financial

33.01

2.55%

Hartford

233.11

1.9%

ADP

20.77

2.7%

Paychex

21.67

3.88%

Out of the companies listed above Aflac seems to be the cheapest, with its low PE, and strong ability to grow earnings over time. Fairfax Financial as well as Hartford Financial both may offer excellent investment opportunities at the moment, but for different reasons. ADP and Paychex are slightly more speculative, however if factors improve for these companies or they see a pull back it may make sense for investors to begin accumulating shares.

It is important for investors not just to be diversified, but also to be hedged from various risks. Insurance companies as well as payroll service companies may help protect dividend as well as bond investors from a rise in interest rates. There are still other risks however that these investors need to worry about. Increases in dividend taxes, capital gains taxes, and broader changes in the economy could threaten an investor’s portfolio. Individuals should look for ways to hedge or diversify away from these risks as a strategy for preserving and accumulating wealth.

 Kyle is the editor of The Farrah Report: A blog that highlights dividend, growth, and value stocks.

 


kf9211 owns shares of Aflac, and Fairfax Financial. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Aflac, Automatic Data Processing, and Paychex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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