How to Use High-Yielding Stocks to Pave the Way to Double-Digit Capital Gains

By , Money Morning •

Money Morning Special Investment Report

If you want to succeed as an investor in today's whipsaw markets, you have to be a real bulldog.

An "Alpha Bulldog," that is.

Money Morning Contributing Editor Martin Hutchinson - a 27-year investing veteran of the global financial markets - has these days become well known for his timely market calls. Slate magazine early this year lauded Hutchinson's prescience for having correctly predicted the major correction of the U.S. stock market. In April 2008, long before an implosion in a derivative security known as a "credit default swap" caused the implosion of insurance giant American International Group Inc. (NYSE: AIG), Hutchinson warned Money Morning readers that credit default swaps were a $50 trillion problem.

As editor of the new Permanent Wealth Investor trading service, Hutchinson has continued to make such calls: He's even been able to correctly predict that some stocks with near-double-digit dividend yields would likely generate mid-double-digit returns in fairly short order.

Money Morning Executive Editor William Patalon III sat down with Hutchinson this week to ask about the veteran investor's stock-picking strategies, and to also seek his current views on stock prices, commodity prices, inflation fears, economic growth and the most promising global markets.

Here is a partial transcript of that exchange.

Money Morning (Q): Martin, your Permanent Wealth Investor trading service is based largely upon a strategy in which you seek out high-yielding stocks. And a central piece of that is something called the "Alpha Bulldog" stock. What are "Alpha Bulldogs?" What defines them ... what parameters do they share ... and how do they contribute to your overall strategy of permanent wealth creation?

Martin Hutchinson: An Alpha Bulldog is a publicly traded company that displays the share with the following five characteristics:

  • A stock with a high dividend yield - at least 7.5%-8.0%, but preferably higher.
  • A "permanent" (sustainable) business model, with operations solid enough to allow dividends to be maintained ad infinitum - meaning the corporate business plan has no "self-liquidating" feature.
  • A pro-shareholder management team that welcomes paying high dividends - and that doesn't embark upon dividend-sapping, management-aggrandizing schemes.
  • A business that offers dividend-growth potential once the global economy resumes its expansion.
  • The first dividend is "locked in" - having been declared - but there is still time to invest before the "ex-dividend" date.

Only a small percentage of high-yield stocks are actually Alpha Bulldogs, making them suitable for permanent wealth investment. Some high-yield stocks have dividend payouts that are much greater than actual earnings, an unsustainable gambit designed to make the companies appear more solid than they actually are. Others have been beaten down by declines in profitability, and are unlikely to maintain their current high-yield payouts. Still others - such as many real estate companies, or Canadian royalty trusts - are "self-liquidating," in that they have a finite life. These entities will pay dividends for maybe 10 years, but at the end of that time there will be nothing left: 10% a year for 10 years and nothing at the end is, needless to say, not a particularly great investment!

(Q): Back in the middle part of April - when we last sat down to talk about the launch of your Permanent Wealth Investor trading service - I asked you how much the overall market has to do with the success or failure of your strategy, and you said that the Permanent Wealth strategy is not suited to long periods of market overvaluation, essentially what U.S. investors had from 1996-2007. Since we had that discussion, the Standard & Poor's 500 Index has surged 21% (as of Tuesday's close). How are you addressing this?

Hutchinson: One of the features of this market rally is that it hasn't affected all stocks. In long bull markets, the analysts eventually catch up, and even obscure companies become fully valued. This time around, there are still lots of companies whose stocks are still trading at prices that are much closer to their 12-month lows than they are to their highs. Some of those are the Alpha Bulldog stocks - and in those cases, you have the additional benefit that they may be due for a short-term re-rating. Obviously, if the Dow [Jones Industrial Average] continues steadily back up to 14,000 [its record high], "Alpha Bulldogs" will become scarce, but I don't expect it to do so.

(Q): You've had some major successes since this trading service launched - I believe we're talking real (not annualized) gains in excess of 40% to 50%. Could you highlight one or two of these successes and talk about why your strategy worked so well?

Hutchinson: Our two biggest gains were cases where the market had become over-pessimistic on the stocks back in March, and where investors hadn't realized that these particular companies were navigating the downturn quite nicely. One was an international bank that was simply better managed than its peers, the other was a leasing company where the market got scared and knocked it down to a quarter of its net asset value. In both cases, the maintenance of the [high-yield] dividend was a signal that management was confident that their company wasn't sharing its' competitors' woes. That's why I like buying beat-up shares just after management has declared a dividend; it tells you that the company's leadership thinks that things are okay.

Q: Any sectors shaping up as interesting? Or are you more of "special-situations" guy?

Hutchinson: I'm more of a special tuations guy. Financials were fascinating early in the year, but have now mostly recovered. Currently, I quite like natural resources-companies. Commodity prices have bounced far off their lows, because of demand in China and the global economy bottoming out, but many companies' prices don't yet reflect this.

Q: I had the opportunity to watch the video of the interview you just did with Money Morning Publisher Mike Ward. In your "Alpha Bulldog Report" video, you said that you're looking at three potential "Alpha Bulldog" candidates right now.

Hutchinson: That's right. And each one is very interesting. One, for instance, is a branded clothing company that has licensing deals all over the world. And it has a dividend yield of nearly 10%.

[Editor's Note: A link to this video interview is also posted at the end of this interview.]

(Q): Dividends are a major component of your Permanent Wealth strategy. I've seen you recommend stocks with yields of 12%, 14% or even 16%. I also find it interesting that by investing for income, you often get capital growth - but if you invest for capital growth, you often take a collar. Why is income investing the better path to travel?

Hutchinson: The problem with going for capital growth is that very often you don't get it, and then you've got nothing - the investment just sits there. As I've discussed here in Money Morning many times before, buy dividend stocks - and you will at least be well paid as you wait for the market to go up.

The other reason for buying dividend stocks is that capital gains are so damnably difficult to spot. Tell me honestly: Are you really capable of telling which kind of high-tech widget is going to take off and which one will turn out to not have the "magic" features the techno-geeks want? Me neither, and I'm a Math major.

(Q): But dividends can actually lead to capital gains?

Hutchinson: Absolutely. As you mentioned in your question above, dividends can create wealth in one - or both - of two ways.

First, they provide cash flow that you can either use for living expenses or to reinvest: That means there's no more having to sell shares, often at a depressed price, to meet your monthly bills, or to finance a vacation or home remodeling.

Second, if you buy shares with high dividend yields, there's a good chance that the market will eventually notice the superior [dividend] payouts, and revalue the shares so that their dividend yield is back down around the market's average. For a dividend yield to go down in this manner, the stock price has to go up. Once that happens, you have received dividends and capital gains.

Dividends are easy - you can drop them on your foot, as it were. All you have to do is figure out which companies are run by sharpies - and are paying dividends out of capital - and which companies have genuinely solid business models that aren't going away.

(Q): You've stated that while almost all high-dividend stocks tend to be "low P/E stocks" (stocks with low Price/Earnings (P/E) ratios), it doesn't necessarily mean that low P/E companies are high-dividend payers.

Hutchinson: That's right. Investing for high dividend payouts is a type of "value investing" - investing in stocks with low P/E ratios, or in companies whose stock prices are low relative to the firm's asset values.

With this focus on dividends, you reap all the benefits (the higher returns) of the value-investing strategy. However, by investing in stocks with high dividend yields, you also are getting paid to wait. And you're also defending yourself against a corporate management that wants to throw away your value through unwise investments: Once you have the cash, it's no longer locked up inside the company; it's yours to keep.

Investors don't see this because they buy stocks through brokers and read about stocks in the financial media. A 100% capital gain is much more exciting than a 10% dividend yield, and a new tech concept that turns out to work is more exciting than a business that just keeps on turning out good profits and paying those profits out to shareholders as dividends.

What's more, high-yield stocks lend themselves well to a "buy-and-hold" strategy that maximizes returns for the investor but not for the broker. If a growth stock doesn't go up, the investor has nothing; but the broker can then make another commission by making the investor switch to a different "growth" stock, playing on the investor's boredom and feeding him a new "concept."

Corporate management teams, Wall Street stock brokers, and even the mainstream news media all have a vested interest in promoting "growth" stocks to investors; it's not surprising that most investors buy mostly what is sold to them.

Q: What's your outlook for the U.S economy? Over the next six months, 12 months, three to five years?

Hutchinson: I think over the next six months it will appear as though the U.S. economy is beginning to recover, but it will be a giant head-fake. Interest rates are too low and the federal deficit is too big; at some point, we will get higher inflation and higher interest rates, which will push us down into a second dip - a "double-dip" recession - which could be pretty scary. That might not happen until 2010, but the stock market will probably anticipate it, even if during the fourth quarter the economic numbers look good.

Q: Martin, your international experience is well known. What global markets do you like right now, and why? In a recent column, for instance, you stated that you were intrigued by a "game-changing" situation in Japan.

Hutchinson: I like Japan because of next Sunday's election. The DPJ (the opposition Democratic Party of Japan) has some of the problems of Western left-of-center parties, but assuming it wins it will be able to gain some easy economic victories quickly, but cutting out a lot of the waste that the 55-year rule by the Liberal Democratic Party of Japan (LDP) has brought: Too much construction and subsidies to big exporters, for example. So domestic Japanese companies, and those aiming at middle-class consumers, ought to do well. Remember, the Japanese (stock) market is still trading at only a quarter of its 1990 high.

I also like Germany; it did no "stimulus" and the European Central Bank (ECB) has been more cautious than the Fed. So the German recession should be single-dip, with a good recovery that continues.

Q: Do you still like gold? Any other commodities?

Hutchinson: The slam-dunk reappointment of central bank Chairman Ben S. Bernanke makes me worry even more about U.S. inflation, because he has such a bias in favor of printing money. So gold, silver and other commodities look good. It will be interesting to see whether in September's meeting the Fed reverses its decision of two weeks ago, and starts buying U.S. Treasuries again (now that the Bernanke reappointment is all but finished). If it does, we're in for really nasty inflation.

[Editor's Note: In a brand-new videotaped interview with Money Morning Publisher Mike Ward, Permanent Wealth Investor Editor Martin Hutchinson further details his investment strategy and talks about several potential new "Alpha Bulldog Stocks" that he's identified. The "Alpha Bulldog Report" video, which is free of charge to watch, can be accessed by clicking here.]

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