What’s the difference between a Ponzi scheme and a utility company? Before I answer that question, let’s look at what a Ponzi scheme is.  Wikipedia defines it as:

A  fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned. The Ponzi scheme usually entices new investors by offering returns other investments cannot guarantee, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors to keep the scheme going.

In effect, a Ponzi scheme pays yesterday’s investors with money from today’s investors. It works great until there aren’t enough new investors to pay the old investors. In a similar manner, most utility companies rely on new capital either in the form of debt or equity to fund investment and to pay dividends. Consider the following:

Atmos Energy Corp. (ATO) – Yield: 4.88%
Shares Outstanding: 2000 31m; 2009 92m
Long-Term Debt: 2000 363.2m; 2009 2,159.5m
Years of Negative Free Cash Flow: 5 of 10

Black Hills Corp. (BKH) – Yield: 5.10%
Shares Outstanding: 2000 22m; 2009 38m
Long-Term Debt: 1999 160.7m; 2008 719.2m
Years of Negative Free Cash Flow: 7 of 10

Connecticut Water Service Inc. (CTWS) – Yield: 4.01%
Shares Outstanding: 2000 7m; 2009 8m
Long-Term Debt: 1999 65.4m; 2008 92.2m
Years of Negative Free Cash Flow: 5 of 10

California Water Service Group (CWT) – Yield: 3.29%
Shares Outstanding: 2000 15m; 2009 20m
Long-Term Debt: 1999 156.6m; 2008 373.5m
Years of Negative Free Cash Flow: 10 of 10

Consolidated Edison, Inc. (ED) – Yield: 5.52%
Shares Outstanding: 2000 212m; 2009 276m
Long-Term Debt: 2000 5,415.4m; 2009 9,854.0m
Years of Negative Free Cash Flow: 6 of 10

MGE Energy Inc. (MGEE) – Yield: 4.40%
Shares Outstanding: 2000 16m; 2008 22m
Long-Term Debt: 1999 148.6m; 2008 272.5m
Years of Negative Free Cash Flow: 7 of 10

Middlesex Water Co. (MSEX) – Yield: 4.31%
Shares Outstanding: 2000 10m; 2008 13m
Long-Term Debt: 1999 82.5m; 2008 118.2m
Years of Negative Free Cash Flow: 10 of 10

Progress Energy, Inc. (PGN) – Yield: 6.48%
Shares Outstanding: 2000 157m; 2008 260m
Long-Term Debt: 1999 3028.6m; 2008 10,659.0m
Years of Negative Free Cash Flow: 5 of 10

Integrys Energy Group, Inc. (TEG) – Yield: 6.17%
Shares Outstanding: 2000 26m; 2008 76m
Long-Term Debt: 1999 634.5m; 2008 2,396.7m
Years of Negative Free Cash Flow: 10 of 10

Each of the above companies are growing their debt and shares outstanding while generating insufficient cash to fund their operating expenses, including normal capital replacements, in at least 5 of the last 10 years. For a company to consistently raise its dividends, it must generate strong cash flows sufficient to meet operating obligations and to service outstanding debt. When the day comes that these companies can not raise enough capital to fund the operating requirements, the first source of additional cash will likely come in the form of a lower or eliminated dividend.

So, back to the original question, what is the difference between a Ponzi scheme and a utility? The answer is simply disclosure. All the above information on these companies was made available via S.E.C. filings. Unlike Bernard Madoff, these companies are telling you exactly what they are doing, thus there is no intent to defraud. I own some of the companies above, but I won’t be rushing to add to increase my positions.

Caveat emptor!

Full Disclosure: Long ED, PGN, TEG. See a list of all my income holdings here.

(Photo Credit)

High-yield investing often carries a greater degree of risk than I am willing to accept. Recently, a reader alerted me to an article describing a 20-year study by the Schwab Center for Financial Research demonstrates that investments with the highest yields don’t necessarily provide the highest returns and offers a safer way to implement a high-yield approach. Here are some key excerpts from the article:

• Stocks with the highest dividend yield haven’t provided the best total return.
• Research found the highest-yielding stocks had twice as many dividend cuts as the other dividend-paying groups.
• Price momentum is a stock indicator based on the idea that stocks that have been outperforming in the past will continue to do so.
• A simple screen using the six-month price momentum strategy applied to the highest-yielding stocks can help you pick the best performers.
• The screen is implemented using:
  • Stocks in the S&P 500, 400 and 600 indexes.
  • Dividend Yield and click the dividend yields greater than 1.5 times the S&P 500 yield.
  • Capture analyst ratings.
  • 6 Months Price Performance > Price Change.
  • Sort by price performance and select the highest analyst ranked  stocks within the top 45.

Since the article was very Schwab specific, I tried to generalize the above screen. If you have a Schwab account, please refer to the article for more specific instructions.

So, what does all this mean? If you are an income investor that enjoys trading instead of buy and hold, then this may be something you want to explore further.  However, the 11.5% earned with this strategy vrs. the  10.73% for dividend stocks not in the highest yielding group hardly seems worth the effort.

For me, I will continue to focus on high-quality dividend stocks at lower, but growing,  yields. However, for those looking to bump their yield a little, below are several Dividend Aristocrats and Achievers that are currently yielding more than 5%:

CenturyLink Inc. (CTL) – Aristocrat – Yield: 8.6%
Lilly Eli & Co. (LLY) – Aristocrat – Analysis -Yield: 6.0%
Integrys Energy Group Inc. (TEG) – Aristocrat – Yield: 7.8%
Consolidated Edison Inc. (ED) – Aristocrat – Yield: 5.8%
Progress Energy Inc. (PGN) – Achiever – Analysis – Yield: 6.5%
Realty Income Corp (O) – Achiever – Yield: 7.1%
Health Care Property Investors, Inc. (HCP) – Achiever – Yield: 6.8%
Cincinnati Financial Corp. (CINF) – Aristocrat – Yield: 6.2%
Leggett & Platt Inc. (LEG) – Aristocrat – Analysis – Yield: 5.7%
Pitney Bowes Inc. (PBI) – Aristocrat – Yield: 6.0%
AT&T Inc. (T) – Achiever – Yield: 6.2%
Black Hills Corp. (BKH) – Achiever – Yield: 5.8%
Capital City Bank Group (CCBG) – Achiever – Yield: 5.6%
Universal Health Realty Income Trust (UHT) – Achiever – Yield: 7.5%

This by no means is an endorsement of the above stocks. If you are looking for high-yields, you might lower your risk some by looking at a pool of stocks that have a long history of increasing their dividends.

Full Disclosure: Long CTL, LLY, TEG, ED, PGN, O, HCP . See a list of all my income holdings here.

(Photo: Steve Woods)

I have been using my new evaluation model now for about a month now. So far, I have been quite pleased with the results. It is helping me to efficiently review a lot of dividend stocks and identify those with strong financials, that are likely to continue increasing their dividends and that are fairly priced.  As I was developing and testing the new model I noticed it had a distinct dislike of Real Estate Investment Trusts (REITs) and utilities.

This got me to looking at these classes of stocks and asking the fundamental question, ‘Are they really quality dividend investments?’ Sure both are known to have above average yields, but as any knowledgeable dividend investor will tell you, current yield is just one small part of what makes up a great dividend stock.

I currently own three utilities and three REITs.  In addition to those, I follow three other utilities and three other REITs. Let’s take a look at some of them and determine if they are good dividend investments:

REITs
Health Care Property Investors Inc. (HCP) – 0 Stars
Debt to Total Capital: 52%
Free Cash Flow Payout: 131%

Realty Income Corp (O) – 0 Stars
Debt to Total Capital: 47%
Free Cash Flow Payout: -65%

Federal Realty Investment Trust (FRT) – 2 Stars
Debt to Total Capital: 51%
Free Cash Flow Payout: 101%

Kimco Realty Corporation (KIM) – 2 Stars
Debt to Total Capital: 55%
Free Cash Flow Payout: -1753%

National Retail Properties, Inc. (NNN) – 4 Stars
Debt to Total Capital: 39%
Free Cash Flow Payout: -144%

Utilities
SJW Corp. (SJW) – 0 Stars
Debt to Total Capital: 49%
Free Cash Flow Payout: -94%

Progress Energy, Inc. (PGN) – 1 Stars
Debt to Total Capital: 56%
Free Cash Flow Payout: -36%

Atmos Energy Corporation (ATO) – 1 Stars
Debt to Total Capital: 54%
Free Cash Flow Payout: 1045%

Black Hills Corp. (BKH) – 2 Stars
Debt to Total Capital: 48%
Free Cash Flow Payout: -105%

Integrys Energy Group, Inc. (TEG) – 3 Stars
Debt to Total Capital: 18%
Free Cash Flow Payout: -47%

Consolidated Edison, Inc. (ED) – 3 Stars
Debt to Total Capital: 52%
Free Cash Flow Payout: -40%

For a company to consistently raise its dividends, it must generate strong free cash flows sufficient enough to meet other obligations, such as debt, before paying a dividend. I look for a maximum of 45% Debt to Total Capital and a maximum of 60% Free Cash Flow Payout with the last 10 years positive.

With the exception of NNN and TEG, each of the above companies failed the Debt to Total Capital and Free Cash Flow Payout tests.  NNN and TEG passed the Debt to Total Capital test while failing the Free Cash Flow Payout test. All the above companies had multiple years of negative FCF over the last 10 years thus their dividends are supported via non-operating cash such as debt issuances and property sales. Ironically, NNN was the only 4 Star stock and it just recently froze its dividend.

Most REITs and utilities may provide your income portfolio with an additional boost in yield, but may end up costing you more in the long run. I will continue to look at REITs and utilities, but they must measure up like any other stock.

Full Disclosure: Long HCP, O, NNN, PGN, TEG, ED. See a list of all my income holdings here.

Long considered the domain for “widows and orphans”, utilities have developed a somewhat stodgy reputation.  Why are utilities considered good for widows and orphans? Here a few reasons:

1. They are generally less volatile than the market as a whole (low beta)
2. Their products are something that people continue to need and use no matter what the economy is doing, thus
3. Their dividends tend to be more stable and secure

Utilities would be the perfect dividend income investment, except for one thing – they tend to have low dividend growth rates. As such, you wouldn’t want a whole portfolio of utilities and you need to be very selective in which utilities are added, and when they are purchased. In my personal allocation, utilities are limited to a maximum of 10% of my portfolio (currently, they make up 3.7% of my total investment portfolio).

In addition to the regular buy criteria, I look for a higher yield when buying utilities, generally greater than 5.5%, but I really prefer around 6%.  This eliminates many utilities, but there are still several from my Stock Ideas page that might be worth an additional look. Here is a list of all the utilities that have paid a dividend for more than 25 years and have a yield of 5.5% or greater:

Vectren Corp. (VVC) – 6.23% Yield
This energy holding company, headquartered in Evansville, IN, provides natural gas and electric energy to more than one million customers in Indiana and Ohio. It also offers energy related products and services to customers throughout the Midwest and Southeast. It has increased its dividend for 49 consecutive years. It last increased its dividend in November 2008.

Consolidated Edison (ED) – 6.29% yield
This electric and gas utility holding company serves parts of New York, New Jersey and Pennsylvania. With its February 2009 dividend increase, ED has now increased its dividend for the last 36 consecutive years. (most recent analysis)

Otter Tail Corp. (OTTR) – 6.35% yield
The company produces, distributes and sells electric energy in Minnesota, North Dakota and South Dakota and has interests in health services, manufacturing and other businesses. OTTR missed is normal dividend increase in February 2009. Instead, the company left its dividend flat with 2008. The last time OTTR increased its dividend was February 2008.

Integrys Energy Group (TEG) – 7.27% yield
This utility holding company serves about 485,000 regulated electric and 1,674,000 regulated gas customers. The company also operates an unregulated energy supply and services business. With its February 2009 dividend increase, TEG has now increased its dividend for the last 51 consecutive years. (most recent analysis)

Black Hills Corp. (BKH) – 7.48% yield
This diversified South Dakota-based holding company encompasses electric utility and integrated energy businesses. With its February 2009 dividend increase, BHK has now increased its dividend for the last 40 consecutive years. Prior to this last increase, the company went five quarter with no increase dating back to November 2007.

Of the five utilities listed above, I would not consider OTTR until the future dividend direction can be determined.  BKH’s late increase is a little concerning, but I could not disqualify it at this time.  I own and am currently purchasing  TEG and ED as their valuations and my allocations allow.

Finally, looking at current and some historic returns over shorter periods of time, certain utilities have done quite well. Remember, there is a reason the widows and orphans own them.

Full disclosure: Long ED, TEG

Here are several companies rewarding their shareholders with higher cash distributions through increased dividends:

• HCP (HCP) Raises Qtr. Dividend 1% to $0.46/share (8.00% yield)
• Aqua America (WTR) Bumps Quarterly Dividend 8% to $0.135 (2.57% yield)
• Avon Products (AVP) Increases Dividend 5% (3.86% yield)
• Black Hills Corp. (BKH) Raises Qtr. Dividend (5.97% yield)
• Infinity Property and Casualty (IPCC) Bumps Dividend to $0.12/share (1.22% yield)
• Ross Stores (ROST) Increases Qtr. Dividend by 16% to $0.11/share (1.24% yield)
• J.B. Hunt Transport (JBHT) Boosts Qtr Dividend 10% to $0.11 (1.64% yield)
• Archer Daniels Midland (ADM) Bumps Quarterly Dividend (1.95% yield)
• L-3 Communications (LLL) Raises Qtr. Dividend by 17% to $0.35, (1.51% yield)

Retirement is not when you want to start learning how to dividend invest. There is a degree of art to dividend investing. Start young, time is always a great ally.

Full Disclosure: Long HCP

(Photo: Steve Woods)