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Investment Strategy

Roger Conrad’s Three Rules of Income Investing

By Roger S. Conrad, on Jun. 19, 2013

Dividend-paying equities have enjoyed a banner year thus far in 2013, with income-oriented fare surfing a tidal wave of cash chasing above-average yields.

But the influx of capital into traditional dividend-paying equities such as utilities, master limited partnerships (MLP) and real estate investment trusts (REIT) has pushed valuations to frothy levels and depressed current yields. For income-seeking investors looking to allocate money to stocks, the universe of names that trade at reasonable valuations has thinned considerably.

To complicate matters for individual investors, much of the institutional money that’s pushed share prices of traditional income-oriented to record highs isn’t necessarily in these stocks for the long haul. By and large, these asset managers are preoccupied with their quarterly and annual returns–not building wealth over the long-term by buying and holding high-quality, dividend-paying stocks.

Against this backdrop, the momentum-driven capital gains racked up by income-oriented fare sets the stage for disappointment when institutions rotate into other areas and valuations normalize.

The stocks at the greatest risk of a pullback, ironically, are those that have proved their resilience by maintaining–or, in some instances, even growing–their payouts during the Great Recession. Two of our longtime favorites, natural-gas distributor Atmos Energy Corp (NYSE: ATO) and oil-logistics outfit Genesis Energy LP (NYSE: GEL), fall into this category.

Investors tend to focus on underperformers when managing portfolio risk. But a big run-up in a handful of stocks can unbalance your portfolio and lead to unnecessary concentration risk. By pruning your exposure to names whose valuations have outrun their underlying fundamentals, you effectively lock in these gains and insulate your portfolio against an eventual pullback. That’s not to suggest you should liquidate your entire position; take only a portion of your profits off the table and let the rest ride.

Although there’s no credible threat to the dividends paid by the Atmos Energy, Genesis Energy and the coterie of high-quality names that investors have ben bid to the moon, these names face a potential downside of 25 percent or more from current levels when the momentum dissipates. You’d have to collect a lot of dividends to make up for a pullback of this magnitude.

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