The Best Portfolio Protection Money Can Buy

Shares of Apollo Investment (Nasdaq: AINV  ) and Prospect Capital (Nasdaq: PSEC  ) are down 20% and 7%, respectively, since July 10, 2008, yet I've made money on both stocks without shorting or using a sophisticated options strategy.

These aren't necessarily outliers. Using the same strategy -- the one I'll reveal in a minute -- you could have enjoyed 25% or better returns in each of these two "losing" stocks:

Company

Unadjusted Return*

Total Return

N. European Oil Royalty Trust (NYSE: NRT  ) (3.4%) 26.1%
Resource Capital (NYSE: RSO  ) (5.2%) 73.2%

Sources: Capital IQ, a division of Standard & Poor's, and Yahoo! Finance.
*From July 10, 2008, per Yahoo! Finance.

Our family portfolio has done almost as well. Our stake in Apollo Investment is up 18%, while Prospect Capital has returned 33%. Gross losses became net gains thanks to some not so fancy maneuvering on my part.

How did I do it? You know the answer.
Think about what these four stocks have in common and you'll realize how they became winners so quickly. Have the answer? That's right, it's dividends. But not just any dividend -- a high-yielding payout reinvested over the course of years.

And when I say big, I mean BIG. At 8.7%, Northern European Oil Royalty Trust's dividend is the lowest yielder among this group, while Resource Capital pays 15.2% as of this writing. Both Apollo Investment and Prospect Capital pay 10% or more -- more than four times the 2.25% offered by the average S&P 500 yielder.

2 dividend strategies, winners all around
By the end of this article, I'll have another 10% yielder that may be of interest to you. But I should first mention that you don't need huge yields in order to produce huge returns. Fool.com Managing Editor Brian Richards found that following a simple strategy of investing in dividend payers that increase their payouts by 10% annually for at least 10 years tend to produce market-beating results when held over time.

For those seeking market-crushing returns, high yielders also tend to be a good choice. A study by dividend expert and noted finance professor Jeremy Siegel found that over 45 years, the highest-yielding 20% of S&P 500 stocks outperformed the broader index by three times. More recently, Foolish colleague Dan Dzombak invested $10,000 of his own money on a portfolio of 10 high yielders and is reinvesting the proceeds. He's beating the market by more than 3 percentage points as of this writing.

The beauty of effective yield
I'm with Dan. I'm a huge believer in high-yield dividend reinvesting and have been since before Apollo Investment and Prospect Capital help lift our family portfolio out of the dark days of fall 2008. To me, their performance is a testament to the power of effective yield.

What's effective yield? When you reinvest dividends you buy more shares at the stock's price on the day the payout is made. Each new reinvestment brings more shares, and more shares means more dividends. Think of it like compounding interest. Or better yet, let me show you using my stake in Prospect Capital as an example:

Type

Shares

Cost/Share

Annual Dividends*

Cost Basis

Cost-Basis Yield

Purchase 200 $12.29 $320.00 $2,458.95 13.0%
Reinvestment 86.474 $0.00 -- $0.00 --
TOTAL 286.474 $8.58 $347.21 $2,458.95 14.1%

Source: Personal portfolio records.
* Calculated based on 2008 run rate ($0.40 a quarter) and current run rate ($0.101 per month).

Two things should jump out at you in reading this table:

  1. Prospect Capital has cut its annual per-share payout by 24% since I began investing.
  2. My effective yield is 1 percentage point better than it was in 2008 and roughly 4 points better than what today's investors enjoy.

There is a catch, however. Fidelity lets me reinvest free of charge. Most brokers are equally generous, but some holdouts remain. Scottrade doesn't offer reinvesting, for example. (Get the skinny on what the best brokers offer in our Discount Broker Center.)

A great dividend payer worthy of further study
So reinvesting works and it's usually cheap. Now it's time to send you off with a high-yield idea worth exploring. The one I have in mind is one of two found by Capital IQ that:

  • Trade on a major US exchange.
  • Command more than $250 million in market value.
  • Earn 7.5% or better returns on capital (double the risk-free rate).
  • Have increased dividends per share by 10% or more over the past 7 years.
  • Yield 10% or more as of this writing.

One of these stocks is Terra Nitrogen (NYSE: TNH  ) , a 15.5%-yielding limited partnership that specializes in producing and distributing specialized fertilizer. The other is Telefonica (NYSE: TEF  ) , Spain's leading telco and a stock recommended by my Foolish colleague Jordan DiPietro for his Rising Stars portfolio -- and one I'd recommend as well. Want details? Click here to read Jordan's latest thinking.

And when you're ready for more high-yield ideas, I recommend "13 High-Yielding Stocks to Buy Today." This free special report takes you under the hood of some of the market's top yielders and introduces you to a company one of our senior retail analysts calls "the dividend play of a lifetime." Get instant access to the name of this winner and 12 other top yielders by clicking here -- it's free.

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Apollo Investment and Prospect Capital at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader.

The Motley Fool owns shares of Telefonica. 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.


Read/Post Comments (2) | Recommend This Article (10)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 01, 2011, at 2:54 PM, surfgeezer wrote:

    TNH, since being bought by CF, will NOT be getting higher distributions nor is it getting close to a 15% yield now.

    UAN is a better call in fertilizer space if you are willing to take a risk on a brand new co. 1st divvy should be about 10% (1.9?) for year if price stays around 20$. High yield IS my strategy also, but INCREASING high yield is VERY important. I believe PSEC will increase yield from here as they have learned important lessons since they cut.

  • Report this Comment On June 05, 2011, at 10:43 AM, mwaurelius wrote:

    Agreeing with the geezer, the 15% yield ONLY applies if you look at MRQ dividend. TTM is only a little over 8% and the dividend history is highly volatile. Possibly worth consider (I have been) but nothing near what the gem Tim suggests.

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