Volatility and uncertainty have reared their head over the past week, reminding investors that a steady incline in stock valuations isn't a guarantee. In fact, if we look back over the past 66 years of the S&P 500, we'll see 35 stock market corrections of at least 10% based on data compiled by Yardeni Research. Stock market corrections and volatility are normal investing occurrences, and investors should be well prepared when one rolls around.
One of the best ways to proactively protect your portfolio from inevitable stock market corrections is by investing in dividend-paying stocks. Companies that pay a dividend usually have a time-tested business model and a positive long-term growth outlook and are clearly making an effort to put shareholders first. Dividend payments can also help investors hedge their losses during stock market downturns, or they can be reinvested back into shares of more dividend-paying stocks in a process known as compounding, which, over time, can really accelerate your growth.
The big question is where to look for the stock markets' top dividend stocks. If you're eager to add superior income stocks to your portfolio before the next inevitable correction, I'd suggest perusing these three industries.
Among dividend-paying industries, you'll struggle to find any with a higher average annual dividend yield than mortgage real estate investment trust's or mREITs.
Mortgage REITs earn their keep based on the difference between the rate at which they borrow money (since leverage is an important aspect of their business) and the rate of return they get from the assets they hold. In this case we're typically talking about mortgage-backed securities (MBSes). Generally speaking, falling and/or low interest rate environments favor mREITs, since their net interest margins expand as their borrowing costs fall. However, when lending rates are rising it shrinks a mortgage REITs net interest margin, hurting its profitability. We could be entering the latter scenario where profitability shrinks a bit for mREITs as the Federal Reserve looks to tighten monetary policy. However, even with reduced margins, the mREIT industry should still be capable of yields that are between two and four times the average yield of the S&P 500.
A company to consider in this industry is Annaly Capital Management (NLY -3.75%). Annaly primarily invests in agency-backed MBSes, meaning a default on its MBS holdings would be covered by Fannie Mae or Freddie Mac. Though agency-only assets have substantially lower yields than non-agency assets, the added protection of agency-only assets allows Annaly to leverage its portfolio to pump up its gains.
Further helping Annaly has been the subpar inflation and growth of the U.S. economy. Even if the Federal Reserve institutes an interest rate hike this month or later this year, we're still talking about a relatively favorable lending rate environment for mREITs. Currently boasting an 11.2% yield, Annaly or its peers could be worthy of your consideration.
Another smart move investors can consider to proactively prepare for a market downturn is to peruse the water utility industry. Water utilities don't offer anywhere near the same yields as mREITs do, but they'll deliver more consistent profitability and cash flow regardless of how well or poorly the economy is performing.
The allure of water utilities is pretty straightforward: inelasticity. Water is a basic component of life, and if you have a home in America you also likely have a water bill. You may not water your lawn seven days a week if the economy heads into a steep recession, but water usage on a month-to-month basis for the consumer is fairly consistent.
Furthermore, water utilities tend to be fairly consolidated, since it takes a lot of money to lay the infrastructure needed to get a water utility off the ground. This means consumers usually only have one choice as to what company will provide their water services. The upside is twofold. First, it practically eliminates the possibility of competition, and secondly it often means the industry is regulated. While regulation can be a bit of a bummer if a water utility doesn't get approved for a desired rate request, it also means no exposure to wholesale prices and very predictable cash flow (which investors tend to like).
The company I'd encourage investors to look into here is American Water Works (AWK -1.62%), the largest publicly traded water and wastewater utility in the U.S., currently servicing an estimated 15 million people. American Water Works has been masterful at using its cash flow from operations to fuel its steady expansion through acquisitions. Combined with cost-cutting initiatives designed to improve its operating efficiency, American Water Works CEO Susan Story believes the company has 7% to 10% compound annual profit growth potential between 2016 and 2020.
Its yield of 2% might be underwhelming next to Annaly Capital Management, but keep in mind that American Water Works regularly increases its annual payout, and that its shares are up more than 240% since May 2008. Its payout, combined with slow and steady share price growth, could be just what your portfolio needs.
A final industry that's full of attractive top dividend stocks is cigarette producers.
The obvious concern for the cigarette industry is the profiled health concerns of tobacco. The Centers for Disease Control and Prevention have been waging war against tobacco for decades, and the fight appears to be working. U.S. adult smoking rates have fallen from more than 40% in the mid-1960s to just 16.8% of adults as of 2014. This reduction in volume is a challenge for tobacco producers, who've actively had to cut costs in order to maintain their margins.
However, cigarette producers also have two key advantages that should allow their profits to grow. First, competition is minimal. Just a handful of tobacco companies worldwide have the brand-name and marketing capability to attract consumers. More important, though, is the addiction factor of nicotine, which gives tobacco companies nearly unparalleled pricing power. Even with sales falling, many tobacco producers are able to generate profit increase thanks to higher prices and a smaller workforce.
A stock worth considering here is Philip Morris International (PM -1.73%), which operates in more than 180 markets outside the United States. The reason Philip Morris could be a smart choice is that it doesn't operate in the U.S., thus avoiding the United States' stringent tobacco laws and regulatory costs. Even with tobacco laws tightening in some markets, like Australia, operating in more than 180 markets gives Philip Morris an opportunity to hedge its growth. An emerging middle-class in both China and India could more than outweigh higher regulatory costs in select developed markets, giving Philip Morris a clear path to success.
Boasting a 4.1% yield, which is double that of the S&P 500, Philip Morris International, or perhaps its peers, could be a smoking good deal for income investors.