"What do you mean, get paid while you wait? A stock with a 4% dividend that falls 25% in price is still a losing proposition."

That's from an email I got recently in response to a post in which I added Ensco (ESV) to my watch list.

That is, of course, absolutely right. A 4% dividend gets wiped out pretty quickly when a stock tumbles in price. Ideally, you'd like to buy dividend stocks that never go down in price and that don't share in market volatility -- except to the upside.

Unfortunately, in my experience, "ideally" doesn't exist. In a down market, dividend stocks tend to go down less than the typical stock -- because they have that dividend yield to support their price -- but they do go down. Dividend stocks can also turn in bad quarters, and when they do, they go down in price. Even stocks with long, uninterrupted histories of never cutting dividends, and even of raising them every quarter, can fall in price.

If you're going to wait until you've found a dividend stock that never goes down, you're never going to buy one. Instead, look for the ones that won't go down permanently.

Keys to income investing

Keys to income investing

Today, I'm going to review my 10-stock dividend income portfolio, add a couple of new picks and offer advice on how to avoid losers.

Permanent impairment of capital

If you were going to wait for that ideal income investment that never goes down, you'd never buy a bond, either. Bond prices fluctuate with interest rates, inflation, fear and the credit ratings of the issuer.

What we hope for from a bond is that, despite the fluctuations in price, it will 1) pay the interest promised to buyers and on time, and 2) when the bond matures, it will pay off 100% of its promised maturity value.

Image: Jim Jubak

Jim Jubak

Now, dividend stocks are riskier than bonds. They don't have a maturity date, so they don't carry a promise that you'll get back what you paid on that nonexistent date. By buying a dividend stock, you're signing up for more volatility than you'd get with a bond. Hopefully, you'll also get a higher return than you'd get from a less-risky bond. But you certainly aren't looking for an investment without any volatility.

Indeed, what you're looking for is a stock that pays its promised dividend on time and raises its dividend over time -- and where the stock price doesn't show a permanent impairment of capital.

What's "permanent impairment of capital"? It's what you want to avoid in a dividend stock (and indeed, in any income-investment vehicle). You don't mind if a stock gyrates in value while you hold it, as long as it doesn't go down and stay there. When you need to sell it, you want it to be worth as much or more than you paid for it, so that the yield you earned by owning it isn't wiped out by the drop in capital.

Let me show you what I mean by looking at the stocks in my Dividend Income Portfolio on my Jubak Picks website (registration required) as well as on MSN Money.

It's easier when they go up

Of the 10 stocks in that portfolio, six wouldn't cause a dividend income investor any second thoughts: In the time since I last reviewed this portfolio on May 6, 2011 (or from when I bought them, if I purchased the shares during one of my periodic updates), all six have climbed in price.

Some of the gains were pleasingly hefty. Magellan Midstream Partners (MMP) was up 25.8% from May 6, 2011, through June 29, 2012. Oneok Partners (OKS) was up 31.8%. AmBev (ABV) was up 21.5%.

Some were more modest; although in this market, I'll take modest. General Electric (GE) was up 11.5% from my Feb. 3 purchase through June 29. CPFL Energia (CPL) was up 5.1% from my Sept. 20, 2011, purchase through June 29. Penn Virginia Resource Partners (PVR) eked out a 0.9% gain from May 6, 2011, through June 29, 2012.

In all six of those cases, a dividend investor wouldn't have had to worry about a decline in share price detracting from the yield on the stock. (Just the opposite, in fact, with the gain from price appreciation adding to the income from the dividend.)

Deciding whether stocks in this group were a good or bad income investment during the period is straightforward. You don't have to subtract any losses to capital from the income they generated: the 4.7% yield on Oneok Partners, the 4.8% yield on Magellan Midstream, the 8.5% yield on Penn Virginia and the 6.6% yield on CPFL Energia. Good, straightforward income investments.

In the case of General Electric, with its 3.3% yield as of June 29, and AmBev, with its 3.8% projected yield (because the company pays a dividend only once a year, the trailing 12-month dividend yield can be deceptive), the analysis is equally straightforward. Are the current yields -- and the prospects for increases in company dividends -- high enough to make these good income investments?

In the case of General Electric, which is about to start getting dividends from its financial unit again, I'd say the answer is yes. In the case of AmBev, I'd say the answer is no, and I'm dropping it from this portfolio with this column to replace it with a higher-yielding stock.

Losing makes for tough choice

In the case of the other four stocks in the portfolio, I'm showing losses -- in two cases sizable losses -- that make it important to bring "permanent impairment of capital" into my thinking. Shares of Westpac Banking (WBK) were down 1.3% from my Feb. 3 purchase date through June 29. Kinder Morgan Energy Partners (KMP) was down 7.1% from May 6, 2011, to June 29, 2012. Total (TOT) was down 17.8%, and Banco Santander (SAN) was down 39.1% in the same period.

Although you might shrug off the 1.3% loss on Westpac in light of its 7.7% current yield, the losses on the other stocks are big enough to wipe out all the dividends those stocks paid and more. When you're looking at drops in price like those, the current 6.1% yield on Kinder Morgan, the 6.4% on Total and the 17.6% on Banco Santander aren't especially impressive.

It is correct to say that those losses won't be realized until you sell, and that in the meantime, you're collecting real dividends. (Well, mostly "real." Banco Santander is paying in scrip -- offering more shares instead of cash.)

But that isn't an excuse for thinking those losses aren't real. Your portfolio is poorer today than it was a year or so ago, to the tune of that 39% drop in Banco Santander and that 18% drop in Total.

The big question an income investor faces with underwater positions like these is: Are the losses permanent (or of such long duration that they might as well be permanent)? What do you have to look forward to with these stocks?

Keys to income investing

Keys to income investing

If Banco Santander is going to come back to anything like the $10.20 a share price that I paid in 2010, then it's a great dividend income investment on the basis of its current 17.6% yield (and investors ought to be buying more at the current price). It would be a very attractive total return investment as well. If the trend in the stock is still down, the extraordinarily high yield doesn't matter. A drop of an additional dollar or so per share would wipe out that yield, and investors should sell. (This is especially true for Banco Santander, because the bank has been paying much of its dividend in scrip. If the bank's shares fall, the value of the dividend will, too.)

So the analysis of whether to buy/sell/hold these underwater income stocks comes down to your belief about how permanent the current impairment of capital is.

'Losers' worth keeping

I certainly wouldn't recommend selling Westpac right now, because I think the shares will make back the current minuscule loss when the Australian market isn't so worried about a slowdown in China. I wouldn't sell Kinder Morgan, either, since I think the loss on the stock is a temporary reflection of slower growth in the U.S. economy. Total's shares are down more in the last year (17.2%) than those of ExxonMobil (XOM) or Chevron (CVX), which show 7.8% and 6% gains, respectively, but it isn't out of line with the losses on smaller oil company stocks. Shares of Apache (APA), for example, are down 28.3% in the past year. I expect the price of Total shares to come back when oil prices and demand do -- in 2013, I estimate -- and in the meantime, I'm willing to get paid 6.4% while I wait.

Banco Santander is the tough one in this group. My expectations are that the bank will come out of the current Spanish debt crisis with a bigger market share in its home market of Spain and with much of its global banking kingdom intact. I haven't materially changed my take on the bank since my post on April 13, and I think that the decision of the recent European summit to allow direct capital injections into struggling Spanish banks (a group that doesn't include Santander) lessens the risk that Spain's weak banks will drag down the Spanish government and in turn drag down Spain's stronger banks.

At this point, I'll keep it in the portfolio. But anyone holding this stock should recognize that you don't get paid 17.6%, even in scrip, without taking on a lot of risk.

Check out the 'winners,' too

Your permanent impairment of capital analysis shouldn't be limited to just your underwater positions. You should also try to project the possibility that any stock now above water will join the underwater part of your portfolio in the near future.

The one stock in the positive section of the portfolio that worries me on this basis is Penn Virginia. The company's coal comes from the relatively high-cost eastern United States, and while I understand the company's diversification into natural gas collection and pipeline systems, if I wanted to own more of this kind of asset, I'd look to increase my investment in Oneok or Magellan, or buy Western Gas Partners (WES). I'm selling Penn Virginia Resource Partners from this portfolio with this column.

That leaves me with two slots to fill. One goes to Western Gas Partners. The stock is currently a member of my Jubak's Picks portfolio, but I think it's a better fit with this income portfolio, given its 4.2% yield. The shares have recently pulled back on news that the company was going to sell 5 million new units. The other slot goes to Seadrill (SDRL), another stock that I'm moving over from Jubak's Picks. The stock was down 7.5% from May 1 through June 29, and it now pays a 9.2% yield.

I'll have detailed write-ups of these drops and adds in the next day or so, as I add them to the portfolio.

Performance update

Since I re-launched this portfolio on October 6, 2009, it has traded yield for capital appreciation. The dividend yield on the S&P 500 index ($INX) from October 6, 2009 to the end of June 2012 was 1.97% a year. The dividend on the portfolio averaged an annual 5.7%. In calculating the value of the portfolio, I assume all dividends from the portfolio are distributed to the owner of the portfolio as income and that no dividends are reinvested. The value of the portfolio -- the value of the 10 stocks in the portfolio plus the cash balance, if any, from buy and sells -- has climbed to $120,642 from the original $100,000 in October 6, 2009, for a gain of 21%. During that same period the Standard & Poor's index has gained 29%.

So far, then, that's the trade-off -- about 3.8 percentage points higher annual yield versus a slower increase in the value of the portfolio of a total of about 8 percentage points from October 6, 2009 to June 29, 2012. My hope is that the current impairment in the value of stocks such as Banco Santander and Total won't be permanent. That would clearly change the parameters of the trade-off.

I'll revisit this portfolio on its three-year anniversary in October 2012.

Updates to Jubak's Picks

These recent blog posts contain updates to the stocks in Jubak's market-beating portfolios:

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At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own shares of Banco Santander, Magellan Midstream Partners, Seadrill and Westpac Banking as of the end of March. A full list of the stocks in the fund as of the end of March see the fund's portfolio is here.

Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market-beating Jubak's Picks portfolio; the writer of the Jubak's Picks blog; and the senior markets editor at MoneyShow.com. Get a free 60-day trial subscription to JAM, his premium investment letter, by using this code: MSN60 when you register at the Jubak Asset Management website.

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