Stop Dumping On Dividends
Income seekers, I feel for you. (I like income as well, so I feel for me too.) Bad enough the Fed has been attacking for ages, pushing benchmark interest rates far below what anybody who knows anything about business understands to be the make-or-break cost of capital. But it seems as if we’re also under attack any time we try to get what we can in this murderously difficult environment. We’re told junk bonds are rotten (I’m one of those who says this.) Higher-yielding mortgage REITs are also dicey. The long end of the yield curve is a tax loss waiting to be realized. And even those who pursue the most classic equity strategy of all, dividends, are told we’re doing wrong. Enough! With all the real problems we have, let’s at least stop dumping on dividends.
Naysayers Gone Wild
Here’s just a smattering of what’s out there against dividends.
- They’re taxed as income versus capital gains (subject to one’s ability to unravel the regulatory mysteries of qualified dividends). My answer: I want to pay as much taxes as I can, because that means I’m making m-o-n-e-y. If I’m worried about reducing taxes, I know how to generate losses by investing in garbage (see, e.g., long-term fixed income).
- It’s not about yield, it’s about total return. My answers: (1) Not if you need the cash now, as many do. (2) Not if you want to control risk by realizing some positive returns now rather than risking the potential for all or part of today’s unrealized positive “expected” returns to become tomorrow’s realized “actual” losses.
- The more yield you get, the lower your potential growth. My answer: If you want growth, go for growth; nobody’s stopping you. If you want/need income, tell growth investors to do their own thong and mind their own business. And see # 2 above. There’s a difference between “expected” growth and “actual” income. That said, while income seekers don’t pursue firms expected to grow from nothing to something, or from small to large, there are legitimate growth choices that can be made within the context of a dividend strategy, as will be discussed below.
- Empirical evidence does not show a meaningful relationship between yield and return. My answer: Statisticians who say this need to go back to school and learn how to define research questions. Nobody who matters cares about the correlation between yield and return. Those who matter and know what they’re doing are smart enough to know they need to do some analysis and weed out yields so high as to suggest serious risk of dividend cut or elimination.
- Income stocks are overvalued. My answer: Yes, they are. But so, too, is everything else. That’s what happens when the cost of capital is driven down to about zero. Always has. Always will. The question is what, if anything, we can do about it. And income investors, by getting portions of their returns up front, at least have decent opportunities to keep reinvesting and, in essence, averaging down their cost basis (similar to what happens with high-coupon low-duration bonds). And since dividends come out of corporate profits, the potential for higher profits to result front a better economy that allows rates to rise allows for dividend growth and enhances the reinvestment opportunities. This isn’t as good as buying things that are undervalued on day one. But if one has no choice but to buy things that are overvalued, at least this approach gives the investor a fighting chance to ultimately succeed.
Approaches to Choosing Income Stocks
Essentially, equity income investing boils down to two important choices:
- Current Yield versus Safety: Yields that rise very high tend to do so not so much because dividends are generous but because the stock price is weak, and that reflects market fears regarding the future of the dividend stream and possibly even the company. The higher the yield you accept, the more you need to scrutinize dividend security through whatever analytic approaches you choose. And there is something to be said when screening for yield to not only set a floor (a minimum acceptable yield) but also a ceiling (a maximum allowable yield).
- Current Yield versus Dividend Growth: There is no right or wrong answer here. One’s choice of a position on the continuum should be based on one’s goals and needs for immediate cash. Lower yielding stocks are associated with companies for which the investment community sees more opportunity for dividend growth, a significant consideration when rates are expected to rise due to an improved economy. Higher yields (in the below-junk-yield area) are associated with expectations of lesser dividend growth but produce more here and now cash which can be used for reinvested (if not needed for consumption), also important in a rising rate environment. Again, there’s no right or wrong choice. The only thing you need to get right is your assessment of your own situation and goals.
The Smart Alpha Equity Income Approach
The Smart Alpha Equity Income portfolio, (available for free on portfolio123.com), the stocks in which have yields that average 3.5%, sits near the middle of the current-yield-versus-dividend growth continuum possibly shading a bit toward the current-yield side of center.
As to dividend security, it takes an unusual approach, one we believe allows us to push the yield higher than it would be elsewhere for the level of safety we seek. Rather than betting our chips on such traditional standbys as payout ratios (which are necessarily backward looking), we use a constellation of general fundamental quality metrics (which we believe are indicative of future dividend safety) and sentiment indicators. The latter is unusual, but our observation and research suggests Mr. Market is actually quite good at assessing dividend risk and we think the qualitative considerations he brings to the table are valuable (we are, after all, dealing with future expectations, rather than naïve assumptions that what we saw in the past will persist going forward). For more on our approach, click here.
Figure 1 shows performance of the model since it went live on 10/23/15.
Figure 1
(Click on image to enlarge)
Image from Portfolio123.com
The Stocks
This portfolio is refreshed every three months and this is a strategy for which it is normal to see the roster of stocks turn over heavily each time. In the refresh that just occurred, only three stocks out of 20 remain from the prior three-month period: Best Buy (BBY) and Cracker Barrel Old Country Stores (CBRL), and Universal Insurance (UVE).
It’s tempting to assume income stocks, being more stable, should be amenable to longer holding periods and low turnover. But that notion owes more to folklore than the realities of the world, where things change all the time, especially yields and expectations of future performance and risk. That’s why I take the trouble to control transaction costs by using a very low-cost firm (in my case, Folioinvesting.com), rather than hold onto stocks the data is telling me ought to be sold.
Figure2 shows portfolio characteristics of the current list.
Figure 2
(Click on image to enlarge)
Image from Portfolio123.com
The biggest change from the historical norms is the reduced stake in the theme we refer to as “Population Growth.” Others refer to this group as “defensive.” The key is that prospects for the companies are not so much tied to the ups and downs of the economy but to the existence of people per se.
Considering what we think it will take to make this strategy viable in a rising rate environment (improved economy, improved profitability and growing dividends), it makes sense to see a reduction in exposure to the group least likely to be impacted by stronger economic activity (the historical average allocation to the Population Growth theme is 22%). Much of the reduced allocation to Population Growth was taken up by increased exposure to Financial (seen by many as a direct beneficiary of higher rates) and “Innovative” (tech and other R&D intense areas which stand to benefit from better levels of global economic activity – more so tech than, say, pharma).
Table 1 lists the current portfolio:
Table 1
Ticker | Company | Yield % |
BBY | Best Buy | 3.23 |
CA | CA Inc. | 3.12 |
CATO | Cato Corp | 4.34 |
CBRL | Cracker Barrel Old Country Store | 4.57 |
CMP | Compass Minerals International | 3.44 |
CSCO | Cisco Systems | 3.40 |
EBF | Ennis | 3.99 |
EMR | Emerson Electric | 3.38 |
GIS | General Mills | 3.01 |
HCI | HCI Group | 3.34 |
HF | HFF | 5.91 |
IBM | International Business Machines | 3.33 |
MCD | McDonald's | 3.06 |
MED | Medifast | 3.14 |
MXIM | Maxim Integrated Products | 3.39 |
PAYX | Paychex | 3.05 |
TAX | Liberty Tax | 4.30 |
TGT | Target | 3.09 |
UVE | Universal Insurance Holdings | 2.68 |
VFC | V.F. Corp. | 2.98 |
Disclosure: I’m long all stocks referenced in Table 1.