For newcomers to investing, the markets can be daunting. I often get many questions from friends and family when they make the good decision to invest their savings instead of spending it. What do I invest in? Are bonds good? What will make me money? Which stocks should I buy? These types of questions are predicated upon the myth that there is some secret to the markets that only a few people know.
The reality is that the financially savvy have a pretty firm grasp on the expected return of most assets and the real question is: what type of risk and volatility are you comfortable with? Or in other words, how much are you willing to stomach seeing your investment drop if you know it will likely come back?
As I noted in my post Why I Rarely Buy Individual Stocks and Most People Probably Never Should, the chances that YOU as a novice investor are going to pick one stock or a few stocks that consistently outperforms the entire market are highly unlikely. The investors that end up having have the best returns put money in index funds and forget about them.
When I point this out to most people, there is usually someone who has a story of how they invested in some hot stock, or in gold or in something exotic like crypto, and they trounced the market return. However this is usually a one shot deal and they beat the market for a year or two. My response to them is always this: so do it again. Then do it again next year, then do it 5 years in a row after that. The chance over time, that with your hot stock or asset, you will beat the stock market or just a boring mix of stocks and bonds in a single fund over time is likely close to zero.
I don’t say these things because I found them on Google one day or through another blog. It took many years of my own investing stumbles to learn these lessons the hard way. I have spent thousands of hours scouring the market for every new kind of stock, bond fund, ETF, factor fund, closes end fund, smart beta ETF, business development corporation, REIT etc. trying to see if I could track down that magic that would get me some great return on an asset everyone overlooked.
Getting to the Dividends
One of those hard lessons I had to learn was about stocks that are known as dividend traps. The dividend yield is calculated as the annualized dividend of a stock divided by its price and expressed in a percentage.
Not all stocks have dividends. Growth companies usually don’t because they have high growth opportunities to put their cash flow towards. Dividends tend to be the sign of a mature company that is generating more money than they have growth projects to fund, so they give the money back to shareholders.
In the US, investors like dividends. In fact it’s been found to be a cultural thing. Investors here expect dividends to climb for years and will dump a company that cuts its dividend. This is not so much the case in Europe and Asia where dividends are cut more frequently. It’s also why corporate bosses care so much about the dividend in the US and are loath to cut it for fear of the market perception.
The dividend yield is also affected by interest rates. Why take the 2% payment from a stock this year if you can get a 3% payment from say, a 30 year bond?
That choice has become more difficult recently though, as low rates and pushed down yields for long term bonds almost to the point where they pay as much as the yield on stocks.
Source: pionline.com
Let’s be honest, yields of 2% on anything are snoozers. Making a 2% return on your money is like watching grass grow. Many people, especially the young and new investors, are looking for double digit returns or at least something more exciting than 2%.
The average annual return of the S&P 500 over the last 147 years is about 9.05%. Of that return, dividends made up about 40% of the return, assuming they were automatically reinvested. So dividends make a huge difference in your long term return. The problems start to arise when people think, well if I just up the dividend then, I will get more guaranteed money and maybe even a better return.
Going Down the Yield Rabbit Hole
This is the logic that usually attracts people to the dividend trap, or the ultra high yielding stocks with fat payouts. Beware though, the companies with high yields usually are paying out now in exchange for a lack of growth or no growth later. For example as of June 2019, these were the stocks in the S&P 500 with the highest dividend yield:
Source: Yahoo Finance
I won’t get into all of these but each has its own unique circumstances. I’ve posted previously about Iron Mountain, the document storage company in a day and age when fewer people are using paper.
Macerich is a mall REIT that owns “town square” type malls with tenants like J.C. Penny and Dillard’s. Malls are in decline due to e-commerce so you can guess as to why this one is yielding a pretty penny.
Altria is the US business of the former cigarette maker Phillip Morris. Smoking is declining in the US as a whole and they occupy the top spot in a shrinking market. A nice yield but a bleak future.
If the high yielding stocks have better business prospects then they may also be highly leveraged and the market anticipates a cut in their dividend to shore up cash to pay creditors back. I’m looking at you AT&T.
The Alternatives
Some investors searching for yield understand the weak growth prospects for stocks like these and instead invest in either closed end funds like the Aberdeen Income Credit Strategies Fund or REITs like Annaly Capital Management, which sport yields of 11.94% and 11.67% respectively.
A closed end fund has a fixed number of shares and capital and usually holds a stable level of assets, usually bonds or bonds with a mix of stocks. The price of a closed end fund fluctuates with the value of the assets or the perception of how they are managed by the portfolio manager. One important aspect of closed end funds to keep an eye on is Net Asset Value or NAV. This is the funds assets minus its liabilities. The stock price of a closed end fund usually follows the NAV but can also trade at a premium or discount to the NAV.
A mortgage REIT on the other hand, has a little more flexibility in terms of issuing shares but as a REIT is required to pay out at least 90% of its income. The difference here is that the assets the REIT can hold tend to be limited to those in the real estate sector. Mortgage REITs tend to hold mortgage bonds, which can contain thousands of originate mortgages within them.
There is no magic to the yields these funds offer though. In both these cases, these funds or companies buy regular assets such as corporate bonds or mortgages yielding 2% to 4% but they then juice these returns by issuing debt. This debt is usually high yielding preferred equity, which they use the proceeds of to buy more assets.
If we assume their underlying assets are paying the high end of that yield range at 4%, that means that about 2/3’s of all the bonds these companies buy are with borrowed money. This also means you get about 3 times the volatility of a regular bond which makes the swings in the price more like a stock. The other disadvantage is that bonds can only increase so much in value so the stock price stays flat over time and you are left to the whims of what the fund decides to do with their dividend for all your return.
I have been watching Annaly for many years and of all the mortgage REITs, it is managed the best and seems to have the best risk and hedging compared to other mortgage REITs. Given Annaly is the best, does its dividend translate into market beating returns? A quick look at their investor relations site offers some evidence.
Source: Annaly Capital Management
Over the past 15 years assuming dividends were reinvested, Annaly returned 170.54% which just barely beats the S&P 500 return with reinvested dividends of 168.5%. Although investing just in Annaly involves much more risk since it is a single company while the S&P 500 is highly diversified. Over a ten year period however, Annaly returned 67.01% while the S&P 500 returned 187.29%. The high yielding mortgage REIT was trounced by stocks over this period.
Conclusion
If you would really like to go behind the curtain of a leveraged closed end fund, take a look at a post I made in 2016 called Leveraging Muni Bond Returns With Closed End Funds. I go in depth as to how one Pimco fund uses high yield debt to leverage returns and the issues that it creates. There is no magic bullet, high yielding funds and stocks either have some fundamental issues or they are highly leveraged and you should expect little upside and a lot of volatility. Be careful out there and keep an eye out for the dividend traps.
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