Investiv Daily Sunday Edition

[Sunday Edition: Pitfalls & Risks Of Chasing Yields] By Thomas Moore on January 1, 2017 When the purpose of your investments is to generate useful income, it’s natural to look around at all of the different investment vehicles available to you to find the highest yield for your dollar. The problem is that in today’s economic environment, investment yields work much differently than they did 20 or 30 years ago. As a kid, I spent a lot of time hanging out with my Grandma. She wasn’t wealthy, but she had been a careful saver for her entire adult life, and so by the time she decided to stop working, she had a comfortable nest egg built up to supplement her Social Security income. I remember once a month or so she’d go to the bank to put money from an expiring CD into a new one. Throughout the 1970s and 1980s, CD rates never seemed to drop below 8%, and were often in the double-digits. That meant that a saver like Grandma could earn a nice, comfortable level of interest with practically zero risk. By the time I entered the workforce full-time to start supporting my own family in the early 1990s, the picture had already changed. The savings I was so carefully trying to build following Grandma’s example was now earning around 3% – if I was lucky. I did the math and quickly figured out that the bank wasn’t really doing much to help me out except giving me a place to put money and write checks. The really sad part of the story is that since then, the picture has really only gotten worse. CD rates in the late 1990s hovered between 4% and 5% before dropping below 3% by 2003. After temporarily rising a little above 4% in 2007, they plunged yet again, and have not recovered since then. Every drop in the last 15 years has been spurred by Fed policy, which was intended to encourage small business investment and spur the economy. At the beginning of this year, the average rate on a 5-year CD was less than 1%; as of today it has risen to about 2%. The picture for other “safe” investments isn’t really any better. A 5-year Treasury bond is offering a 2.08% yield. The only way to get even close to 3% is to buy a 30-year bond, which will give you all of 3.18%. And even though the Fed did actually raise rates another .25%, and even though they have “pencilled in” three more hikes in 2017, their monetary policy decisions since the beginning of 2015 should make it obvious those hikes are anything but a given. When the yields on so-called “safe” investments are so low—and they stay that way for years at a time—that you couldn’t do much worse by stuffing your savings under your mattress, there is a real problem. Even careful, conservative savers like my Grandma start to look around for alternatives. In the 1990s when I saw such deplorable yields, and reasoning that I was young with time on my side, I decided I could be more aggressive, so I started putting my savings into stock mutual funds. Why not? The stock market then was in the midst of its biggest bullish trend to date, and earning a 20 – 25% return per year from a diversified mutual fund sounded a whole lot better than the measly 2 – 3% I might get from a CD. We find ourselves in much the same situation today, with otherwise sensible, conservative people starving for useful yields. Fed policy today seems as determined to keep propping up the stock market as it has been in the past to encourage small business development, and as a result people who would normally gravitate to more conservative vehicles are discounting the stock market’s inherent (and, I believe, increasing) risk. As an income investor, I see this trend manifesting itself in a couple of the areas my system is designed to focus on: stock dividends and put sales. Chasing Dividend Yields About a year after we started our Retirement Revival and Rebel Income services, I started seeing an increasing number of articles and news stories about the usefulness of dividends in a long-term investing plan. At the time, it made me smile, not only because it was validating what we were already doing, but also because I hoped it would encourage people to look more critically at the investments they were making. Since then, it seems like I’ve begun seeing an increased emphasis on high-yielding dividend stocks. The longer the market’s current bullish trend lasts, the more people seem to think the stock market is a can’t-miss place to put their money, and if that is true, why not look for the stocks offering the highest dividends right now? What I think is being ignored is the reality that dividends, while being an important part of a company’s fundamental profile, by themselves do not equate to fundamental strength. Recently I pulled a list of some of the stocks offering very high dividend payouts right now. I then screened those stocks based on a few simple fundamental measurements that I felt would help frame their high yields in contrast to, or in support of the company’s core financial and operating strength. Let’s take a look. Stock Price Dividend Yield ROE Debt/Equity Debt/FCF [FTR] $4.09 10.22% -10.06% 3.34 10.21 [NRP] $27.08 6.42% -128.31% 7.98 5.33 [WMC] $10.35 21.53% -7.98% 5.03 24.29 [CELP] $10.23 15.94% -8.46% 5.96 9.57 Investors who are simply looking for the highest dividend yield might be tempted to load up on shares of a stock offering annualized dividend yields as shown above, but the Return on Equity (ROE) and Debt/Equity numbers alone should be enough to give anybody pause. I added the final column to enhance the risk picture even further because I put a lot of emphasis in my fundamental evaluation on Free Cash Flow (FCF). It isn’t all that unusual, or even problematic to see fundamentally strong stocks carrying a higher level of debt than they do cash. I’ve written before about the fact that debt, in and of itself, isn’t automatically a bad thing in business. The question is whether a company is managing its debt effectively enough to use it as a tool to enhance their business. I don’t have an absolute cut-off level for where a company’s debt versus Free Cash Flow should be, but as much as possible, I prefer to see Free Cash Flow within shouting distance of a company’s total debt. A ratio as close to 1 as possible is preferable, but as high as 2 or 3 is usually okay too. Much higher than that, though, and my concern about what the company is using debt for, and their ability to manage that debt rises. The stocks in the table above are working with very high levels of debt – so much so that I believe the risk to an investor is much higher than that I would prefer to accept. Their ROE numbers, showing that these are extremely inefficient companies, certainly call into question how their boards can justify paying such high dividend yields. If you’re looking at a stock offering an outsized dividend yield, take the time to look more closely. You might find elements like what I’ve used here that indicate the stock isn’t really as attractive as it might seem. Dividend yields can get pumped up in a few different ways – a large drop in the stock price while the company keeps the dividend consistent, or possibly even increases it, for example. That may not be a bad thing, but if the company’s operating strength doesn’t justify the dividend, there might be something else going on. Chasing Put Selling Yields This next danger isn’t as common, simply because put selling isn’t a widely used trading strategy, but it’s just as real. There’s a temptation when you start using put options to generate income to look for the highest yield available in the shortest period of time possible. My experience is that stocks with outsized put sale yields usually also carry more risk than the stocks I prefer to use. Take a look at these examples. Stock Price Put Yield Price/Book Debt/Equity Debt/FCF [DB] $14.56 5.56% 0.26 2.48 19.55 [NRP] $27.08 5.56!subscriber_id!delivery_id!MVL_311650320!subscriber_id!delivery_id!MVL_311650321!subscriber_id!delivery_id!MVL_311650322!subscriber_id!delivery_id!MVL_311650323!subscriber_id!delivery_id!MVL_311650324!subscriber_id!delivery_id!MVL_311650325!subscriber_id!delivery_id!MVL_311650326!subscriber_id!delivery_id!MVL_311650327!subscriber_id!delivery_id!MVL_311650328!subscriber_id!delivery_id!MVL_311650329!message_url!contact_email!account_organization!account_address1!account_address2!account_city!account_state!account_zip!forward_url!manage_url!poweredby Disclaimers Investing is Inherently Risky There are risks inherent in all investments, which may make such investments unsuitable for certain persons. These include, for example, economic, political, currency exchange, rate fluctuations, and limited availability of information on international securities. 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