Ignore Yield by David Merkel, CFA of AlephBlog
Yield is not an inherent feature of an asset. Why?
- Dividends can be cut.
- Bonds can default.
- Taxable income can fall for REITs, BDCs, and MLPs, thus lowering their distributions.
- Bonds sometimes have funny features where they can be called away from you, and you get to reinvest in a lower yield environment.
- With structured notes, your income or principal can be considerably reduced when bad events happen that you thought were unlikely, but really aren’t so unlikely.
Rather, focus on the things that drive the increase in value of an asset. You can create your own “dividends” by selling off pieces of investments that you own. Commissions are small if you have the right broker.
Why do I write this, this evening? I keep running into writers and investment advisors that say, “You need a certain yield? I can get you that yield!”
Yes, and I can get you that yield too, but I would hate doing it because it would expose you to risks that I would not like to take with my own money. People forget all of the dividend cuts in the ’70s. They forget how many times REITs have failed as a group over the past 50 years. They forget how much money was lost on Limited Partnerships in the ’80s while trying to cheat the taxman.
Even Jonathan Clements, a writer who I would recommend to everyone, is somewhat duped by the need for yield. Getting yield from stocks is an uncertain proposition. Focusing on the highest quality stocks, and it is less uncertain, but still uncertain.
One thing is a constant with stocks and dividends — it is better to focus on stocks with low dividends that are growing rapidly, than on stocks with high dividends that grow slowly. The reason for this is that good management teams pay out a conservative amount of free cash flow as dividends, and reinvest most of the free cash flow to grow the company.
It is also not certain that bond yields will rise. The US economy is not strong, and there is no great demand for business loans at banks.
At a time like this, charlatans arrive telling you how high yields can be achieved in a low yield environment. Investment banks offer structured notes with high yields. Don’t believe them. Instead focus on the investments that might preserve or increase value best.
Now for the controversial bit: time to increase allocations to cash and gold (or commodities). You might think, “Wait, are you you saying in a low yield environment, I ought to drop my yield further?” Yes. I am also saying that when yields are too low, the opportunity costs of holding gold or cash are also low, and maybe that will help to preserve value if things go wrong.
I manage stocks and bonds for total return. I don’t look at yield as an important guide to future total return in an environment like this. I try to view all investments through a “What could go wrong?” lens, rather than a “How much cash will this investment send to me next year?” lens.
Here’s a way to think about it. Pretend that all investments don’t make distributions. What investments would you want to own? Which grow value the best? That is your first pass in how you should think about investments. The second refines it by adjusting for tax rules, because some types of income are tax-favored. That said, put value generation first, and tax consequences second.Yield