Illusory Investment Income: The Danger Of Yield


Illusory Investment Income by David Merkel, CFA of Aleph Blog

Yield is an illusion, whether it comes from stocks, REITs, preferred stocks, bonds, loans, limited partnerships, etc.  Yield from investments is not the same as being a farmer with chickens, where each day you can collect eggs, enjoy or sell them, and your net worth is not affected by harvesting the eggs.

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I say this because one has to consider the enterprise paying the dividends, interest, or distributions.  What are the odds that the enterprise might have to scale back or eliminate dividends or distributions?  What are the odds that the enterprise might default on interest payments?

I have said it, and I will say it again: focus on the health and growth of the enterprises, and not on the dividends (and buybacks).  The ’70s had many people buying stocks with high yields, dividends often exceeding what earnings could deliver.

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Some naively say, “Dividends don’t lie.”  Well yes, the money you receive is yours, but is the company as healthy after the dividend?  Will they be able to keep it up?  Often that is not the case.

In an era of financial repression, where the Fed punishes savers who deserve a better return, many reach to try to get a higher income off of investments.  In the process they end up taking a lot of risk that their income streams will be cut through dividend decreases, and outright defaults on interest payments.

Income payments rely on the health of the entities making payments.  This means that an intelligent income investor acts like a value investor, and looks for overall prosperity of the enterprise as security for the payments and growth in payments he would like to receive.

Now dividends and stock buybacks do signal the willingness of management to hand assets back to shareholders and maximize short-term returns to shareholders.  Even debt finance, with an unwillingness to issue more equity is usually a sign of a management team that is shareholder oriented.  But both of these findings rely on the idea that the management team has not overextended itself, such that they risk insolvency, cutting the dividend, or reducing the buyback.

Broader investment variables to indicate growth in the value of the enterprise have more punch than the shareholder income measures.  Look at earnings, book value, growth in book value, cash flow from operations, and free cash flow instead.  And with industrials, sales per share is often the best indicator, particularly in a market like the present one where sales growth is anemic.

Okay, look at the shareholder income-based measures if you must, but analyze:

  • The payout ratio — are they paying out more to shareholders than they are earning?  What if earnings decline?  Will they maintain the payouts?
  • Times interest earned — how secure are the interest payments relative to earnings?
  • How likely are they to safely raise the payouts to equity?  Growth in dividends is often more important the the level of dividends.  The best performing REITs have had lower payouts that grew more rapidly.

Guard the return of your money, rather than seek a high return on your money.  When the  credit cycle turns negative, and it will turn negative, it always does, management teams that have been too aggressive will get punished.  Try to avoid the punishment.

I write this as an equity manager that has an above average yield on investments, but the yield stems from low price-to-earnings, -sales, -cash flow, -free cash flow and -book.  15% of my companies don’t pay a dividend, and I don’t care.  If the management teams have good places to reinvest money to grow value, that is the best place of all to be.  Buffett loves investing excess cash if he can find highly productive places to do so.

With all that said, analyze companies for growth in value, safety, and prudent use of free cash flow.  If income is a part of capital discipline, well good, but be aware of the risks in an adverse economic scenario.  When the tide goes out, we find out who has been swimming naked.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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