Dividend-Paying Common Stocks: IF Interest Rates Rise…

A Brief Note on Dividend-Paying Common Stocks by David Merkel, CFA of The Aleph Blog

The equity strategy that I have run for the last 13+years always has a slightly higher yield than the S&P 500.  But I never look for dividends.  It’s not a factor in my process. That said, looking for businesses that produce free cash flow, and voila, the dividends appear.

At present, with interest rates so low, many people look at dividend paying common stocks as a means of obtaining income.  They also add REITs, MLPs, BDCs, and an assortment of other things that trade like stocks and have yield.  I don’t think this is a safe way to get yield, at least not now.  Here’s why:

1) Think of the 1970s, when I was a teenager.  Not only were interest rates higher, and inflation eating away at purchasing power, but when companies got into trouble, they would cut their dividends, and often severely.  During that era, you had to make sure that the company was actually earning the dividend, or were they borrowing to pay it.

2) There have been many flameouts in REITs, especially mortgage REITs.  I remember buying broken mortgage REITs in the mid-90s at less than half of their net worth after they had bought exotic CMO pieces, trying to create funds where the value rose as interest rates moved higher.  They got crushed in the early-90s by Greenspan’s hyper-easy monetary policy.  In 1994, as rates were rising, they rallied significantly.

Mortgage REITs also got crushed in 2008-9.  But Equity REITs have their times of trouble as well — they tend to be bull market babies.  When commercial real estate is doing well, they do extra well.  When it goes badly, extra badly for the REITs because of all the leverage.

3) I mentioned 1994.  In 1994, as rates rose, dividend paying stocks underperformed.  The value manager that Provident Mutual used at that time was an absolute yield manager.  In other words, that manager only bought stocks that had a yield higher than a fixed threshold.  At that point, the threshold was 4% or so.  From 1982 to 1993, as interest rates fell, this manager was golden, but it was an artifact of the era.  In 1994, the performance was abysmal.  The manager was replaced the next year.

High yielding stocks paying out a large portion of their earnings as dividends tend to have their dividends grow slowly, because there is little left over to reinvest into new business.  It is akin to owning a bond disguised as a stock.  Lower-yielding stocks often grow their dividends more rapidly, as they reinvest more free cash into new business.  With Equity REITs, the latter strategy has generally been more successful.  Better to buy the lower yielding REITs that grow their dividends faster.

4) The REITs, MLPs, and BDCs that pay out a a high proportion of their taxable income are weak vehicles because they are forced to pay out so much.  During crises, that really bites them.

(This wasn’t as short as I thought it would be.  Oh well.)

Conclusion

If interest rates rise, and I do mean if, because the economy is weak, be ready to see these modern income vehicles take a hit.  If we have a severe recession, be aware that dividends do get cut.  Do not rely on stocks for income.  Bonds are designed for income and return of principal.  Stocks are designed for gains or losses depending upon the underlying business performance.  They aren’t income vehicles, but performance vehicles.



About the Author

David Merkel
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 RealMoney.com. 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.