Ignore Yield

Ignore Yield

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.

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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.

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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 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.

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