With growth investors battered by declining markets, there is lots of talk about investing for dividends. However, unless the stock provides:
- Yields that are high enough to leave you something after real inflation and taxes
- Protection of the value of your principal and income
Then you can profit only if the market rises. That’s a risky bet these days.
Dividends Don’t Necessarily Equal Income After Inflation and Taxes
Income investors should have a clear idea of what % yield they want when selecting stocks for income. There is a distinct difference between ordinary dividend stocks and dividend stocks for income. Many so called "dividend aristocrats," even with their prices beaten down, pay dividends below 5%. Will this give you a meaningful yield after inflation and taxes?
For example, assume you invest $10k in a stock yielding 5%. Your income is $500. Assuming it's a qualified dividend (will Obama leave that alone? questionable) and no Alternative Minimum Tax issues, your after tax return is $425.
Meanwhile, REAL inflation, for those of us who eat meat and produce, use fuel, consume health care services, has been well beyond the supposed 2-3% of the CPI over the past years, at least 5% - more for the above mentioned items.
Yes we may have some temporary deflation given that we're in the worst economic crisis since the Great Depression, but since the government is committed to printing about 13 Trillion new dollars (about the size of our GNP), inflation is just a matter of time.
But ok let's stick with 5% to keep the math easy.
Nominal after tax income: $425. At 5% inflation, your 10K principle in a flat stock market erodes by $500/ year, leaving you with negative real returns. Yes, the better companies grow their dividends over time, but usually not by enough to meaningfully stay ahead of inflation. In the end, low yield stocks are still just another bet on the market rising. A bad bet these days for the near term.
Quality High Yield Stocks-An All Weather Strategy for Steady Returns
My point is that the best strategy for this market is to seek stocks with the following criteria.
1. High Yields: Unless you're getting a minimum of 8% or more (even that may prove inadequate for most stocks if inflation grows the same magnitude as our money supply), you're not getting income. You're just making a bet on the stock market rising, and getting a bit of opportunity cost covered. Quality high dividend stocks pay you up front and have the solid fundamentals to sustain that high yield and give you steady income regardless of the markets' travails. As long as you don't need the cash for the next few years, you can sleep at night and collect income out of proportion to the risks if you choose the right stocks. See my prior and coming blogs.
2. Steady, Reliable Yields Supported by Healthy Businesses: You need to find stocks with yields that are both high and reliable. High yields usually suggest higher risk, but at times that's a misperception of the market. There are stocks with both high yield AND steady yield because the underlying business is sound and able to generate revenues and cash flow needed to sustain and ideally grow the dividend.
3. Protects Against Declining Long Term Dollar Purchasing Power: You need stocks that give you a hedge against the dollar's long term declining purchasing power, typically those tied to better currencies, hard assets, and that have strong market positions that allow for pricing power.
See my prior and future blogs for stocks that meet these criteria. Ticker symbols of recent mentions include: Atlantic Power Corporation (OTC:ATPWF), Energy Savings Income (OTC:ESIUF), Macquarie Power and Infrastructure Income Trust (OTCPK:MCQPF), Enterprise Products Partners (NYSE:EPD), and Teppco Partners (TPP). For more risk, but lots more potential reward, Enerplus Resources Fund Trust Units (NYSE:ERF), Vermilion Energy Trust (VETMF.PK).
DISCLOSURE: I have positions in most of the stocks I cover.