Dividend Investors Beware: A New Paradigm Shift Is Coming

by: Friedrich Research

Over the last few years interest rates have fallen to historically low levels and investors who have needed income have found a comfortable home investing in high dividend paying stocks. Since banks CDs, treasuries and corporate bonds have paid a pittance, those living on a fixed income (who are also asset rich) have been feeling pretty good about investing in stocks like Century Telephone (NYSE:CTL), AT&T (NYSE:T), Suburban Propane (NYSE:SPH), Verizon (NYSE:VZ) and Altria (NYSE:MO). I mention these stocks because, in my opinion, they have the best financials for those looking for dividend plays.

I am writing this article to convey my worries about the new paradigm shift that I see clearly arriving at our doorstep. This paradigm shift has several catalysts creating it, of which the most important is the signing by the President of the almost $1 trillion health care bill. My job here is not to give my opinion on whether this is the right move or not as you have thousands of pundits on TV expressing their opinions one way or another. My job is to give my opinion on how this will affect the investing environment going forward.

To get to the point, this new paradigm shift is basically that I believe that many high income investors will eventually switch out of dividend paying stocks and move into high growth, zero to low dividend players that have little or no debt on their balance sheets. I say this because with the government printing money like crazy 24/7 and the Congress and President spending money like trust fund babies with an unlimited credit card, there will come a point when the bills will come due and someone will need to pay them. But the main difference between a trust fund baby and the Congress is that the trust fund baby can have their credit card taken away by her parents or trustee, but the Congress has the power to tax and thus will force us to pay the bills when they come due. Imagine a trust fund baby who cannot have their credit card taken away from them and has the power to force her parents to pay the bills. It’s an unbelievable scenario but that is what we are allowing our government to do to us.

So what is coming? Everyone by now knows and those in the higher tax brackets will see their taxes, Federal, State and Local + sales taxes go through the roof. In some states like California I would expect total tax rates to hit 50-60%. So the story going forward is very simple, those who are in these tax brackets will want to reduce their reportable income dramatically and the last thing they want is to own stocks that will just force them to pay higher taxes. Thus, there will be a shift to high growth, zero to low dividend payout stocks with little or no debt on their balance sheets. My guess is to stocks like Apple (NASDAQ:AAPL), Coach (NYSE:COH), NetFlix (NASDAQ:NFLX) and Aeropostale (NYSE:ARO), which have had tremendous run ups in their stock prices recently, and in my opinion can partly be attributed to this paradigm shift as well as their great management.

Just as bonds are selling at levels that remind me of the dotcom days for stocks back in 2000, I feel that High Dividend stock investors are skating on thin ice and the loss of principal could be quite high. I say this because the only reason that most investors are in these stocks, in the first place, is for the dividend. Stocks with high dividend payout ratios usually have little growth associated with them. Thus, if you take away the benefit of the high dividend, you have very little reason to be in them. Dividend stocks like the ones I mentioned above are a lot safer than the majority of high dividend stocks as they have the free cash flow to cover their dividends. But with Capital Gains taxes going from 15% to 28% soon I would expect that most investors who have been in these stocks will sell over the next 8 months and move on to the new paradigm I outlined of high growth and low dividend payout stocks. This will be done mainly to pay the lower 15% capital gains rate.

This will be very healthy for the markets as a whole as more people will stop trading and become long term investors again and invest in stocks with strong Free Cash Flow Yields and strong FROICS.

  • Free Cash Flow Yield = Free cash Flow/Market Capitalization (inverse of Price to Free Cash Flow)
  • FROIC = Free Cash Flow return on Invested Capital or Free Cash Flow/Total Capital
  • Free Cash Flow = Cash Flow from Operations – Capital expenditures
  • Total Capital Employed = (Long Term debt + Other Long term Debt + Total Equity)

To read more about FROIC you can read my instablog here.

And to find stocks that have high earnings yields and high FROICs, I have analyzed all the stocks in the S&P 500 by both parameters to assist you and you can see them by going here.

And once you create a portfolio or analyze your current holdings you can compare your portfolio to the Total FROIC and TOTAL Free Cash Flow Yield for the entire S&P 500 and see where you stand.

· Note: For financial stocks Earnings yield and ROIC were used instead of Free Cash Flow Yield and FROIC as free cash flow cannot be easily determined for many financials so that is my solution to the problem.

When interest rates start to rise you will see that high dividend stocks will need to up their dividends rates to keep up with competing interest rates and inflation. Unfortunately for them, since they are mainly slow growth engines to start with, they cannot use earnings to pay the higher rates, but must borrow money to do so. Thus, you have a slow growing company, forced to borrow money and pay out dividends that are more than what they earn (sort of like Uncle Sam and the states).

This article is written as a warning to investors in high dividend stocks to please do their due diligence, for just like bonds, when interest rates start to rise your principal is at high risk and my motto has always been “Capital Appreciation through Capital Preservation”. I see no Capital Appreciation in bonds or dividend payers over the next few years and see great danger for those investing in them. I envision a scenario of what happened between the Nixon to Carter years of high Inflation + high interest rates. It is coming because the dollar, due to oversupply, must fall. The only reason that it hasn’t yet is that Europe and the Euro are in worse shape than we are. Again, this is just my opinion and one should carefully examine their portfolio and more importantly, talk to their advisor about this new paradigm. If your advisor doesn’t have an opinion or a clue about any of this, then it’s time to get a new advisor.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about. Please note, investments involve risk and unless otherwise stated, are not guaranteed. Past performance cannot be used as an indicator to determine future results. Strategies mentioned may not be suitable for everyone. We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice. Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for you. Before acting on any information mentioned, it is recommended to seek advice from a qualified tax or investment adviser to determine whether it is suitable for your specific situation.

Disclosure: Positions in NFLX, ARO, COH, AAPL. No Positions in VZ, T, MO, SPH