As discussed in my previous articles (here and here), I believe that we are seeing better values among lower-dividend consumer stocks today than among the typical blue-chip holdings like Procter & Gamble (NYSE:PG), Coca-Cola (NYSE:KO), and General Mills (NYSE:GIS). These industry giants pay a fat 3% dividend but are heavily leveraged and trading at historically high multiples. I believe they are likely to struggle with slow growth and weak shareholder returns over the coming decade. In contrast, there are high-quality brands in both the Consumer Staples and Consumer Discretionary sectors that are poised for substantially superior growth, including Disney (NYSE:DIS), Nike (NYSE:NKE), and VF Corp. (NYSE:VFC) that I highlighted previously. I will call these "dGi stocks", as they carry a lower dividend yield but emphasize the cash flow and dividend growth that is essential to healthy long-term portfolio returns.
The dilemma is that while the total returns from dGi stocks might be greater, the immediate dividend yield is comparatively weak. As one author after another has found, including this excellent article by Eric Landis, the high-quality growth stocks in the DGI sector today tend to offer yields between 1.5% and 2.2%. If an investor is already retired, or is retiring in the near future, what options might that investor have to generate the needed income?
TIGHTEN THE BELT TODAY
The first and simplest alternative is to "tighten your belt". While a 4% portfolio draw has historically been well supported by the DGI strategy, most investors have seen their portfolio value rise much faster than the underlying earnings over the last five years. If valuations have expanded by a third, then the sustainable draw (the inflation-adjusted income stream you can take from a portfolio indefinitely) may reasonably have fallen to just 3% of the current portfolio value. Rather than attempting to squeeze the same percentage out of our inflated assets, perhaps we should accept what the market freely delivers? You can still construct a high-quality DGI portfolio that delivers an immediate 3% dividend with solid long-term growth prospects.
The parameters of such a portfolio might vary, but it could include equal allocations to REITs and utilities averaging 4.5%, higher-dividend stocks yielding 3%, and dGi stocks yielding 1.5%. All of these figures are very conservative, allowing an investor to construct a high-quality portfolio with an average yield in excess of 3% while still having a third of that portfolio growing at healthy rates. In fact, such a portfolio might be closest to the classic DGI model before investors felt pressured by the low interest rate environment to "stretch for yield".
While "tighten the belt" is never welcome advice, this might be an attractive approach for a DGI who is looking at massive capital appreciation over the last five years as the market has doubled. (The S&P 500 has delivered a 102% total return since August 19, 2011, and many DGI portfolios have done even better than that.) While a 3% yield today may seem puny, that still represents a 6%+ Yield-On-Cost on a portfolio initiated in January 2011. Surely, that would still be on target for an investment plan? This approach might also be the answer for somebody who agrees that the Consumer Staples giants are overvalued, but feels that the alternatives are equally expensive. Living within what the market gives you freely is always the safest approach. We hear again and again that we should "stay the course", as second-guessing the market leaves an investor open to costly mistakes.
TIGHTEN THE BELT TOMORROW
Of course, we can still construct a portfolio with a higher dividend yield, such as this example from Doug Meeks last year. Unfortunately, the dividend growth has not kept pace with his initial 7% annual target, and the trades proposed are unlikely to boost that growth rate. (Preferred shares carry a fixed dividend, so he will see no dividend growth from the WFCpL position.)
This may be a sensible approach for a retiree who needs the immediate income and cannot afford the lower draw; however, such a portfolio may ultimately prove vulnerable to dividend cuts or erosion from inflation. Many of these companies are highly leveraged and would be squeezed by higher interest rates. Moreover, a portfolio that doesn't grow will run the risk of shrinking! It may not have enough built-in growth to compensate for a wave of dividend cuts.
Thus, this approach would likely be preferred by somebody skeptical of my reasoning. If the Consumer Staples stocks turn in better growth than I anticipated, there is no need to shift strategy. These are companies which have been successful through wars, depressions, and endless market cycles. Perhaps they will also deliver upside surprise through this one? And while investing in slow-growth stocks at high valuations has historically been a bad idea, perhaps this time is different?
ADD HIGH YIELDERS
One common way of boosting the dividend yield for retirement is to filter for higher-yield securities throughout the selection process. While some of the top-quality REITs like Reality Income Corp. (NYSE:O) are trading at yields below 4%, there are others like HCP Inc. (NYSE:HCP) that carry a 6% handle. Your top-quality dividend stocks like PG and GIS might pay 3%, but Flowers Foods (NYSE:FLO) tempts you with a 4% yield. There are moreover some fat yields among the mature tech companies like IBM (NYSE:IBM), in the oil patch like Chevron (NYSE:CVX), and from the cyclical industrials like Ford (NYSE:F) and Boeing (NYSE:BA).
Unfortunately, these stocks offer a higher yield because the market perceives an elevated risk of falling earnings and/or a dividend cut. While it may be wholly reasonable for an investor to salt their portfolio with a handful of these companies, a portfolio that is built by emphasizing yield will inherently be a higher-risk portfolio than one that is built with a consistent emphasis on quality and stability.
An income-managed Closed-End Fund (also known as a CEF) can help manage income needs. (Contributor Douglas Albo covers the sector on Seeking Alpha.) These funds invest in equities, distributing a portion of their capital gains in addition to the portfolio income; ideally, this provides investors with a strong income stream backed by a rising NAV. Unfortunately, they can only manage risk, not eliminate it. In a weak investment climate, a CEF will eventually be forced to reduce the distribution or watch the NAV fall to zero. Those who are uncomfortable with selling shares to fund their retirement should probably be uncomfortable with CEFs that operate this way.
Remember, "There Ain't No Such Thing As A Free Lunch". TANSTAAFL! If you are receiving an unusually fat dividend yield, you are necessarily accepting corresponding risk in the process. It is typically a bad idea to "reach for yield" unless you fully understand and are comfortable with the risks you are taking on.
CASH OUT SHARE BUYBACKS
One possible way to increase the yield of your portfolio, especially applicable to cyclical sectors, is to expand the definition of what makes a "sustainable draw". There is little theoretical difference between a dividend and a share buyback; each is convertible to the other. A dividend is a direct cash payment, which (if not needed by the investor) is often converted into an increased ownership share through a dividend reinvestment program. Conversely, a share buyback increases the ownership share of the remaining shareholders, but can be converted into cash by the sale of a corresponding fraction of the position. For example, Nike has retired 10% of its shares over the last five years. If I also sold 10% of my shares over that span of time, I would end up owning the same fraction of the company that I started with - and would have boosted my cash yield on the position to over 3%!
It is important to note that this is NOT a "decumulation" strategy. If I limit my trimming to the proportion of shares actually repurchased and retired, then I own the same assets with which I started. The share count through which that fractional ownership is mediated is somewhat arbitrary. Moreover, since both the buybacks and the fractional sales execute at the market price, this approach is equally effective when the market is low as when the market is high. The shareholder payout depends only on the funds the company allocates to the buyback. Still, while the above is theoretically accurate, there are a few important distinctions between a dividend and a share buyback.
First, share buyback programs do not always result in the shares actually being retired. Coca-Cola spent over $17B on share buybacks from 2012 to 2015, almost as much as it spent on dividends, yet despite this heavy spending the company retired only 241 million shares (5% of the total outstanding) at an average cost of over $70 per share retired. The remaining shares were re-issued, perhaps as part of their lavish executive compensation package? An investor needs to focus on the shares that are actually retired, not the headline number.
Second, share buybacks have recently been boosted by debt issuance. For example, 3M (NYSE:MMM) spent almost $11B on share repurchases from 2014-2015, but funded 40% of this through the issuance of new debt. While this increase in leverage can be wise given the very low cost of debt at this time, it should be treated as a one-time event and factored out of the cash flow analysis. I would not recommend cashing out shares that were repurchased through debt issuance.
Finally, perhaps most significant to an income investor, a dividend is seen as a commitment. Companies will borrow to fund the dividend through an economic downturn, while a share buyback program will be (and should be) suspended when cash flows are insufficient. The last recession saw S&P 500 buybacks fall from 5% of market cap to 2% of market cap, a decline that would be even more dramatic in terms of dollars actually spent (since the shares were being repurchased at much cheaper valuations at the bottom). Dividends also dipped in 2009-2010 but only by 25%.
In conclusion, while matching share buybacks with fractional sales can be a sound way of drawing income from positions in companies with active and sustainable share buyback programs, it requires watching the financial reports and debt levels carefully, and is less reliable through a recession. It would be a mistake to rely on this to cover your essential budget.
SELL THE UPSIDE
The whole rationale for exploring this topic is the presumption that we are thinking about replacing a higher-dividend company in our portfolio with a lower-dividend company that enjoys substantially stronger growth prospects, replacing a Dgi stock with a dGi stock. If there were only a 1%-2% difference in the growth expectations, we would be comfortable sacrificing that for the higher and steadier dividend payout. Yet, an investor who does not need rapid growth might consider selling some of that upside potential in exchange for immediate income. For example, Nike closed on Friday at $55 and change, while paying an annual dividend of 64 cents. If your goal is to generate a 3% cash yield on the position, you would need to increase that by roughly $1 per year. In comparison, a January 2018 call option with a strike price of $70 closed at $1.41 - more than enough (even after commissions) to bridge the gap between the actual dividend and the desired yield.
When you "write a covered call", you are selling somebody the right to buy your shares on (or before) the specified date at the specified price. If the shares increase in value to close above the strike price on the date the option expires, then whoever holds the option will choose to "call the shares". You will then receive proceeds equal to the strike price. If the shares fall below the strike price, then anybody could buy the shares more cheaply on the open market, and thus the option will not be executed and expires worthless. When you write a covered call, you retain ownership of the shares, rights to the dividend, full exposure to the downside, but sell any potential upside gain beyond the strike price.
If I write the described call option on my Nike shares at $70, then I receive immediate proceeds of roughly $1.41 per share (you can consider that an immediate dividend) in exchange for agreeing to cap my gains over the next 16 months at $15/share. In contrast, an investment in PG will pay me that same 3% as a dividend, even without options, but offers limited potential for gains given the already-high valuation. I can write the described covered call on Nike and still enjoy every penny of a 10% gain, a 20% gain, or even a 25% gain over the next sixteen months. The shares would only be called if the gain exceeds 27%, comparable to PG shooting past $112. How much do I lose by selling the upside beyond that point? Is that a price you might be willing to pay to boost your immediate income?
While this is not intended to be a tutorial in writing covered calls (that merits a full article by itself), I should also highlight some cautions against this strategy. First, both markets and individual stocks are volatile. While I would currently be happy to sell Nike at $70 (I see "fair value" in the $55-$60 range), it is easily possible that they could surprise me with some strong quarters and an improved outlook. I could ultimately be giving up more than it seems today. Second, we need to remember TANSTAAFL. My counterparty in an options trade is most likely more sophisticated and better informed than I am. On average, I should expect an options trade to cost me money (because my counterparty is very likely expecting a profit). The goal should not be to improve my expected returns but to complement my fundamental investment strategy - in this case to generate a greater income stream from a position that otherwise doesn't pay much. Third, while an option like this will usually expire worthless, leaving me with a clear gain, I need to be prepared for the scenario in which the shares are called away. I could conceivably repurchase Nike with the proceeds; however, I would be paying a higher price and receive fewer shares. Most likely, I would need to find another cheaper investment. NEVER WRITE CALL OPTIONS ON A POSITION YOU ARE NOT WILLING TO LOSE AT THE STRIKE PRICE. Finally, I believe options are taxed as short-term capital gains, and if the shares are called away, you may realize a tax bill on that position as well. My own options positions are held within IRAs, thus avoiding that issue, but if they were held in a taxable account it would further complicate the strategy.
In conclusion, writing covered calls can be a sensible strategy for a moderately sophisticated investor who is comfortable capping their potential capital gains on a position in exchange for greater cash income on the position. It has the added benefit of reducing overall portfolio volatility, as the option is a "short" position, partially hedging movements in the underlying stock position. The option trade wins when the stock loses, and the option trade loses when the stock wins. Thus, it can somewhat reduce portfolio risk, in contrast to some of the previous strategies discussed which substantially increase portfolio risk.
CREATE YOUR OWN DIVIDEND
The final answer to our dilemma, my personal favorite, borrows from the "planned decumulation" playbook, selling a small fraction of your shares each year to generate income. Of course, since you never want to be selling shares into a bear market, an investment strategy that relies on selling shares to generate income must have a plan to avoid this hazard. Think of a bear market as a "chasm" in the landscape - you need to plan a bridge to cross that chasm.
Historically, bear markets have generally lasted two years, with a recovery that can easily take another two to five years, but the key danger to your portfolio is a shorter window around the bottom. For example, while it took roughly seven years for the market to regain its 2000 highs, an investor could have sold in 2001 or 2004 (or thereafter) for just a 20% loss from peak. Any investment plan should have enough of a safety margin that a 20% loss should not sink it! Thus, the investor merely needed to avoid selling in 2002 or 2003. We saw a similar pattern in the Financial Crisis, where an investor could have sold in 2008 or 2011 at a loss of less than 20% and merely needed to avoid selling in 2009 or 2010.
Keep in mind that we are not talking about fully cashing out a portfolio. We are discussing ways to generate an additional 1.5% income on the fraction of the overall portfolio (a third?) that is invested in dGi stocks, perhaps selling 0.5% of the portfolio total annually on average. You can "bridge" a two-year gap on this income by holding just 1% of assets in cash. You can skip these planned sales for five years by holding just 3% in cash. I would argue that a conservative income investor deserves even greater insurance; consider holding an amount in cash equal to 20% of the assets invested in these lower-dividend growth stocks. If 30% of the portfolio is invested this way, then hold at least 6% in cash. If 50% is targeting growth, then hold 10% in cash.
Thus, instead of targeting a 4% portfolio yield with 100% of assets, as Doug Meeks attempts, an investor might consider a 2.5% portfolio yield with 80% of assets. The remaining 20% would then be held as cash, or as CDs laddered over ten years. The investor would still have the bulk of assets invested in high-quality stocks paying growing dividends, the essence of a DGI strategy, but would not rely solely on that portfolio for immediate income. Consider how the numbers might project over a ten-year time frame?
In the scenario below, the portfolio yielding the initial 4% dividend grows at a 4% rate, while the lower-yielding portfolio grows at a 9% rate. These are essentially optimistic projections, likely not achievable across a recession, however a recession would likely threaten the dividends in the higher-yielding portfolio, and thus any projections in that scenario would be speculative. (Remember the high levels of leverage we are seeing. I have greater confidence in the ability of a high-quality growth-oriented portfolio to withstand the next economic downturn than in leveraged companies carrying a high dividend.) The $20,000 initially reserved as cash is more than sufficient to bridge the dividend gap between these portfolios over a ten-year period, as that gap can be expected to slowly close.
Note that even after ten years, the dividends from the lower-yielding portfolio have not caught up. Dividend House argues in this article that we cannot expect that to happen in any reasonable time frame. You should not ignore the anticipated principal growth, however, or the implications that holds for a longer-term strategy. If share prices appreciate in step with the projected earnings and dividend growth rates, the dGi portfolio will end up with 28% greater value than the Dgi portfolio, despite an identical income stream (supplemented from the cash allocation). So where does that leave us after ten years?
- If growth is robust and inflation remains low, our investor may find that the ending dividend from the dGi portfolio is sufficient to meet ongoing income needs. In that case, no further changes are required, and the portfolio will continue to supply a sufficient and growing dividend stream.
- If the market remains strong, our investor could revisit this plan in five years and pull out additional cash (perhaps another 10%) to extend this strategy. This approach need not have a "sunset" as long as market conditions then are similar to what we see today.
- Of course, I would not want to adjust this strategy in the throes of a bear market! But the worst part of the bear market is short lived, and rational trading will resume on the other side. We are seeing unusually high valuations across the Dgi portfolio at this time, with little difference in forward P/E between faster-growth and slower-growth DGI stocks. Thus, while a market correction would take both portfolios lower, there is not fundamentally any reason that one should suffer worse than the other. The modeled 28% difference in terminal value would likely be sustained across a recession, even if the actual returns come in much lower. An investor could "change tracks" following a recession and still come out ahead.
I find this solution to our dilemma to be the most compelling, especially for less sophisticated investors who might not be wholly comfortable with options. As Robert Schwartz puts it, we need to achieve some balance between "pay me now" investments and "pay me later" investments. But the simplest way to "pay me now" is to sell a few shares and bank the proceeds. Higher-dividend securities are trading at historically high valuations, so you know you are getting a good price on anything you sell today. Is there any reason not to take advantage of this opportunity to assure your next five years of withdrawals? Or even a ten-year bridge (supplementing dividends) as described above?
Having done so, this extends your investment window from the immediate present to a 10+ year time frame. This allows the investor to focus on companies that are showing growth and will be paying fat dividends ten years from now, rather than excluding any that do not provide an immediate income stream. This is not to say that an immediate income stream is bad, since compound reinvestment of dividends can generate long-term growth, but if it is not necessary, then I have a wider range of investment options. Some of these appear to be trading at favorable valuations in the current market.
In conclusion, I believe investors today should strongly consider a substantial cash allocation to their portfolio. While I understand the urge to "put the cash to work", we could view this 10% allocation as cash that has already completed its work in the market run-up over the last seven years. Now that the market is fully valued again, having a few dollars "taking a breather" should not imperil your portfolio goals. Equally importantly, this cash allocation allows the remaining 90% to "work harder", allowing the investor to take advantage of the relatively better values among the lower-dividend growth stocks. This is a reduced-risk strategy, since cash gains value (buys more shares) when the market falls. A cash allocation is the perfect option, committing the investor to nothing while allowing full flexibility to take advantage of any opportunities that arise.
If you believe as I do, that higher-dividend DGI favorites are currently overvalued by 25% or more, then a dividend growth investor faces a dilemma today. How can we generate a sufficient immediate income without sacrificing the growth that is necessary for the long-term health of our portfolio? This is not a challenge for my own investing, as my personal version of DGI is implemented with a total-return focus over the next decade; however, it is a very serious question for somebody who is retired or who expects to retire in the near future. Do you:
- Tighten your belt to live within the new investment reality of lower returns?
- Live in the present and hope that the future is better than my fears?
- Cash in your share buybacks to supplement the dividend?
- Accept higher risk in your portfolio to bridge the yield gap?
- Trade upside potential for income?
- Hedge against volatility with a substantial cash allocation?
Just remember the principal of TANSTAAFL. One way or another, we pay for anything beyond the "risk free return" that is typically represented by Treasury yields. We can only hope to understand and manage the risks involved.
Disclosure: I am/we are long MMM, AMGN, AAPL, BDX, BA, CSCO, KO, CVS, DIS, F, GILD, SJM, JNJ, NKE, PG, UNP, UTX, VFC, WFC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.