“Income” doesn’t mean “safe.” “Growth” doesn’t mean “risky.”
Understanding how an investment generates cash is more important than how it’s defined.
Many investors assume that stocks that pay dividends are inherently safer investments than growth-oriented names that offer no yield.
The logic goes that companies with dividends offer steady income, while gains from growth stocks are ephemeral, based solely on ever-shifting expectations of future earnings prospects and economic conditions.
Investing for growth and capital gains is all too often associated with painful memories of the technology bubble in the late 1990s, when investors shunned value and dividend-paying stocks, bidding up valuations on growth-oriented names to unprecedented levels.
After all, those who drank the New Economy Kool-Aid projected the Internet would offer companies limitless growth opportunities. Some concluded that dividends were undesirable, that companies should reinvest their cash to grow the business.
The folly of chasing growth regardless of valuations became apparent after the technology bubble burst in March 2000. But the easy money polices of the Federal Reserve after 2001 helped inflate an income-stock bubble that was every bit as pernicious as the tech boom-and-bust that preceded it.
The US national average yield on a one-year Certificate of Deposit (CD) collapsed from more than 6 percent at the beginning of the decade to less than 2 percent, an insufficient payout for most investors looking for regular income from their savings.
Unsatisfied with the paltry yields available on CDs, government bonds and other traditional income groups such as real estate investment trusts (REITs), investors were seduced by big yield numbers. And far too many yield-seekers had little regard for underlying business risk.
Bonds rated B by Standard & Poor’s are two levels below investment grade and are considered highly speculative. But at the height of the income bubble from 2005 through 2007, 10-year bonds of industrial companies rated B-, an even lower rating than B, offered a yield less than 300 basis points (3 percent) over the 10-year Treasury bond.
Investors were willing to accept considerable risk in exchange for only a slight yield premium. Ultra-low interest rates, courtesy of the Fed, essentially forced income investors into riskier, more exotic investments.
To meet what seemed an insatiable demand for high yields in a low-yield world, Wall Street created an alphabet soup of preferreds, exchange-traded mini-bonds, trust income securities and income depository securities (IDS).
Although not all are inherently poor investments, many were issued by fundamentally weak companies looking to raise capital cheaply in a yield-hungry market. Predictably, hare-brained, over-indebted businesses offering big yields performed just as poorly as the dubious dot-coms of the late ’90s.
The Great Recession has proven conventional wisdom on the “inherent safety” of dividend payers and the “income at any price” paradigm just as devoid of reason as the growth-centric, “New Economy” mantra of the late ’90s.
Income-oriented stocks largely underperformed the broader market averages in the bear market of 2008. If you had purchased the 50 highest-yielding stocks in the S&P 500 at the end of 2007 you would have lost a little less than 40 percent of your capital by the end of 2008. The S&P 500 was down just 37 percent during the same time frame.
Five stocks in the high-yielding group discontinued their dividends entirely by the end of 2008, one filed for bankruptcy, and 17 cut their dividends by an average of more than two-thirds by Dec. 31, 2008. If you focused on yield without thoroughly examining the underlying businesses, you got scorched. (See “Burned, Baby, Burned.”)
Contrariwise, some of the best-performing sectors since the October 2007 market highs have been groups traditionally thought to be growth-oriented.
For example, the S&P 500 Information Technology Index outperformed the S&P 500 by roughly 12 percent in the two years after the 2007 market highs. The Energy and Consumer Discretionary indexes—both traditional growth-focused groups offering lower-than-average yields—also beat the market.
I don’t recount these facts to disparage income investing; in fact, income stocks should form a core part of your portfolio. Roger Conrad, editor of PF’s Income Portfolio, has always closely scrutinized the underlying business that supports a dividend rather than simply looking for the highest possible yields. This is why the Income Portfolio outperforms year-in and year-out.
But just because a stock offers a yield doesn’t mean it’s a safe investment. Selectivity and careful analysis of the underlying business is every bit as important for income-paying securities as it is for growth stocks.
Likewise, companies that don’t pay dividends aren’t necessarily riskier. If you bought technology and retail stocks your portfolio outperformed those of more income-oriented players in the two years after the ’07 market highs.
The only way to flourish in this volatile market is to put together a balanced, diversified mix that includes exposure to quality income and growth themes.