This article is in response to this recent Seeking Alpha article, which discusses the merits and pitfalls of synthetically creating income growth vs. organic dividend growth.
The author uses sound logic to outline how to produce income growth when holding a zero-growth asset. The Income Growth can be similar to Dividend Growth under certain conditions. The main point of his article is that you can grow the income stream synthetically by re-investing it. The same thing happens when you let the interest build in your savings account. You will earn interest on your interest for compound growth whether the actual interest rate increases or not.
While I agree with the principles of creating income growth, both in the first and the follow-up article, there are some aspects that I feel warrant further consideration.
These are my main questions: what income enhancements are applied to the "Income Growth" approach? Are income-enhancing techniques in the "Income Growth" model applied fairly to dividend growth stocks? What would happen if they were?
One income-enhancing method discussed in the article was leverage.
Many of the "Income Growth" funds listed in the original article used leverage to boost income yields. No leverage was applied to the dividend growth stocks. Yet, these two products were compared side by side when considering both yield and income growth.
The author presents reasoning to support the case for using leverage. I will assume (for the purpose of this article) that the author is correct and that the benefits of using leverage outweigh the risks. To compare the products fairly, we should also apply leverage to dividend growth stocks.
- The SPDR S&P Dividend ETF (NYSEARCA:SDY) is an example of a non-leveraged ETF that tracks dividend growth stocks. You could trade this with leverage supplied from your broker.
- ETRACS Monthly Pax 2x Leveraged S&P Dividend ETN (NYSEARCA:SDYL) is an example leverage applied to dividend growth stocks which can be traded from your RIA.
The history of this fund (SDYL) is short. Using Portfolio123 I emulated the SDYL fund by trading the SDY with 2x leverage, adding in 0.30% fees to represent cost of management (or 0.60% expense on leverage) and rebalancing every 4 weeks.
It should be noted that while the dividends are doubled, the current yield is still fairly low (just above 5%).
If you are able to use margin in your own account, you can buy a basket of dividend growth stocks and boost dividend income yourself. The chart below shows the simulated historical return of buying dividend growth stocks with a minimum of 10 years of consecutive dividend increases. The stocks must be in the Russell 3000 universe. I added 0.2% slippage, one percent annual cost of margin and rebalancing every 4 weeks. The minimum dividend yield is set at 5%, so that with leverage, you are yielding at least 10% per annum.
Leverage does have a scary downside, but again, we are not discussing the risks of leverage. The goal here is to compare leveraged products to leveraged products. The above model is just a hypothetical example of how you can trade dividend growth stocks with leverage.
- Options Income
Some of the funds associated with the "Income Growth" strategy utilize the buy/write option strategy. This is where you buy the underlying asset and sell options that are slightly out of the money.
How is this strategy often applied? Every month you can sell call options, which gives the option holder the right to acquire your shares if the price is above a certain level. This will produce income. As long as you hold the shares on the ex-div date (the option holder does not exercise his rights), you continue to receive any dividends. Funds will often write options that can be exercised if prices rise 2% or 3% and which expire one month out. The income you receive from writing the option will remain yours no matter what. In many instances, you can enhance the income return by 0.5%-2% per month (depending on expected or implied volatility). You also have limited participation in market moves to the upside (up to 2% or 3% per month).
Once again, we are not discussing the merits of writing covered calls as opposed to not writing them. I have serious concerns about how useful the buy/write strategy really is for total return. In volatile up markets your gains are capped and in volatile down markets you receive a small hedge. The point being made here is that for fair comparison between income growth and dividend growth, we should be writing covered calls on both products. Either that or we should understand why writing covered calls on debt instruments carries similar risk to dividend growth stocks, which do not write covered calls.
This is a quick example using a real dividend growth stock:
- Verizon (NYSE:VZ): At the of time of writing, Verizon's share price is $49.33. If I own these shares, I can write call options that expire in less than 30 days, which will generate 40 cents per share of income. This translates into a 0.81% total income yield. Multiply this by 12 for a potential 9.7% annual yield in addition to any potential dividends.
You can also purchase the SDY ETF and write call options on it.
If you were to combine leveraged buying of dividend growth stocks with the buy/write method, it is conceivable that you could generate up to 30% annual yields based on your capital. There are some serious risks to doing so, but the point is that we need to compare income enhancement techniques on both bond/debt instruments and equities alike. Or else we need to make a case as to why a certain product with leverage (and/or option writing) has a similar risk profile to a non-leveraged product.
This is by no means an attack on alternative ways to generate income. There are numerous ways to create or enhance income return if that is your objective. I did feel, however, that the comparison between assets using leverage and covered call writing to boost income yield and non-leveraged instruments without covered call writing was imbalanced. If the rewards (in this case yield and income growth) are to be compared side by side, there needs to be a discussion of why the author feels the risk is comparable.
I look forward to reading a future article from this knowledgeable author on how bonds, CEFs, leverage and covered calls can produce better risk-adjusted income returns (such as this white paper does) than dividend growth stocks. I respect the author and think he is onto something, but that "something" needs to have the risk measured before it becomes a replacement for dividend growth stocks.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.