The 3 Paradoxes Of Income Investing

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Includes: LTC, WELL
by: Bruce Miller

Summary

For true income investors, sometimes things are not as they seem.

Capital appreciation can be a ball-and-chain to portfolio management.

A sudden hike in short-term interest rates should be a cause for celebration.

A recession and crashing stock market is time for joy and happiness.

As retirees, my wife's and my only sources of income are a pension, modest book royalties and, mostly, dividend income (we will not begin Social Security benefits for several years). With rare exception, I do not sell income securities and I do not reinvest dividends. We rely on dividends to pay our monthly bills and allow us to enjoy the life style we have spent our working years planning for. For the past 16 years, our income portfolio has done just that. So needless to say, dividend sustainability, reliability, dependability and their ability to grow our income portfolio annual income with inflation are paramount to us. My energy in managing such a long term income portfolio is devoted to avoiding picking income stocks which will not be able to sustain and grow their dividends, recognize those income securities we currently hold that show the signs of being unable to 'carry their weight' and pitch out those we've been watching that now demonstrate they are at too great a risk of not being able to sustain their dividend as we expect them to. With rare exception, valuation and price movement have little-to-nothing to do with this process.

In our evolving understanding of the nuts and bolts of pure income portfolio management, we have made some very interesting discoveries along the way. In fact, interesting is really not the right word; counterintuitive would be a better word, or even better yet, paradoxes. A paradox is defined as "something that is seemingly absurd or contradictory to established thought but, in fact, is or may be true". That is the perfect description!

So let's take a look at what I've determined are the Paradoxes of the pure income approach to providing long term reliable retirement income.

Paradox #1: Capital appreciation is unwanted in a taxable account and where possible, should be avoided.

Come again?!?! Seriously?? I mean, since we've been old enough to understand the fundamental concept of buying something and selling it for more than we paid for it, we've put at the core of our investment universe that we must have capital appreciation to succeed. But because an income portfolio produces income from dividends and interest, not from proceeds of security sales, the movement up and down of prices is not a factor. Yes, a declining price MAY be indicative of a company whose fundamentals, hence their ability to sustain their dividend, may be deteriorating OR a price decline may be a sign the economy is improving and investment 'opportunities' are growing elsewhere causing investors to sell boring dividend paying stocks and redeploying their dollars, as happened in the 1990s. In short, price movement is a sensitive but non-specific indicator of changing company fundamentals. Now, certainly, over time, most companies which consistently generate net operational cash flow sufficient to adequately cover their growing dividends are going to see their share prices appreciate….I'm just sure of it. But for the income investor, this could prove to work against their primary investment objective. How so? Let's use an example:

In this case, LTC was purchased in March of 2003 as a long term dividend growing income stock, which it has been. But let's say for purposes of this example only, that in late in 2014 it was announced the Board of Directors is considering replacing the LTC CEO and other officers with REIT Management and Research (RMR) to 'unlock shareholder value'. Ooookay, now I want the heck out of this thing…fast. But due to the capital appreciation of this stock, I'll have to take a dividend cut in moving this investment to a peer healthcare REIT, HCN, of over 18%, with about 12% of this income loss due to the tax on the capital gain. Generally, the larger the realized capital gain in a taxable account, the greater the financial disincentive. So in this fictitious example, I'd have to make a decision: will I just wait to see if the price of LTC drops, as it almost certainly will with RMR in charge, as it has with other REITs managed by them….or sell and take a cut in household income. Capital gains in effect have chained me to the stock.

Of course, how much the tax on capital gains affects one's sell/replace decision will depend. If this all happens within the 15% Fed tax bracket or if in a tax deferred account (such as an IRA), tax expense would not be a factor, while taxable accounts for those in the 25% and higher tax bracket and those with a state tax (Oregon's tax on this transaction would be 9%), the added expense of the tax is indeed a factor.

One way to mitigate this kind of situation for taxable accounts and those in the 15% bracket is to do a periodic sell/immediate repurchase to realize long term capital gains while keeping within the 15% bracket. This would, in effect, raise the tax basis of the stock without any Fed tax liability. And if the brokerage allows for 'deemed sales' (simulated sell/immediate repurchase) there should be no additional brokerage commissions. Another way to mitigate growing capital gains is to be watchful for those brief periods of market inefficiency where an equivalent income-risk income stock is being sold off for this or that reason unrelated to its long term fundamentals and its yield suddenly jumps up as the momentum selling continues. But this requires a fundamental understanding of the company's dividend history and current cash flows and the ability to move quickly, as market inefficiencies for yield do not last very long, in my experience. It also requires careful math to make sure such a full or partial sell/replace makes financial sense.

One last note on this condition. It may be tempting to reach for higher yield to make up for the portfolio income loss due to the tax expense of selling/replacing. But higher yield almost always means more income risk, with the exception of unusual and temporary yield inefficiency (as noted above) there is generally no free lunch. So unless one is willing to take on more income risk, it is important to make sure the replacement income stock is risk-equivalent to the stock being replaced, as I have shown in the above example of comparing LTC and HCN.

Paradox #2: An unexpected hike in interest rates should be cause for celebration

The word on the street today is the Federal Reserve will raise the Federal Funds Target Rate sometime in the next few months by .25% (25 basis points), although this kind of interest rate hike has been predicted to happen 'later this year' for the past 3 years. But let's say the Federal Reserve Chairperson surprises everyone by announcing a full 100bp rise in the target rate, from the current 0%-to-.25% to 1.00-1.25%. Stocks whose interest expense is at least 20% of their Net Operating Cash Flows, fixed income such as preferred stock and investment grade bonds and any securities whose net cash flows rely on an interest rate spread would see immediate and significant price drops causing sudden reduced valuation on such interest rate sensitive securities. Because these are so broadly held, there would almost certainly be a market wide sell-off which, through momentum, would most likely lead to temporary panic selling. It would be pure income investor heaven. Those who have been accumulating cash due to such poor income stock pickings over the past couple of years would feel like home woodworking hobbyists in a Powermatic tool warehouse fire sale. There would be tremendous sales popping up right and left to pick and choose from. Of course, it would be necessary to know which companies would indeed have cash flow compression through a higher interest rate expense that could encumber future dividends versus income stocks that would see little to no negative impact on future cash flows but are simply getting pulled down by the whirlpool effect. But generally, this is a condition income investors don't get to see very often. So when it happens, the true income investor will treat it as the buying opportunity it is, will add to their portfolio income without increasing income risk and will celebrate with much merriment.

Paradox #3: A recession is a time for joy and happiness

Prolonged economic recessions, leading to increasing unemployment, a slowing or even a declining GDP, declining consumer confidence and tale-after-tale of the impending end of life as we know it flowing from the news media - all of this will be led by a gradual sell-off of stocks, with quarter after quarter of reduced earnings projections followed by quarter after quarter of declining stock prices, that seems to worsen with each quarter, as retail investors simply cannot take it anymore and decide it's time to 'get out' with what they have, lest they lose it all. For the income investor, this is a time of jubilation and excitement, as they know that companies which make/distribute what we always want, must have or are addicted to, will continue to provide it, and in so doing, will also provide us the dividends we and the majority institutional shareholders want. Household portfolio income of the true income investors will increase, income risk will most likely decline and nights of restful sleep will reward the income investor.

Sometimes things are not as they seem and so demand careful thought over convention and the noise of media hyperbole.

Disclosure: The author is long HCN, LTC.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.