We all know that rates are low, but have you looked at what's available recently? Take Wells Fargo (NYSE:WFC) as an example. A standard rate, 1-year certificate of deposit at the bank pays 0.05%. If you started with the minimum $2,500 required balance that would equate to collecting $1.25 during the course of the year, just a dime a month.
Granted with a linked account, higher starting balance and longer term (up to 58 months) you could "boost" this to up 0.55%, but still it's obvious that you're not going to have much (or any) return generation in this arena. Naturally that could be the point - a guaranteed higher balance - but I would contend that the potential loss of purchasing power is just as large of a risk here.
Common shares of Wells Fargo currently trade hands around $46. The company is in the middle of paying out a $0.375 quarterly dividend or $1.50 on an annual basis. This equates to a "current" yield of about 3.3%. Instead of collecting $1.25 on a $2,500 investment, you'd anticipate collecting $81.50 or so - roughly 65 times as much. It reminds me of the three types of financial people: those that pay interest, those that collect interest and those that own the bank. Moreover, the dividend payments could qualify for a lower tax treatment as compared to interest received.
Naturally owning shares of Wells Fargo is more "risky" (in generally thought about terms) than having your money in a certificate of deposit. The latter is guaranteed, and as we know there are no guarantees in the common stock world. Yet I would contend that agreeing to very low rate could be just as risky or more so than owning pieces of wonderful businesses, especially in the aggregate over the long-term.
If you own shares of Wells Fargo, along with a collection of other wonderful holdings, your starting income is probably going to be higher. Moreover, the likelihood of your income increasing (and thus ultimately the share values in the long-term) is in my view, exceptionally high as well.
Yet still some opt for the very low rate CD instead of owning pieces of profitable business (incidentally, in this case, the very same business that is offering you the CD in the first place). I'm not talking about an emergency fund, or a set amount of capital you need to be liquid in the short-term. I'm talking about investable funds, and the true notion of what's "risky."
One way to deal with the psychology of it is to forget about share prices (easier said than done). You could think about owning a collection of dividend growth stocks in the same manner as holding a 10-year CD; ignoring the balance, and collecting the cash flows on a regular basis. Eventually higher payouts ought to translate to higher values, but in the interim a lot can happen. If you strike out the volatility, or perhaps more accurately strike out how you feel about volatility, it's a lot easier to see the benefit of long-term investing.
Yet some will always be lured and scared by the everyday ebbs and flows of stock price bids. I could further illustrate that share prices are simply the available liquidity bids available on a given day (no different than me offering you 50% of what you paid for your house) but some will always be swayed. I get it. In light of this, I'd like to highlight two additional possibilities to generate a bit higher cash flow.
First, the CD rates offered by Wells Fargo (while great for the bank's owners) don't perfectly portray what's out there. You can do better. A recent look at bankrate.com showed some "high yield" alternatives with a 1-year CD rate near 1.25%. So we'll use that as our benchmark.
One area to look for higher income sources, aside from common stock, could be preferred shares. Incidentally, Wells Fargo offers several issues with yields starting at 5%+. In looking at these types of securities, the price relative to the potential call price is important (and can go down). Moreover, much like a bond the payouts are the same each period.
The benefits of owning a preferred share is that your starting income is apt to be higher and the payouts are preferential to common dividends. So if the company wants to pay a common dividend, it must first make good on its preferred payout.
The case against owning preferred shares is that over the long-term, the amount of wealth creation is apt to be lower than simply owning the common shares. After all common shareholders effectively issue preferred shares, so it makes sense that they're considering doing so with a higher anticipated return for those funds in mind.
That's one intermediate-step that you could take - in my view it's usually a step below the common (not always) but well above the current low rate CD over the long-term.
Another possibility, an intermediate step if you will, relates to making agreements. You can get paid to make agreements. Let's say that you want a higher rate of return than 1%, but you're not exactly comfortable owning Wells Fargo at a price of $46. Perhaps shares bob around quite a bit, going to, I don't know $35 per share, and that sort of thing would make you uncomfortable. It's not talked about as often, but there's a way to express this uneasy sentiment and get paid for doing so.
As I write this the January 20th, 2017 put option with a $25 strike price has a bid of $0.60 - call it $0.50 to account for transaction costs. Let's look at what this means.
If you elected to sell this put option, that would mean that you agree to buy 100 shares of Wells Fargo at a per share price of $25 anytime between when you sell the option and January of next year. You need to set aside $2,500 to make this "cash secured." For making this agreement, you'll receive $50 upfront - which equates to a yield of 2%. Granted this might not be taxed at the qualified dividend rate, but the same thing can be said for interest as well.
Now one of two things happens with this agreement: either the option is exercised or it is not. If the option is not exercised, a likely scenario if shares are trading anywhere above $25, you keep your premium and your $2,500. You made 2% on the agreement and after January of 2017 you're free to do what you want with the $2,550. Clearly this would be a favorable outcome to agreeing to a .05% or 1.25% return.
The second possibility is the option is exercised, as would likely be the case should shares trade below $25. This may seem like something you do not want - after all we lead up to this agreement with the notion that the individual did not want to own shares outright. Yet I would contend that this sort of transaction would be exceptionally more compelling than where shares sit today (and to be sure today's price could certainly offer favorable returns in the coming years).
Last year Wells Fargo earned $4.15 or so per share. If you owned shares with a cost basis under $25, this would equate to a trailing earnings multiple of about six. Based on the expectation of earning closer to $4.50 per share in the coming year, that's closer to five times expected earnings.
Moreover, with the current dividend payment, this would simultaneously equate to a dividend yield of about 6% to boot. Sure shares could go lower than $25, but it's easier to see that it would be exceptionally more desirable to own shares at $25 instead of today's price.
The last time you could own shares of Wells Fargo at $25 was back in 2011, when the company was earning about 30% less than it did last year. Prior to that you have to go back to 2003 to find a share price of $25, when the earnings-per-share were more than 50% lower.
Naturally none of this comes with the "guarantee" of a CD. But here's the point: unless you need the cash promptly, there are many more attractive alternatives out there. Even if this doesn't mean owning common or preferred shares directly, you could make unlikely agreements (Wells Fargo's shares would need to fall another 45% in this instance) and still generate higher returns.
Naturally there are many more possibilities (and much higher yielding ones, should you agree to buy shares at a higher price). The idea was to go to an extreme case - in this instance, the lowest put option currently available. Even then, in my view, this sort of agreement looks much more compelling than the very low rates being offered elsewhere. Either you receive a higher immediate return, or you get to own shares in a solid business at a much lower price. From there you can begin looking at more profitable and compelling value propositions.
Disclosure: I am/we are long 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.