Don't Chase Yields; Do Buy Gold

| About: iShares Gold (IAU)
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Summary

Investors sometimes use yield or dividend as a shortcut in order to avoid fundamental analysis.

Writer and former WSJ columnist Clements argues in favor of this and other misconceptions.

It isn't a good idea and leads investors to do really questionable things like buy the debt of Iraq, lured by a 6% yield.

Gold yields nothing under regular circumstances but it pays off when you need it most.

"Dividends" as a strategy is terrible. Former WSJ personal finance columnist Jonathan Clements published an article where he makes five observations about the market which lead him to take the other side of the smart money on three counts. He gets there with a few common sense arguments, that are quite common, but which are deeply flawed. Like relying on dividends as a proxy for thinking.

I'll take this opportunity to argue chasing dividends isn't a substitute for a good strategy and dispel some other common nuggets of investment "wisdom." Clements arguments are in quotes followed by my counterarguments:

Third, the so-called Smart Money keeps bashing everyday investors who favor dividend-paying stocks-and dividend investors keep getting richer. The Smart Money's argument: All securities should be priced to deliver the same risk-adjusted return, so what folks make in dividends they should sacrifice in price appreciation. But if that's the case, where's the harm in favoring dividends? If you buy the Smart Money's argument, it should be a wash.

This view ignores tax implications which favor buybacks unless the stock you are holding is overvalued to begin with. In which case dividends can be better. However, it's not a great strategy to hold overvalued stock either and it paying a dividend won't bail you out.

Second, All securities aren't priced to deliver the same risk-adjusted return. I see all the time how high dividend vehicles get peddled to a retail investor crowd and they rely on the dividend to value the stock. Often they get assured the vehicle will keep paying the dividend and it's sustainable while afterwards it turns out to have been peak of the earnings cycle of whatever they are buying.

And there's a chance it won't be a wash-and dividend investors will come out ahead. Dividend-paying stocks are often value stocks, and may benefit from the historical tendency for value stocks to outperform growth stocks. In addition, dividend-paying companies may be better run, because paying that regular dividend forces management to be more careful in handling the corporation's cash.

If you believe in the sustainability of the value premium perhaps you should just invest in value stocks instead of using dividend as a proxy. Or if you insist on dividend stocks, buy the value stocks among them. It seems to work better.

There's some merit to the better run argument but it's a lazy approach. I'll yield to the idea we are likely to see dividend paying companies allocate capital more efficiently. But is it really enough to rely on such a weak indicator? There are dividend paying stocks with terrible management. Meanwhile, all of the Outsiders utilized buybacks. Some of them were famous for it. Perhaps the best CEO of all time, Warren Buffett of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), has never and will never institute a dividend.

Instead I propose we try to form an opinion on management's capital allocation philosophy when buying a stock. If you need a dividend to show you, it might be time to sign up with Vanguard (NYSEARCA:VTI).

That said, ponder this: Many observers-including me-expect muted stock returns over the next decade, perhaps 6% a year. If you buy an emerging market debt fund or a high-yield junk bond fund that yields 6%, you might notch returns that aren't that much worse than the stock market, even if you suffer some capital losses. My hunch: Emerging market debt could benefit as developing countries see their credit standing upgraded, while junk bonds are a dodgier proposition.

There's probably only one thing worse than emerging market debt which is debt of developed nations like France, Italy, Germany, The Netherlands and the U.S. Let's look at the largest Emerging Markets Debt ETF by iShares JPMorgan USD Emerging Markets Bond (NYSEARCA:EMB). The weighted average coupon rate is indeed exactly 6.1%. I won't quibble about the 0.4% expense ratio.

6% sounds good until you realize it depends on Argentina (the country that for a long time refused to pay Paul Singer), The Philippines, Russia, Mexico, Iraq, Kazakhstan, Turkey (locking up any critical journalist in sight) and Oman all paying you back your money somewhere in the next 10 years. If one or several don't it will be less.

I'm fine buying scary stuff but I want to get some serious upside exposure in return. As is, I favor shorting Emerging Market debt and have shorted a euro traded version of the ETF mentioned above.

Note, this is U.S. dollar denominated debt!

^DXY Chart

^DXY data by YCharts

Finally, gold has been on a wild ride this year. It started 2016 at $1,060, got as high as $1,387 and is now back to $1,134. The ride has been even wilder for investors in gold stock funds, which are effectively a leveraged bet on gold. For instance, Vanguard's gold fund-one of the category's tamer offerings-had doubled in value as of August, but now sports a year-to-date gain of 41%. Were you enthusiastic about gold in August? You should be even more enthusiastic now.

Except Trump got elected and we saw a rate hike materialize. Otherwise, things are pretty much the same. However, I agree we should like gold more right now compared to August. I'm not convinced it's crucial whether we buy it at $1000 or $1400.

Gold is a role player that can increase the odds of a portfolio doing well under extreme circumstances. It's better to get it at low prices but determining the intrinsic value of gold is extremely difficult while there's research indicating it is a frontrunner to do well under extreme circumstances as I've argued more in depth in Why You Should Buy Gold. I'm in favor of holding a little bit of something like the SPDR Gold Trust ETF (NYSEARCA:GLD) or the iShares Gold Trust ETF (NYSEARCA:IAU), gold royalty companies or physical.

Disclosure: I am/we are long IAU.

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.