Retiree, Are You Smarter Than A Kindergartner?

Summary

• Seeking Alpha is a great resource in helping retirees and investors.
• Retirees shouldn’t focus on high yields and short-term strategies.
• Dividend investing is a great source of income for a retiree.
• Many REITs are trading at attractive prices.
• Let’s look at where you can start.

Some financial analysts believe that retirement stocks do not exist. This belief is based on the simple idea that total returns can only be positive, negative, or flat. From that perspective, any stock that will go up is a good stock and any stock that will go down is a bad stock. The simplicity is appealing, but it completely ignores individual factors.

In this article, I want to discuss several of the relevant factors.

Taxes

The investor’s tax bracket can be relevant. The attractiveness of different investments depends on the expected after tax return. If the investor is picking stocks for a tax-advantaged account, they will not want UBTI (unrelated business taxable income). UBTI is terrible in tax-advantaged accounts. It does not enjoy the same benefits that most types of income have within those accounts. Therefore, an investor could find a lower yield security with the same pre-tax return to have a much lower after-tax return because it paid UBTI instead of interest and other types of dividends.

Timeline

An investor may be very confident that they are correct about the fundamentals of a stock. However, the short-term price movements are based on emotions rather than fundamentals.

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You might imagine the fundamentals as a man taking a dog on a walk. The share price would be the dog. The dog can run in either direction from the man. However, there is a leash in place. The dog can only get so far away. The price functions similarly. It can disconnect significantly from the fundamental values, but there is only so much leeway. As investors, we won’t know precisely how long the leash is. However, we can all agree that neither Apple (AAPL) nor Google (GOOG) (GOOGL) will be worth zero dollars per share within the next year. That is a very simple conclusion. The price may run up or down, but we can be sure that it will not run indefinitely.

This is particularly important for investors with a shorter timeline. If the investor needs access to their capital within the next few years, it is entirely possible that the share price may move in the opposite direction of the fundamentals over that time period. Consequently, even an investment with an excellent expected return may be inappropriate for the shareholder in significant amounts based on their timeline.

Allow me to provide some examples. There are several excellent REITs with very solid fundamentals. However, the price risk is dramatic. Realty Income Corporation (O) has solid fundamentals. However, the share price is relatively high compared to where many other quality REITs are trading. An investor who needs only the dividend income could reasonably buy a position and plan to use nothing but the dividends for the next 40 years. However, if there is any chance they will need to draw their original cash, the price risk could be too high.

Ethics

Some investors will simply refuse to own certain companies. I have positions in Altria Group (MO) and Philip Morris (PM) because they provide an excellent dividend yield and trade at a reasonable multiple of earnings. The product is addictive and the stock holds up very well when the market is concerned about recessions.

Some investors will simply not be willing to own tobacco stocks. It is worth nothing that Coke (KO), Pepsi (PEP), and McDonald’s (MCD) also contribute to death. Instead of tobacco, they sell saturated fat and high fructose corn syrup. Dead is still dead. If an investor refuses to hold any of the merchants of death, they need to purge many companies from their portfolio.

Accounting

Investors should be aware of their own expertise level when it comes to accounting. Smaller companies are more likely to play games with their accounting. A company with a market capitalization under $500 million knows that they will get vastly less attention from professional analysts. Under $100 million, there will be very few professionals providing any public commentary on the company.

Consequently, some managers of smaller companies decide to provide adjusted earnings metrics that are garbage. Recent examples include Wheeler (WHLR) and RAIT Financial (RAS). Both have recently imploded as investors became aware of the poor fundamentals that were hiding under the adjustments.

Mortgage REITs are another area where accounting is very important. The accounting for mortgage REITs can be quite complex and investors often become blinded by the dividend yield. Many are content to simply buy a black box of dividends and hope the yield is sustained. If the dividends are cut, the investors often blame management.

Even if they bought the shares at what was clearly a sucker yield, they still blame management. It would seem that they believed they deserved a higher total return for recognizing which stock had a higher number listed for the trailing dividend yield. That is not analysis. Recognizing which number is greater is learned in Kindergarten.

That is not a unique skill. It does not demand additional returns.

Sucker yields

Since we are on the topic of sucker yields, it deserves further explanation. Sucker yields are bad for all investors. However, sucker yields are far worse for investors in or near retirement. The sucker yield is extremely dangerous because it can influence other choices.

Retirees who are confident in their 18% dividend yield are dramatically more likely to spend those dividends. They spend the entire 18% while arguing that it is only a paper loss as the company declines. When the yield is 18%, the market has spoken quite clearly about the fundamentals of the company.

When the investor spends the full 18%, the enormous drop in price becomes realized after the dividend is cut and the investor sells their shares. The total return on the position is vastly less than the initial listed dividend yield. The result is a retiree who lost their income source and lost the capital they needed to replace the income source. At least for younger investors, they have time to recuperate from the loss.

How can a retiree position themselves?

Retirees can protect their portfolio through a few simple techniques. One is to look at the balance sheets for the companies they are considering. As a quicker method, they can simply check the credit rating of the company. If the company has a solid credit rating, that is a great sign for the investor. It means management is being more prudent about their level of leverage.

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Anything rated A- or above is being extremely prudent with their leverage. Even BBB+ is quite prudent with their leverage. Anything below BBB- indicates that management felt comfortable taking quite a bit more risk with other people’s money.

The next method is to have an emphasis on larger companies. Generally speaking, the larger companies will have less volatility. Investors shouldn’t assume that large companies are immune to loss. Most are simply positioned to absorb it better. Smaller companies have higher volatility to both the upside and the downside. Investors don’t want that volatility. If they are retired, they especially don’t want that volatility.

If investors need additional income they can supplement their regular choices with some preferred shares. The preferred shares carry much higher yields and provide investors with a boost to the current yield. Most preferred shares will never see an increase in the dividend rate. Investors also need to be careful of the call risk on preferred shares. However, it is a much better strategy than gambling the portfolio on extremely high-yielding smaller companies.

Another technique investors can use is emphasize companies that have recently raised their dividend for several consecutive years. A dividend that has been raised recently is the least likely dividend to be cut. When the dividend is raised frequently, it will often be a question on the earnings call and management will be committed to sustaining and growing the dividend. Cutting the dividend can send the share price lower, but it can also cause the CEO to become unemployed.

That encourages the executives to be less adventurous with the balance sheet. Since retirees should get their adventures on cruises, there is no need for them to take adventures inside their portfolio. They should prefer management who is also opposed to those adventures.

Where can you start?

I’ve prepared a list below of several of the large capitalization dividend payers across several sectors. This list should provide a starting point for retirees hunting for viable income stocks. Allow me to emphasize that it is a starting point and not an ending point.

Consumer Staples			Healthcare			Consumer Discretionary			Technology & Others
Target	(TGT)	3.30%	Gilead Sciences	(GILD)	2.90%	General Motors	(GM)	4.06%	CenturyLink Inc.	(CTL)	12.45%
Kroger	(KR)	1.83%	Johnson & Johnson	(JNJ)	2.61%	Nike Inc.	(NKE)	1.21%	AT&T Inc.	(T)	5.50%
Walmart	(WMT)	2.34%	Eli Lilly & Co.	(LLY)	2.91%	Disney	(DIS)	1.63%	Verizon	(VZ)	4.89%
Costco Wholesale	(COST)	1.06%	UnitedHealth Group	(UNH)	1.33%	Home Depot Inc.	(HD)	2.31%	Intel Corporation	(INTC)	2.45%
Walgreens Boots	(WBA)	2.27%	Amgen Inc.	(AMGN)	2.85%	McDonald's	(MCD)	2.72%	Cisco Systems Inc.	(CSCO)	3.00%

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To maximize the yield on the portfolio, investors should be including REITs. The REITs have several advantages. The lack of corporate taxes is one significant advantage. The dividends are often taxed at a higher rate since they are unqualified, but the removal of corporate taxes gives REITs a competitive advantage in producing total returns to the shareholder. If you could pick between two similar companies and only one had to pay corporate taxes, the winner should be obvious if the valuations before taxes were similar.

On a final note

I will also include a list of excellent REITs that I believe are attractively valued and have solid balance sheets: Simon Property Group (SPG), Tanger Factory Outlet (SKT), AvalonBay (AVB), and Equity Residential (EQR). Full reports on all these REITs can be found on The REIT Forum.

If the investor still needs to pump up their yield a little higher, they could look to the preferred shares from some of the mortgage REITs. For instance, AGNCN from AGNC Investment Corp. (AGNC) has been on sale lately and offers a solid dividend yield with a fixed-to-floating feature after the call protection ends. Because of the floating feature, shareholders can be less concerned about inflation. If inflation picks up, we should see higher short-term rates. That would lead to a higher dividend rate on the security unless it is called. If it is called, the investor receives a very solid yield for the years between now and then.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long AGNCN, AVB, EQR, SKT, SPG, WMT. 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.

No financial advice. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints. CWMF actively trades in preferred shares and may buy or sell anything in the sector without prior notice. Tipranks: SKT, SPG, AVB, EQR.