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Important Note: We will publish the 3th Part to our new series: "Recession-Proof Investing" this week end. In the meantime, we share our latest thoughts on a question asked by one of our members: Should you invest in "High Growth" or "High Yield" in 2019? Please let us know your thoughts on the chat! Greetings to all of you from Riga, Latvia.
MARKET UPDATE - Should You Buy "High Growth" Or "High Yield" In 2019?
High-flying growth stocks have ruled the headlines in recent years during the current economic expansion. However, as economic expectations dim as we move further into 2019, should investors continue riding the growth train or is it time to dig into higher yielding securities?
There are numerous arguments to be made in favor of either investment strategy, and to some degree it depends on the circumstances of the individual involved, but we believe strongly that over the long run, investing in higher-yielding dividend-paying stocks is a superior strategy for retail investors, especially right now. Here are 7 reasons why:
(1) Dividends Outperform Historically
Perhaps the biggest argument in favor of dividend investing is that stocks that consistently pay out dividends have a history of outperforming. The S&P 500 Dividend Aristocrats, for instance, have far outpaced their broader index over the past decade.
This outcome makes sense in theory, too. One study showed that between 1930 and 2015, dividends alone accounted for a whopping 43% of the S&P’s total return. Therefore, if a stock doesn’t pay dividends, it requires it to grow a lot to make up the difference. While this is possible for spurts of time, during recessionary and low growth periods, this becomes exceptionally difficult. In fact, another study has shown that literally every quintile of dividend-paying stocks (sorted by yield) has outperformed non-dividend paying stocks since 1928. If you invested in all the dividend payers in the S&P 500 in January 1972, you would have achieved nearly three times the return you would have received by investing in the non-dividend payers of the S&P 500 over the same time frame.
(2) Dividends Are Better Suited to a Low-Interest, Low-Growth Environment
High-yielding dividend paying stocks are also a good buy right now due to the fact that they do better than growth stocks in a low-interest, low-growth environment for the following reasons: (1) their valuations are usually quite low, meaning that they have less optimism priced in and therefore their prices have less distance to fall in the event of a deteriorating economic growth outlook; (2) their valuations are already attractive relative to growth stocks due to the recent fears of rapidly rising interest rates (which tend to hurt high yielding real asset stocks that rely on significant leverage, as opposed to capital light, rapidly growing businesses); and (3) having a significant dividend underpinning a stock tends to give its price a firmer floor since the intrinsic value of the share is more evident as a cash flowing asset.
Since GDP growth is widely expected to slow beginning with this year and calls for a potential recession as soon as next year are beginning to resonate across the airwaves and internet, the Federal Reserve’s already dovish stance on interest rates will likely only get more dovish in the coming quarters. As a result, interest rates are likely to stay put (if not decline) for the foreseeable future. This should provide a tremendous tailwind to high yield, high leverage stocks which have already taken a beating due to interest rate concerns. Additionally, the slowing growth outlook will likely put a damper on the very optimistic valuations placed on high growth stocks.
(3) Dividends Imply a Healthy, Shareholder-Friendly Business
Paying a sizable and consistent dividend is perhaps one of the greatest proofs that a business can give of the vitality of its operations and fundamental well-being. This is because paying out large sums of cash for a sustained period of time (especially if that number is growing) requires that the underlying operations are yielding considerable amounts of what is truly free cash flow. Many companies can (and do) massage and manipulate their financial statements to paint a pretty picture, claiming to generate a lot of earnings and even free cash flow, but shareholders never touch it. This is especially common with companies whose “adjusted” non-GAAP results differ widely from their GAAP numbers.
However, if the shareholders are seeing these consistent results in the form of a dividend check, quarter after quarter, and ideally even growing year-over-year, they know for certain that this is truly surplus cash that is actually being generated by the business and is not needed to sustain its operations or competitive advantage. A sizable dividend payout also reveals that management is concerned about rewarding shareholders and treating them like true owners of the business who are entitled not only to the fruits of their profits, but also direct control over a sizable portion of them.
(4) Dividends Force Management to Behave
When a company pays out a large portion of earnings in dividends, it significantly reduces the amount of capital it has to reinvest in the business. As a result, two positive things happen: (1) management is forced to be very selective in its growth investments, thereby preventing it from venturing into areas outside of its area of competence or in costly (and often ill-fated) acquisitions and instead requiring that it only invest in the most profitable ventures; (2) if management does want to invest in significant new projects and/or acquisitions, it must go to the markets (debt and/or equity) for additional funds and accept the price it offers them, thereby adding another layer of accountability for their actions and track record of capital allocation.
(5) Dividends Give Investors Flexibility
Dividend paying stocks also give investors enhanced flexibility by creating a steady stream of income which can be redeployed into new investment opportunities as they come along. While it is always possible to sell shares to raise capital for reinvesting elsewhere, the advantage of dividend income as opposed to stock sales is that dividends are typically taxed at the long-term capital gains rate (or even have their taxes deferred as is the case with MLPs), whereas sales of stock held for less than one year will result in capital gains being taxed at the (higher) short term capital gains rate.
Furthermore, selling shares for a good price is subject to the whims of Mr. Market – which are often disconnected from the intrinsic value of the business behind the stock – whereas the dollar value of dividends are unaffected by Mr. Market’s current mood.
(6) Dividends Are Easier to Value
Because growth stocks typically have higher valuation multiples (due to their higher projected growth rates), they are inherently more difficult to properly value. This is because the rate of change in their earnings is often quite dramatic and therefore projecting an accurate growth rate even just 3-5 years in the future is often very difficult to do – especially for the average retail investor – given that such growth rates are often significantly impacted by macroeconomic forces and complex industry and/or technological forces.
Many dividend stocks, on the other hand, especially higher yielding real-asset businesses, have much simpler and more stable business models with slower and steadier growth rates that don’t generally change as dramatically with changing economic and industry trends. As a result, they are far easier to value and do not involve nearly as much margin of error. This helps to prevent many retail investors from getting caught up in hype and skyrocketing price action and overpaying for a stock only to see it crash down to earth again. Instead, dividend-focused investors simply focus on purchasing a stock for the passive income it will generate for them regardless of the short term price action.
(7) Dividends Help You Sleep Well at Night
Finally, and perhaps most importantly, dividend paying stocks can help investors sleep better at night. This is because the steady flow of dividends through all market cycles can help calm an investor’s mind even as his shares are tumbling in price. In fact, it can even help people see the silver lining in a market downturn by giving them the opportunity to reduce their cost bases with the dividend payments they are receiving.
Additionally, as already mentioned, the lower valuation multiples and more stable, cash-flowing business models involved with higher-yield dividend stocks also leads to less disastrous price drops and enables an investor to trust that his business will make it through a downturn safely.
Given these factors in favor of yield-focused investing, how should investors go about building their portfolios?
One easy option is to simply invest in a broader high-yield index fund such as the Vanguard REIT fund (VNQ), the Pro Shares Dividend Aristocrat ETF (NOBL), or even a preferred stock index ETF such as iShares (IPFF). However, this means buying every REIT in the index, regardless of its current price, quality, prospects, or management. While “know-nothing investors” (to borrow a term from Charlie Munger) may find this broad diversification useful, we believe (as does Charlie Munger) that using an intelligent analysis of the qualitative and quantitative aspects of each REIT in order to pick and choose the most opportunistic investments will provide the best total returns over the long term.
At High Yield Landlord, we spend hours researching the REIT market in order to target the highest quality REITs that also are being offered for sale by Mr. Market at low valuations. As a result, we are able to achieve superior dividend yields (currently 8.57% weighted average in our real-money portfolio) at sustainable dividend payout ratios (currently 70.4% weighted average in our real-money portfolio), thereby giving us strong current income (enabling us to capitalize on short term volatility by averaging down on top opportunities) and superior total returns over time.
How do we do this? Aside from closely examining balance sheets to ensure a well-laddered debt maturity schedule, examining the quality of the property portfolio and the outlook for the specific property sectors and markets involved, and calculating an estimated fair value and/or NAV for shares (to determine an appropriate buy price), also can do interviews with management teams to see if we can gain any further insight into the strategies and philosophies that will be governing our hard-earned capital while it's deployed into these securities. This can often confirm our investment thesis or raise red flags that we didn’t notice before that will prevent us from making a mistake and put our long-term financial well being at risk. Finally, we seek to achieve broad diversification across property sectors, with heavier weighted allocations toward those sectors that we deem to be most opportunistic in light of the current market sentiment relative to the macroeconomic environment.
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Jussi Askola & Samuel Smith
Disclosure: I am/we are long ALL STOCKS IN CORE PORTFOLIO AT HIGH YIELD LANDLORD.