August 01, 2016
The Joy of Investing in Income Securities
The Joy of Investing in Income Securities
Many people are fascinated by the stock market, especially stocks with rising price trends reflecting market expectations for future growth. But a common share is simply part ownership in an underlying business. Personally, as a financial analyst, I have always been more interested in businesses than short-term fluctuations in share prices.
If you ask anyone who actually owns and operates a business, they will tell you that what is important is cash flow. You need to be generating income on regular basis in order to pay the bills and maintain operations. If the value of the business happens to go up, it only helps you if you plan to sell – a higher net worth is good, but it does not pay the bills.
Being in retirement is similar to running a business. While it is important to keep an eye on the value of your investment portfolio, you also need regular cash flow to pay for your retirement lifestyle. Hopefully, you will not need to liquidate some of your securities or other assets just to pay expenses. In fact, if you are fortunate to have enough investments that, together with any pension income, produce more regular monthly cash flow than you are spending, you should feel comfortable that you will not run out of money.
And there is another important benefit to an income equity portfolio. Investors understand that stocks provide capital appreciation over time. In the 45 year period from 1970 to 2015, the S&P500 index rose from 93.49 to 1918.60, a compound annual growth rate 6.945%. Including dividends which averaged over 2%, it was possible to achieve a total annual return of roughly 9% (before fees, commissions, and taxes). However, in order to realize such a level of return, you would have had to remain invested consistently because a lot of the gains in market prices were concentrated in relatively short time periods. Recently, CFA Institute contributor Michael Batnick showed that missing the best 20 weeks in the S&P500 since 1970 would mean losing out on 80% of the gains realized over a total holding period of 2411 weeks. That's less than 1% of the time. Capital appreciation is not gradual or predictable in the short term.
In between weeks with strong gains, there are long periods where the market does very little, and there are some weeks that experience sharp corrections. The joy of an income portfolio is that money keeps rolling in each month in a fairly predictable manner, including when markets are flat or down. That can give investors a measure of comfort in trying times. And a healthy dividend yield can also help a stock hold its value better in down markets. Finally, regular cash flow can provide an investor with funds to add to positions at attractive prices during market declines.
Having regular, predictable income just feels good. John D. Rockefeller used to say "Do you know the only thing that gives me pleasure? It's to see my dividends coming in."
I like to tell clients about my friend and tennis partner, Bernie, to illustrate this kind of investing. Bernie is retired now and quite wealthy. He used to be a successful accountant with his own firm, specializing in helping property developers. Through this association, Bernie ended up investing in a number of apartment buildings. To this day he has no other investments – apartments have treated him well. And Bernie does not look in the paper each morning to see if the market value of his property portfolio is up or down. He has no plans to sell. All he cares about is the monthly rent cheques that keep coming in.
Most people would find it difficult to acquire a string of apartment buildings, renew leases, collect rents, and look after repairs. But you can buy REITs that focus on apartments, with diversified properties across Canada and the USA overseen by professional property managers. Of course, there will be fees to pay but, in return, the managers take care of day-today operations and they have the ability to improve properties to increase their value and raise rents, resulting in higher distributions for unit holders. And, if you need to sell for any reason, you have immediate liquidity.
Of course, there is no free lunch. What is the downside of an income portfolio? I am often asked what happens if interest rates go back up. In that kind of environment, income securities tend to sell off as interest-bearing instruments – such as bonds and GICs – provide higher yields, becoming more attractive alternatives for investment capital.
The answer is although income equities have risks associated with any equity investment, businesses that issue them also have the potential to grow and raise their dividends and distributions. Further, if interest rates rise meaningfully, it would be in response to higher inflation associated with improving economic growth. In such an environment, income stocks offer some protection because well-managed companies should be able to adjust to inflation to maintain or even increase distributions. In contrast, bonds simply sell off as yields rise.
Diversified portfolios require several different asset classes with the mix being determined by individual client objectives. In today's low interest rate environment with very high bond prices and minimal yields, income equities are a good option for many investors seeking to fund their retirement lifestyles. Let's talk about whether it's the right approach for you.
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