Category: Dividends

Are Retirees Focused on the Wrong Thing in Their Portfolios?

According to a recent study, a middle class couple aged 65 has a 43% chance that one of them will live to age 95. The challenge for this couple is to continue to enjoy their lifestyle and have enough money to live worry-free. Once you stop working you are dependent on income sources like pensions, annuities, social security payments and withdrawals from the savings you have accumulated over the years.

Most of these retirement income sources are fixed once we retire and are out of our control. It’s the retirement savings component that has people concerned. Most retirees don’t want to run out of money before they run out of time. For many they, themselves, are the income source that makes the difference between just getting by and enjoying life. Many retirees focus on the dividends and interest that their portfolios create. That may not be the best answer. Let’s examine the problems associated with this approach.

For the last five years the interest rate on high quality bonds (and CDs) has been close to zero. People who have chosen the “safety” of U.S. Treasury bonds or CDs have actually lost purchasing power after you take inflation and taxes into consideration. The same holds true for owners of tax-free municipal bonds. Those who bought bonds 10, 15, even 20 year ago when interest rates were higher have realized that bonds eventually come due. And when bonds mature, new bonds pay whatever the current interest rate is. That has meant a huge drop in income for many people who depend largely on interest payments.

Dividend payments are also subject to disruption. The financial crisis of 2008 was devastating for many investors. Those who owned bank stocks were particularly impacted. Bank stocks were a favorite for many income investors at that time because they produced lots of dividend income. Most banks slashed or eliminated their dividends, and some went out of business completely. Even companies that were not considered banks, like General Electric, were forced to cut their dividends. Dividends are nice income sources, especially in a low interest rate environment, but they are not guaranteed and you have to be careful about having too much of your portfolio concentrated in any one stock or industry.

The preferred method of planning for withdrawals from retirement savings is to take a “total return” approach. Total return refers to the growth in value of a portfolio from all sources, not just dividends and interest but also capital appreciation. In many cases, capital appreciation provides more return than either dividends or interest.

So how does one go about taking an income from a total return portfolio? Many advisors use 4% as a good starting point for withdrawals. That means for every $100,000 in your portfolio you withdraw $4,000 (4%) per year to live on while investing the rest. The goal is to invest the portfolio is such a way that over the long term, the growth offsets the withdrawals you are taking. It’s like a farmer harvesting a crop, leaving enough so that your portfolio has the chance to actually grow a little over time.

Of course, as we age other factors enter into our lives and the retirement equation, often headlined by medical problems related to aging. We will deal with these issues in another essay.

"Will a Stock Market Drop Affect My Dividend Payments?"

We got this question from a client of ours earlier this week in response to the stock market’s wild market ride.  It is a great question!
The quick and easy answer is “No, it shouldn’t.”  And we could pretty much stop right there.  But if you know us, you know we love to get into the explanation!  So here it goes…
Let’s go back to the very start, with “What is a dividend?”  A dividend is a payment of a portion of a company’s earnings distributed to the company’s shareholders.  Dividends typically are paid in cash, and the company’s board of directors decides the amount distributed.
Now the next question would be, “What causes a company to raise or lower their dividend?”  The answer is cash flow.  It all comes down to earnings and profitability and how much money the company has remaining after paying for all the things that keep it running, such as salaries, research and development, marketing, etc.  After those expenses and the dividend payment, the remaining profits go back into the company.
When a company pays a dividend, their board is essentially deciding that reinvesting all of the company’s profits to achieve further growth will not offer the shareholders as high a return as a dividend distribution.  That said, companies offer a dividend as extra enticement for investors to buy their stock.  Moreover, a steadily increasing dividend payout is an indication of a successful company.
Therefore, it stands to reason that a company’s steady or increasing profitability will typically lead to steady or increasing dividend rates, and a decline in profitability will lead to that company reducing or eliminating their dividends.  Most U.S. companies are loathe to reduce their dividend rates because it signals to investors that their profits are lagging, which results in their stock price getting pummeled.  And that is not a good thing for their company’s board or management.
The final long-winded answer: You will often see companies cut their dividends when there is a severe economic crash, but not in reaction to a market correction.  Since dividends are not a function of stock price, market fluctuations and stock price fluctuations on their own do not affect a company’s dividend payments.
If you have a question, feel free to send it our way!
(Here is an interesting tidbit: the term “dividend” comes from the Latin word dividendum, which means “thing to be divided.”  With a dividend, companies are dividing their profits up among shareholders.)

How do you get income with interest rates as low as they are?

I was reminded recently how low interest rates were when I downloaded my investment account activity into Quicken. Each account with a money market balance received a few pennies worth of interest, not enough to buy a cup of coffee. Certainly not enough to buy a Happy Meal. The average money market fund yields 0.02%. Every $1,000 investment will give you 20 cents in a year. And that’s before taxes. You could make more money collecting bottles at the side of the road.

There are some alternatives. One way is to invest for growth and forget about income. You can always spend some of the growth when you need the money.

But for those who want to see income flowing into their accounts, there’s always the “Dogs of the Dow.” The “Dogs” are members of the 30 Dow Jones industrial average with the highest dividend yields. This may be the result of a drop in prices, hence the name. For example, two of the highest yielding stocks in the DJIA are oil stocks which have declined in price even as they increased their dividends.

The current yield on the “Dogs” portfolio is over 3.5% and last year the total return (dividends plus capital appreciation) was over 10%. For more information on this strategy, contact us.

Two Views of GE

General Electric is one of the most widely owned stocks in the world.  And as a GE alumnus we are often asked about it.  At present there are two main schools of thought about GE and it’s outlook over the next year.

The bullish case argues that General Electric still has many growth opportunities, especially considering its $223B order backlog. Six out of seven of General Electric’s business segments posted earnings growth in Q2 compared to last year, with three seeing double-digit growth.  In addition, GE is one of the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), with a dividend yield of over 3{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}.

The neutral case is made Goldman Sachs:

“Our view is based on limited upside to 2013/2014 EPS coupled with a balanced risk/reward at this time. Specifically, we believe the 2013 margin targets are aggressive and a lower asset base at Capital will weigh on 2014 growth. Over the long term, we like GE’s position in attractive markets, simplification efforts and actions since the global financial crisis to make Capital stronger/safer. However, while GE appears well on its way to achieving its ENI reduction targets, we believe more can be done to improve its returns/ growth profile, making it a more attractive investment longer-term,”

With a P/E ratio of over 17, our view is that GE has limited upside potential.  We see the likelihood of an announcement of a dividend increase in the 4th quarter.  GE still has a lot of restructuring in its future as it sheds more of its GE Capital businesses.  This stock is not for the impatient.

Income Investing: Investors No Longer Taking a 'Fixed' Approach

While interest rates on bonds have risen slightly from the absolute bottoms, investors looking for income are still not satisfied with the rates that they can get today.  Adding to their concerns is the expectation that when the federal reserve slows “quantitive easing” interest rates will rise to significantly higher levels.  And that means that the bond they buy today will probably go down in value.

As a result, income investors are actually looking at dividend paying stocks to provide the cash flow that they need.  One other advantage of this strategy is that many companies have been raising their dividends regularly, something that bonds don’t do.

What is a dividend?

Experienced investors know all about dividends but we thought it would be a good idea to explain dividends to newer investors.  And perhaps even experienced investors can learn something new here.

A dividend is money that corporations pay our to shareholder.  Older, established US companies will pay dividends to shareholders based on what they expect to be able to pay on a regular basis.  Dividends are usually paid out quarterly, although there are exceptions and investors should be aware of that.  American companies try to maintain the same dividend from quarter to quarter even if earnings fluctuate.  Many raise the dividend as they become more profitable.   This is not the case for foreign corporations whose dividends can be irregular and based on the profit for the quarter or the year.

Not all corporations pay dividends.  Most corporations in their start-up phase use their income to invest in the business for growth.  Shareholders in these growing businesses are rewarded by watching their stock price appreciate if the company is successful.  But after a while a company will reach a limit on its rate of growth and decide to reward its shareholder with a steady income.  There are some issues with dividends however  and they have to do with the tax treatment of dividends that differ from the tax treatment of capital gains.

Unlike interest payments to bondholders, corporations cannot deduct dividends as a business expense.  For this reason, corporations pay out dividends from after-tax profits.  When a stockholder receives a dividend, he also owes taxes in the dividend income.  For this reason, dividend income is generally considered to be taxed twice, one at the corporate level and once at the individual level.  For example, if a corporation earns $100 it can be taxed  up to 39.2%.  That leaves $60.80 that can be sent to shareholders as a dividend.  If all of it is distributed as dividends, the maximum tax rate on qualified dividends is currently 15%, leaving the shareholder with $51.68.  Next year the special 15% rate will be repealed exposing your dividend to a maximum of 43.4%, tax, leaving you with $34.41.  Of course these rates apply only to the top tax brackets but they do illustrate how taxes can affect what people have left to spend and why they change their behavior to avoid excessive taxation.

There are a few other things that investors should be aware of when investing in dividend paying stocks and that has to do with dates.  A corporation will announce its dividend on one date.  It wil also announce what is known as the “ex-dividend date.” 

A stock’s ex-dividend date is the first day an owner can sell the stock without losing the rights to its upcoming dividend. Obviously, it’s also the first day a buyer who purchases the stock will not receive that same dividend. A good way to remember how the ex-dividend date works is to think of it as a synonym for “without dividend.”

A third date is the “pay date”  which is the date on which the shareholder actually receives the dividend.

 

What is a preferred stock?

From Investopedia:

A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights.

Why are investors interested in preferred stock?  It’s all about income.  “Preferreds” (as they are generally referred to) usually pay higher dividends than common stock and have a higher yield than the same company’s bonds.  If the company gets into financial trouble preferred dividends have to be paid before common dividends can be paid.  If a company is liquidated, preferred stock holders are ahead of common stockholders if there are any assets  left to be distributed.

What are the downsides of Preferreds?  They do not have voting rights.  They rank below bank loans, bond holders and most other obligations of corporations except for common stock.  Most “retail class” preferred stocks are issued at $25 per share and usually have “call” provisions.  That means that the issuer can redeem them for “par” ($25) after a number of years.  This “call” is usually not exercise-able for 5 years, but can be exercised by the issuer any time after that.   This means that the price of a preferred stock can drop if the company that issued it gets into financial trouble, but will not rise much above $25 during it’s lifetime.

Bottom line, common stock is purchased for growth, preferred stock is purchased for income.  Choosing Preferreds requires a sophisticated knowledge of that particular market.  If you are interested, be sure to work with an RIA who know this market.

Why dividends matter

A company that is successfully generating free cash flow can do several things with it:

  • Invest internally (research & development) or externally (mergers & acquisitions), to grow the company.
  • Pay down debt, which many companies have already done since the recent financial crisis.
  • Buy back stock.
  • Initiate or increase dividends.

Therefore, by investing in companies that pay a dividend, shareholders not only receive income from a quarterly cash payment, we believe they are also typically investing in quality companies that have the potential to grow profits. Dividends provide a source of income for many people seeking to supplement their earned or retirement income.

Most American companies that pay dividends pay them quarterly.   Unlike many foreign companies that will change their dividend payments based on current levels of profitability, American companies try to maintain the amount of dividends they pay unless they face severe economic distress, as many banks did during the financial crisis of 2008.

Federal tax policy has an impact on the amount of dividends that corporations are willing to pay.  If taxes on dividends are meaningfully higher than taxes on capital gains, investors prefer to invest in stocks that increase in value rather than those that pay dividends at the expense of growth.  When dividends and capital gains taxes are more nearly equal,  dividends become more attractive since they are less subject to volatility and provide a return even if stock prices don’t rise.

In today’s low interest rate environment, with CDs and Treasury securities paying very little, dividend paying stocks are looking increasingly attractive to many looking for current income.

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