Finance

Income Minded

  During the Great Depression, my grandfather and grandmother advised their two daughters to be “income-minded” and have at least 90% of their savings producing some yield. …

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During the Great Depression, my grandfather and grandmother advised their two daughters to be “income-minded” and have at least 90% of their savings producing some yield. The other 10%, they believed, should be capable of producing income in the future. My grandfather wanted his daughters to know how to invest with an eye towards safety, but also towards reliable returns.

Most of my grandparents’ recommendations involved dividend-paying stocks. While dividend-paying stocks have never been entirely out of vogue, they were replaced in the 1980s and 1990s by growth stocks.

Recently, dividend-paying stocks have made a strong comeback. They may even be the most crowded retail investment play right now. Are we headed back to Great Depression investing or will the markets appreciate income only until the next Great Bubble starts forming?

Back in the 1930s, it was believed that income-producing stocks could better weather recessionary times than those that were purchased solely for growth prospects. A company paid dividends out of profits. If the company wasn’t profitable, it wasn’t paying dividends, and therefore should be sold. These favored stocks were deemed safer because the companies had more consistent cash flow.

Flash forward to the 1980s, 1990s and into this decade. Dividend payouts have fallen from around 50% of corporate profits to close to 30%. At the same time, the average yield on stocks has declined from 4% to 2%.

During the tech bubble, many new companies looked with disdain on dividends. The prevailing sentiment was that dividends were issued by companies without imagination and vision.

The biggest perceived risk during the tech bubble was that investors could miss outsized returns if they settled for income-producing equities. You made money by buying low and selling high. Ultimately, it was the belief that stock prices could only go higher that made dividends become irrelevant.

Champions of dividends were not helped by falling interest rates either. Dividends are supposed to pay a rate higher than “risk free” treasury notes. But low interest rates mean that investors will settle for lower dividends. If the ten-year treasury is yielding 2.25%, a 3% or 4% dividend may be acceptable.

With bank deposits paying less than 1% and core inflation hovering around 2%, anything yielding 3% or more has become desirable. That means that higher risk assets (stocks, real estate investment trusts, high yield bonds, etc.) can pay much less than they used to for the same level of risk.

I can remember sitting with clients not too many years back as they griped about the new and lowered money market interest rates that were hovering around 4% or 4.5%. Inflation wasn’t much higher than it is now, but money markets were a disappointment to these clients. Today those same or similar clients are happy to simply preserve what they have, even if the money markets don’t keep up with inflation. Times have changed.

Wall Street has changed too. Institu- tional investors make their money predominantly by trading and merger and acquisition activity. Wall Street does not benefit from the dividends issued to shareholders, and hence, does not usually reward dividend paying companies with the same enthusiasm it does growth ventures. Typically, your dividend-paying stock will fall less to the downside, but it will lag to the upside.

However, dividend-paying stocks are still attractive. They provide a return that can’t be taken away. Once you receive your dividend, it remains in your pocket. And if that dividend is increased each year, you have a shot at keeping up with inflation, even if the markets are flat.

Even better, you don’t have to sell your shares to cash in. The dividend is scheduled to come regularly, regardless of whether you shed shares. True, you pay taxes on each distribution, but since 2003 taxes on dividends and capital gains have been the same: 15%. You can choose to hold onto your stocks and still get paid.

What if interest rates start rising, the global growth story returns or Washington changes the tax code? Any and all of these can take some shine off dividend paying stock companies. That is why investors need to remain properly diversified and monitor their portfolios closely.

If you decide to invest, and choose not to buy individual stocks, look for a fund whose priority is providing a strong dividend. The fund should have a disciplined screening process for company selection with a focus on solid balance sheets and steady cash flows.

Should you invest like the Great Depression? Not exactly. But being “income-minded” is a good idea, at least for a portion of your portfolio. Being invested in an asset that produces steady income with the potential for increase can provide some peace of mind in what remains an uncertain investing world.

Betsey Purinton, CFP® is Managing Director and Chief Investment Officer at StrategicPoint Investment Advisors. You can email her at bpurinton@strategicpoint.com.