Investors Be Warned: Yield and Payout Are Not the Same

03/07/2013 9:00 am EST


Ronald Muhlenkamp

Founder, President, and Portfolio Manager, Muhlenkamp & Company, Inc.

Investors who don't understand the difference between these two concepts may face unexpected tax consequences, says Ron Muhlenkamp of Muhlenkamp & Company.

Nancy Zambell: My guest today is Ronald Muhlenkamp, the founder, president, and portfolio manager of Muhlenkamp & Company. Thanks for joining me, Ron.

Ronald Muhlenkamp: Nancy, it's a pleasure.

Nancy Zambell: You've just written an interesting article called "Creative Sources of Yield."After the recent Orlando MoneyShow, I think we both can attest that many investors are very, very interested in chasing yield. But you really do have to look beneath the surface. Can you tell us about these creative sources?

Ronald Muhlenkamp: One was a royalty trust. The difficulty here is that the person recommending the royalty trust used yield and payout interchangeably, as if they were the same thing.

Nancy Zambell: They're not.

Ronald Muhlenkamp: They're not. Just to be clear, my definition of yield is the interest you receive for use of money. So it would be the interest on a bond or the dividend on a stock. But the yield is only the income or the interest over and above the value of the assets.

You expect when the bond matures you get cents on the dollar back. With the stock, you expect that the yield is over and above what the company needs to keep the company whole.

Think of a royalty trust-a pool of typically oil or gas-as being in a warehouse. It's just that the warehouse is underground. But you get a rental on the warehouse, and at the end of the period you've still got the warehouse.

It's another thing to sell the contents of the warehouse. At the end of the period, the warehouse is empty, and that's what is happening with many royalty trusts. Over a period of say, ten or 20 years, they sell the contents of the warehouse-that is, they pull the oil or the gas out of the ground-and that money comes back (as principal repayment).

But when it's done-at the end of, say, ten years-there's nothing left in the warehouse. So each payment that you get is more heavily the sale of an asset, as opposed to the rental of an asset.

Nancy Zambell: In terms of tax consequences, when you get to the end of your ten-year or 15-year holding period, and your cost basis is down to zero, basically, that means they've depleted the assets. When you file your taxes, you're going to have to pay a lot of money, most likely, right?

Ronald Muhlenkamp: Well, hopefully you would, because that occurs if the assets are worth more than you paid for it.

But let me take the reverse example. Most people make a monthly mortgage payment. Early on, it's very heavily interest, but each payment has some principal. So at the end of the period, say, 30 years, the mortgage is paid off.

If you're on the receiving end (getting the payments), you get the exact same thing. Each month, there's some principal and some interest. This is different than simply the interest on a bond, where the corporation is still there.

The reason it's tax-advantaged is the IRS says you don't have to pay tax on your own money that you get back. What you paid for the oil or what you paid for the mortgage, as that money comes back to you, that part (the principal) is not taxed. You're only taxed on either the income over and above that (principal), or as you say, when you get your basis down to zero.

But to call the payout-the payment that they send you each month-to call that yield comparable with other yields where what you're getting is over and above the value of the asset is incorrect. So the salesman should be absolutely certain as to what he calls yield and what he calls payout.

One of my rules of thumb is if the salesman can't explain it to you, don't buy it. The importance here is how much of that (payout) is the assets I bought in the first place, and how much is return over and above that payout-the portion on which I expect to be taxed.

Nancy Zambell: That makes sense. So basically, if an investor is looking for yield, and he just wants a decent company, doesn't want to worry about tax consequences, and does not really understand the difference between yield and payout, there are still an awful lot of stocks out there that are paying great dividends, right?

Ronald Muhlenkamp: Yes. What we found lately is there are a number of companies whose dividend yield is now higher than the yield (the interest) they're paying on their bonds. Everything from Microsoft (MSFT) to General Electric (GE) to Phillip Morris (PM) are yielding 3.5% to 4.5% on their stocks.

And anytime you look at getting yield on the stock, you want to look at what the payout is. In some cases, the payout is less than 50% of what they're earning. Whereas I was worried about the royalty trust, tting some of your assets back each time, in this case as long as the payout is less than they're earning, then there's a cushion if earnings go down or if they choose to raise the dividend.

But you always want to look through what they're paying out to see if they're earning more than that. And to be sure that what they're paying out is what they're earning on the asset, rather than a sale of the asset itself.

Nancy Zambell: Ron, why would some of them actually pay more out in dividends than what their current earnings are? Is that like a hope and a prayer?

Ronald Muhlenkamp: It's because the investor demands it. Look, Wall Street is a beautiful marketing organization, and if you want more yield, Wall Street will sell you something that promises more yield. It's incumbent on you to determine whether in fact it's an earned yield, as opposed to simply a return of your principal. You have to do your own homework.
Nancy Zambell: How do you feel about all of the companies that are increasing their dividends now? We're also starting to see some buybacks occur. Are you more in favor of buybacks or increasing dividends?

Ronald Muhlenkamp: Last year, capital gains tax rates and dividends tax rates were the same. This year, dividend tax rates have moved up some. For the companies that we own, because we think they're cheap, we'd rather they bought back their own stock.

For instance, when Microsoft sold at 30 times earnings, you may recall at one time they paid out a special dividend. They're telling you several things with the special dividend. They're telling you that they accumulated more cash than they can profitably put to work, and they aren't necessarily really sure that's going to happen every year.

If they thought it would happen every year, they'd probably up the regular dividend, but they didn't. When they were at 30 times earnings and they had extra money, we wanted them to pay a special dividend. Today, at ten times earnings, we'd rather they bought in their own stock.

So my short answer is if the stock is cheap, we'd rather they buy back their own stock. If the stock is fully priced or overpriced, we'd rather they pay a dividend.

We think of ourselves as owners of the company, and we want them to return money to us anytime we can't earn a good return on it. But we also want them to return the money to us in ways that make sense for us from a tax standpoint.

Nancy Zambell: I know this is a great time to be in companies that are paying some income, because the interest rates you can get anywhere else are so low, and as well as equities are kind of scary. What happened this week with the market down, up, down, up, do you foresee that the market's going to continue on this volatility bent?

Ronald Muhlenkamp: We think so, yes, because there is not a clear direction that the economy is going to grow at what would be normal rates of 3% or more.

We do think stocks here are roughly fairly priced. And frankly, when they're fairly priced, they're more volatile than when they're dirt cheap or too expensive. So in essence, we think the prices are fair, and when they're fair, they become very, very volatile.

But what they do today and tomorrow is no more important than whether it rains today or tomorrow. Over the course of a year, you want to get enough rain for your garden to grow, but what day it occurs doesn't matter too much.

If we think stocks are dirt cheap, they tend to come up. That was true three years ago, in March 2009, for a lot of reasons. If we thought they were terribly expensive, as the dot.coms were in 2000, that was fairly clear (they went down).

On average, we're finding stocks to be fair. But that means, on average, they should return 7% or 8% over time. And of course you can get about 3% or 4% on a bond, so we like stocks better than bonds. In fact, we don't own any bonds. We don't think interest rates are attractive.

But if you look through the earnings, or look through the dividends, No.1 you want to be sure the company is going to be around for a decade or two. We want balance sheets strong.

We want a low enough debt ratio that we are convinced that the company can survive, and we want them to be doing something useful that people are willing to pay for. Whether they pay it out in dividends or whether they buy any more stock-both of those are useful things to do with the money.

Now, if they go out and buy a bunch of golf courses and 747s-companies do have ways of pouring money down rat holes-you want to avoid that. We want to know what their criteria are for using the money they're generating, and as long as that makes sense, we think it's a decent time to be owning some of this stuff.

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