Join Kelley Wright LIVE at The MoneyShow Las Vegas!

Join Kelley Wright LIVE at The MoneyShow Las Vegas!

Don't Swing for Fences with Income Stocks

02/24/2012 9:30 am EST


Kelley Wright

Managing Editor, Investment Quality Trends

Income investing is about consistently building your wealth, so don't be lured into big yields because you're likely taking on more risk than you realize says Kelley Wright of Investment Quality Trends.

The World MoneyShow, Orlando, Florida
Truth be told, I really enjoy teaching. When the workshops at the Show are completed, I generally come away both energized and gratified that so many investors find value in our approach.

Who knows, maybe I’ll become a teacher after I plant the flag and retire. Heaven knows my golf game is horrible.

The question and answer period at the end of our workshops generally provides me a good idea of what most of the attendees are interested in or concerned about. At this MoneyShow, it was fairly evident that many investors are frustrated with the low interest rates available from traditional fixed-income securities, and generating income is their No. 1 objective.

Unless I’m totally off the mark, my sense is that many, though not all investors still view capital appreciation as the primary reason for investing in stocks. This is surprising given that so much of the punditry and the financial media have been beating the dividend drum pretty hard the last year.

Still, the majority of questions I received typically circled back to which stocks offered the greatest upside potential. Not everyone was pleased when I told them they were getting the horse before the cart, but for others I could definitely tell when the light came on.

As practitioners of enlightened investing, we can sometimes take the basics for granted as they become second nature, so it is instructive to review what works from time to time in order to avoid complacency.

The sole purpose of investing is to realize a return on investment. In that regard, nothing is more fundamental than the cash dividend. Cash is the means by which we secure our needs, be they food, clothing, shelter, etc. Cash in excess of our needs can be reinvested to grow additional capital for generating a larger stream of cash in the future.

Beyond income, the cash dividend is the most important measure of return, because it provides salient information about a company that traditional analysis does not.

First, the cash dividend is tangible evidence that a company is profitable; a company cannot pay out that which it does not have. Second, a rising dividend trend is a clear indicator of earnings progress; a company cannot increase its dividend unless it has the earnings to support the increase. Stated another way, a rising dividend trend reflects the company’s optimism about its prospects for generating future profits.

We have also concluded that a rising dividend trend is a predictor for stock price increases. When a dividend is increased, the return to the investor is increased. With a greater return, the value of the investment is enhanced, so logically the price of the shares must rise to reflect the increase in value.

It can be observed that a long history of dividend payments and dividend increases also provides a degree of safety beneath a stock’s price. This is not to suggest that a high-quality, dividend-paying stock will not decline in a broad market sell-off—when the plug gets pulled, all the toys float toward the bottom.

What we have found though is that a company with a long history of dividend payments and dividend increases declines less, and recovers quicker, than do shares of stocks that do not pay dividends. McDonald’s (MCD) is a great case in point.

Lastly, when considering the return objectives of capital appreciation and dividends, I cannot stress the importance of understanding that the cash dividend is a policy. As a policy the dividend must be voted for and approved by the board of directors. Therefore, dividends have a record date, an ex date and a payment date. Capital appreciation has none of these conventions.

Obviously, we welcome capital appreciation. We just don’t hang all our investment hopes on it. In our experience, the cash dividend and dividend increases come first; when those are established, capital appreciation generally follows.

Remember too that not all dividends are created equal. I was asked in an interview that should be available on shortly about a mortgage REIT with a 19% payout. As this company is not in our universe, I cannot speak to the specifics of the payout, but I am willing to suggest that it is not all income generated by operations.

Beyond the fact that this payout is far above the current yield environment, my guess is that a portion of the payout is a return of capital, capital gains, or perhaps the premiums received from futures or options contracts. In any of these instances, there is no guarantee this payout can be replicated for a sustained period of time like the dividend can in a Johnson & Johnson (JNJ) or a Coca-Cola (KO), for instance.

For the greatest upside potential and downside protection, great companies must still be acquired when they offer good value. Long-time readers of course know this is the area we call Undervalue.

At times, there is much to choose from in the Undervalue area, and at times there isn’t. This requires patience, which is difficult to maintain when animal spirits are lively and market sentiment is perhaps ahead of the underlying fundamentals.

In our approach, there is no need to be anxious. Let the market of stocks come to you instead of chasing the stock market. As Geraldine has said many times, “stocks and opportunity are like streetcars; another one will come along soon.”

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