When the purpose of your investments is to generate useful income, it’s natural to look around at all of the different investment vehicles available to you to find the highest yield for your dollar. The problem is that in today’s economic environment, investment yields work much differently than they did 20 or 30 years ago.
As a kid, I spent a lot of time hanging out with my Grandma. She wasn’t wealthy, but she had been a careful saver for her entire adult life, and so by the time she decided to stop working, she had a comfortable nest egg built up to supplement her Social Security income. I remember once a month or so she’d go to the bank to put money from an expiring CD into a new one. Throughout the 1970’s and 1980’s, CD rates never seemed to drop below 8%, and were often in the double-digits. That meant that a saver like Grandma could earn a nice, comfortable level of interest with practically zero risk.
By the time I entered the workforce full-time to start supporting my own family in the early 1990’s, the picture had already changed. The savings I was so carefully trying to build following Grandma’s example was now earning around 3% – if I was lucky. I did the math and quickly figured out that the bank wasn’t really doing much to help me out except giving me a place to put money and write checks.
The really sad part of the story is that since then, the picture has really only gotten worse. CD rates in the latter 1990’s hovered between 4% and 5% before dropping below 3% by 2003. After temporarily rising a little above 4% in 2007, they plunged yet again, and have not recovered since then. Every drop in the last 15 years has been spurred by Fed policy, which was intended to encourage small business investment and spur the economy.
At the beginning of this year, the average rate on a 5-year CD was less than 1%; as of today it has risen to a whopping 1.66%. The picture for other “safe” investments isn’t really any better. A 5-year Treasury bond is offering a 1.35% yield. The only way to get above 2% is to buy a 30-year bond, which will give you all of 2.61%. And while the Fed hasn’t ruled out raising rates for a second time in December, there is increasing speculation that it will hold off yet again, which means that yields in general aren’t going to improve anytime soon.
When the yields on so-called “safe” investments are so low – and they stay that way for years at at time – that you couldn’t do much worse by stuffing your savings under your mattress, there is a real problem. Even careful, conservative savers like my Grandma start to look around for alternatives. In the 1990’s when I saw such deplorable yields, and reasoning that I was young with time on my side, I decided I could be more aggressive, so I started putting my savings into stock mutual funds. Why not? The stock market then was in the midst of its biggest bullish trend to date, and earning a 20 – 25% return per year from a diversified mutual fund sounded a whole lot better than the measly 2 – 3% I might get from a CD.
We find ourselves in much the same situation today, with otherwise sensible, conservative people starving for useful yields. Fed policy today seems even more determined to keep propping up the stock market under current conditions as it ever has been in the past to encourage small business development. As a result people who would normally gravitate to more conservative vehicles are discounting the stock market’s inherent risk. As an income investor, I see this trend manifesting itself in a couple of the areas my system is designed to focus on: stock dividends and put sales.
Chasing Dividend Yields
About a year after we started the Rebel Income service, I started seeing an increasing number of articles and news stories about the usefulness of dividends in a long-term investing plan. At the time, it made me smile, not only because it was validating what we were already doing, but also because I hoped it would encourage people to look more critically at the investments they were making.
It seems that every so often, the conversation among talking heads starts to shift back to the usefulness of high-yielding dividend stocks. The longer the a bullish trend lasts – and to be clear, even with this year’s drop to bear market levels, the much longer-term upward trend remains in place – the more people seem to think the stock market is a can’t-miss place to put their money, and if that is true, why not look for the stocks offering the highest dividends right now? What I think gets ignored is the reality that dividends, while being an important of company’s fundamental profile, by themselves do not equate to fundamental strength.
A few years ago I pulled a list of some of the stocks offering unusually high dividend payouts to use as a reference point. I screened those stocks based on a few simple fundamental measurements that I felt would help frame their high yields in contrast to, or in support of the company’s core financial and operating strength. Let’s take a look.
Investors who are simply looking for the highest dividend yield might be tempted to load up on shares of a stock offering annualized dividend yields such as what is shown above, and the truth is that you can find these kinds of yields in just about any market condition; but the Return on Equity (ROE) and Debt/Equity numbers alone should be enough to give anybody pause. I added the final column to enhance the risk picture even further because I put a lot of emphasis in my fundamental evaluation on Free Cash Flow (FCF).
It isn’t all that unusual, or even problematic to see fundamentally strong stocks carrying a higher level of debt than they do cash. I’ve written before about the fact that debt, in and of itself, isn’t automatically a bad thing in business. The question is whether a company is managing its debt effectively enough to use it as a tool to enhance their business.
I don’t have an absolute cut-off level for where a company’s debt versus Free Cash Flow should be; but as much as possible, I prefer to see Free Cash Flow within shouting distance of a company’s total debt. A ratio as close to 1 as possible is preferable, but as high as 2 or 3 is usually okay too. Much higher than that, though, and my concern about what the company is using debt for, and their ability to manage that debt rises. The stocks in the table above are working with very high levels of debt – so much so that I believe the risk to an investor is much higher than that I would prefer to accept. Their ROE numbers, showing that these are extremely inefficient companies, certainly call into question how their boards can justify paying such a high dividend yields.
If you’re looking at a stock offering an outsized dividend yield, take the time to look for more closely. You might find elements like what I’ve used here that indicate the stock isn’t really as attractive as it might seem. Dividend yields can get pumped up in a few different ways – a large drop in the stock price while the company keeps the dividend consistent, or possibly even increases it, for example. That may not be a bad thing – but if the company’s operating strength doesn’t justify the dividend, there might be something else going on.
Chasing Put Selling Yields
This next danger isn’t as common, simply because put selling isn’t a widely used trading strategy, but it’s just as real. There’s a temptation when you start using put options to generate income to look for the highest yield available in the shortest period of time possible – or to sell more time to increase the yield over shorter expirations. My experience is that stocks with outsized short-term put sale yields usually also carry more risk than the stocks I prefer to use. Take a look at these examples.
I’ve put the Price/Book ratios for each stock in this table in place of ROE to provide another perspective. Sometimes a put sale looks so good, and covers such a short period of time, that it’s easy to be tempted to ignore things that could indicate the story isn’t as good as it looks. HEES, for example, doesn’t have a horrible Debt/Free Cash Flow ratio, and the put sale yield looks pretty nice. Seeing the stock’s price, at not quite $16 per share, already 4 times higher than its Book Value should make you wonder how much upside this stock really has. And while DB has a nice put sale yield and a terrific Price to Book ratio, the company’s outsized debt relative to Free Cash Flow should be enough to scare away any serious income investor.
There is a term I’ve learned over my years in the stock market, and that I think applies to this discussion: “Pigs get Fat – Hogs get Slaughtered.” I think this is a great idea to keep in mind as you think about the yields you’re looking for. During the boom of the 1990’s, I found it easy to justify taking more risk in exchange for a higher potential return on my investment. Watching the dot-com boom go bust – and watching my retirement accounts dwindle to a fraction of their previous levels – taught me a hard lesson about working with reasonable returns with minimized and carefully managed risk.
The Rebel Income system is designed to work with conservative yields on stocks with strong fundamentals behind them. Like everybody, I get excited when I can bring in an inflated premium. If the stock’s fundamental strength and its value proposition, however don’t justify the trade’s risk, I’ll always err on the side of caution.
If you are a new subscriber, please take some time to review the videos in the Getting Started area of the website. These will give you a pretty comprehensive view of the value-oriented approach I use to generate income with put selling and covered calls. You will also find it useful to read my Frequently Asked Questions article. Also feel free to review my previous posts as you’ll find additional answers to many of the questions you may have.