UNP - Build Portfolio Wealth With Total Return Value Investing

2023-07-12 13:47:44 ET

Summary

• High-yield dividend stocks and dividend growth investing were all the rage in the post-Great Recession bull market for all the wrong reasons.
• Thoughtful, disciplined, and patient investors are steadfast in dividend value investing for total return from capital gains and dividend income.
• Mistake number one for many investors is buying into an investment based on a tip from a broker, financial writer, or worse, a neighbor. Do your research.
• A profitable alternative to high-yield investing is calculating the yield-on-cost of quality companies with low payout ratios already residing in your portfolio.
• Instead of chasing yield, buy quality at a reasonable price, and hold for as long as you can, perhaps forever. Any dividend payouts are a bonus.

Chasing dividend yields and non-dividend growth are recipes for junk. Build wealth with total-return investing — capital gains plus income — thus, in retirement; we are pursuing bucket list items instead of higher dividend payouts.

I rebalance our family portfolio perhaps once a year — by adjusting the holdings to maintain asset allocation — driving it as a total-return vehicle instead of one of income only. Remember, dividends keep us compensated in the short term as we wait for capital appreciation of the equities held over time.

This article explains why and how total return best serves thoughtful, disciplined, and patient quality-driven value investors.

Practice Total-Return Investing

Quality dividend value investing, or total return, focuses on dividend yields below 5 percent, a range where companies pay far lower than 100 percent of earnings in dividends, also referred to as the payout ratio, addressed later in this article.

Many companies behind 6 to 10 percent and higher-yielding shares must grow dividend rates, or the stocks need to fall in price, or a combination thereof, for the dividend yields to remain high or increase. Those are recipes for disaster.

It is rare for popular trends to become remedies for struggling investors. Time and again, each investment fad is harmful to portfolios. Common sense investors favor companies where the average of trailing dividend yields plus the yields on earnings and free cash flow exceed the prevailing Ten-Year Treasury rate. Nevertheless, we cannot predict the future accurately and never attempt to do so at the expense of our portfolio and the family it supports.

Although safer than high-yield dividend or non-dividend growth investing, dividend-paying value investing carries the shared risks of investing in the stock market. All dividend stocks face unexpected rate reductions or suspensions by the company's board of directors.

The dividend-paying common shares of quality companies tend to be less vulnerable to ticker price volatility and market liquidity than forward high-yield dividend or non-dividend growth stocks.

All the Rage for the Wrong Reasons

High-yield dividend stocks were top-of-mind for investors starving for higher payouts in the low-interest-rate environment of the post-Great Recession bull market.

Many top subscription offerings and financial media pieces focused on the forward high-yield paradigm. History tells us the crowd is almost always wrong regarding fads and favorites. High-yield dividend stocks — defined as 6 percent and higher yields on common shares — are no exception, and that is why Quality Value Investing ((QVI)) maintains a perpetual bearish view of the practice.

Along with high returns, loom risky headwinds and questionable underlying fundamentals. Just ask the victims of the high-yield junk bond bubble in the 1980s. Perhaps the recent bull market and its high-yield equity opportunities were somehow different; the permabulls rejoiced.

The junk bond craze returned to the epic bull market through forward high-yield dividend stocks. And history reminds us how that bubble burst during the 1987 stock market crash. This time, instead of leveraging mergers and acquisitions at the corporate level when available capital was insufficient, high-yield equities influenced daring risk/reward plays as retail investors and advisors sought outsized returns to leverage retirement account balances.

Defining high-yield equity is debatable and broad. Therefore, this article distinguishes high-yield dividend stocks as publicly traded equities distributing at least one-and-half times the prevailing Ten-Year Treasury rate that stood at 3.98 percent as of the market close on July 11, 2023. Hence, we arrive at 6 percent or higher as our arguable definition of high-yield equity.

Consider the sub-1 percent rates an anomaly in the epic bull market context. An inevitable cyclical downturn in the overall stock market preempts the principal capital invested by millions of retail investors concentrated in risky, high-yield dividend equities such as business development companies [BDCs], master limited partnerships [MLPs], and real estate investment trusts [REITs]. This time, the coronavirus pandemic and inflationary bear market reared their ugly heads and pummeled many high-yield portfolios.

Disciplined, rational investors never buy stocks based on market euphoria or the dividend yield alone.

His Neighbor Yelled, "Buy the Yield"

For some background: High-yield dividend investing appeared on my radar earlier in the post-Great Recession bull market from a retired family member.

Acting on a tip from a neighbor — mistake number one — he moved a substantial amount of capital from a well-known, blue-chip equity REIT to the unpriced, non-marketable security of a high-yielding hotel REIT.

The REIT staple sold out to create the capital, ended up a seven-bagger stock with an approximate range of 4 to 5 percent in average annual dividends in the subsequent years. As promised, the unpriced hotel REIT paid much higher dividends, and the security, in due course, went public at about the original cost per share. On the precipice of the COVID-19 coronavirus correction in early 2020, the price of the now publicly traded hotel REIT was down 15 percent since the IPO, although it continued to pay healthy dividends. A preliminary result in the scheme of things, as it equated to a no-bagger, in stark contrast to the seven times return of the blue-chip REIT sold to create capital for the high-yield, unpriced security.

The misfortune of the family member is an example of the risks involved with unpriced securities. However, priced or unpriced, the persuasion of retirees to sell below 5 percent stable yielders for the 6 to 10 percent plus forward yields of risky equities was widespread. Again, caveat emptor prevails.

The enticement of high yields on a stock seems to overshadow the necessary due diligence required to determine if the representative company is stable enough to justify the yield with capital allocations and shareholder returns from a well-managed operation. Do we prefer to own a quality 4 percent yielder with compounding average capital gains of 6 percent a year or a high-risk stock yielding 10 percent, although averaging a minus 5 percent annualized capital loss?

Quality-driven value investors are averaging a plus 10 percent average annual total gain in the former. In contrast, the high-yield fan is settling for a meager plus 5 percent average annual total return in the latter.

Perhaps some retirees have had the opposite experience by investing in high-yielders producing double-digit total returns each year during the recent bull market. Like a raucous party, this bubble burst when the coronavirus pandemic arrived uninvited. High dividend investors who think it possible to time the perfect exit are sailing on the proverbial ship of fools.

Chasing Yield: A Recipe for Junk

Many top financial advisors, bloggers, and investors focus research and investing energies in forward high-yield dividend investing, such as REITs, BDCs, and other closed-end funds [CEFs], energy transfer partnerships, and preferred stocks.

For those wondering, QVI is exclusive to common shares, whereas preferred stock is an equity instrument presented as a glorified bond emphasizing the dividend. Despite holding no voting rights, preferred shareholders are paid some earnings before the common shareholders. However, if we are committed to owning tiny slices of quality companies, there is less worry about getting in line for payment.

Thus, take the secondary dividend and the first voting rights — and, more important, the capital gains — of the common shares of high-quality, enduring companies.

Some well-crafted story headlines and marketing pitches cast a positive spin on the paradox of a safe, high-yielder. Such absurdity is akin to fishing for sushi-grade salmon in a crystal clear river known as toxic from a colorless pollutant.

As expected, these pundits remind us of what we missed, disregarded, and tripped over in the amateur analysis, challenging some of our assumptions and conclusions. Although the professional debate is encouraged and welcomed, QVI's premise remains that investors chase dividends more than enterprise quality with forward high-yield stocks. Nonetheless, if a conscientious trading strategy puts income ahead of capital gains, so be it with cautionary best wishes.

Remember, dividend rates adjust monthly, quarterly, or annually from board-directed payouts; the corresponding yields go up and down each market day as a prisoner of the stock price. The concept of dividend payouts involves a simple paradigm in the fundamental economics of the price/yield relationship, whether bonds or equities.

The yield goes down when the price goes up, and vice versa.

The Alternative High-Yield Dividend Model

Measure a stock holding's yield-on-cost instead of chasing current dividend payouts. The return on cost represents the yield of the current dividend rate relative to the cost basis of the common shares.

For example, as of the market close on July 11, 2023, the yield-on-cost of five select holdings of the QVI Real-Time Portfolios was far superior to their current forward yields.

Yield-on-Cost of Select Five Holdings of the QVI Portfolios

( Source: Quality Value Investing, as of the market close on July 11, 2023 ).

Table Key

• Ticker — DICK'S Sporting Goods ( DKS ), Coca-Cola ( KO ), 3M ( MMM ), Microsoft ( MSFT ), and Union Pacific ( UNP ).
• Dividend Rate — Trailing one-year dividend payout.
• Cost Basis — Original cost of each common share of stock adjusted for splits and dividends in the QVI Portfolios.
• Forward Yield — Dividend rate divided by the market-day share price.
• Yield-on-Cost — Dividend rate divided by cost basis per share.

Note: Although 3M now meets QVI's definition of a forward high-yield stock, it was added to the portfolio in July 2010 as a total compounder.

Payout Ratio

The payout ratio is the proportion of earnings paid out as dividends to shareholders, expressed as a percentage.

A lower payout ratio is preferable to a higher one. A rate higher than 100% indicates that the company pays out more in dividends than it earns in net income. Many inflated payout players are REITs and BDCs, required by financial laws and regulations to distribute up to 90 percent of taxable income to shareholders.

When I screened high-yield dividend stocks trading on the U.S. major exchanges for this article, almost half of the companies listed had payout ratios higher than QVI's targeted ceiling of 60%, and close to one-third had payout ratios above 100%. Where is the cash flow to support this generosity?

The concern is whether the excess payout is coming from somewhere on the balance sheet or cash flow statement detrimental to the financial stability of the operation. Instead of chasing risky, forward high-yield dividends, calculate the yield-on-cost of portfolio holdings with low payout ratios.

The five holdings of the QVI Portfolios showcased in the preceding yield-on-cost table had payout ratios of between 19.53% (DICK'S Sporting Goods) and 70.63% (Coca-Cola). Seek companies paying sustainable and predictable dividends to shareholders, as those payments will keep us compensated in the short term as we wait patiently for the capital appreciation of the stock price over the long term. Own a quality company with a sensible payout ratio, and the dividend yield will take care of itself.

Despite the popularity of high-yield securities, become an advocate for the ownership of quality companies represented by dividend-paying common stocks listed on U.S. major exchanges and available at value prices.

In retirement, the dividend becomes income in itself. And when measured by the yield-on-cost, the low payout ratio dividends may earn a high yield worthy of ownership because of the acceptable margin of safety.

Outperform the Market or Join it

The do-it-yourself, active approach to building portfolio wealth with common stocks is about outperforming across each market cycle, whether bull, bear, or range-bound.

Among my favorite individual investors included my wife's Aunt Beverly. She bought and held stocks leaving the share certificates in a bank vault and never selling. Her broker made a pittance off Beverly's lifelong pursuit, and a few of her holdings had gone to zero. Nevertheless, by the end of her life, the robust portfolio delivered a powerful lesson in the potential rewards of buying and holding the common shares of wonderful companies and enjoying the compounding total return of capital and dividends.

A humble reminder that it is possible to outperform the S&P 500 (SP500) over an extended timeline. If a retiree, the priority is to hold stable, blue-chip businesses providing safe cash flows from dividends exceeding the prevailing inflation rate. Remember, instead of serving the market — as many investors do — allow the market to serve us.

Model the portfolios of successful retail investors on Main Street, such as Aunt Beverly, who reminds us that the total return paradigm produces some of the most exceptional performances in common stock investing. As low-fee generators, those portfolios are hard to find on Wall Street.

Such alpha-achieving practices motivate us to build portfolios with limited capital but at lower costs and less risk.

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