ARCC - Wealth Without The Drama: Creating Our Own Growth Through High Cash Yields

2023-05-08 09:09:09 ET

Summary

• "Total return" has two equally important elements: Cash dividends received, and appreciation/depreciation.
• One is a lot easier to control and predict than the other; as we've seen recently, as income investors happily clipped their coupons, growth investors gritted their teeth.
• "Creating your own growth" through re-investment and compounding impressed Einstein so much he reportedly called compound interest the "8th wonder of the world"
• In fact, Einstein almost certainly never said that. But I don't care, since it works for me!

"Non-Heroic" Wealth Building

The message most investors receive constantly from their brokers, advisors, cable channels and other business media is that success depends mostly on placing "winning bets" on the right securities. Then we have to follow their progress 24/7, always being alert to signs of trouble that may require us to bail out or change course at a moment's notice.

Whew! That's a lot to worry about. No wonder so many average investors are stressed out and confused, or throw up their hands and buy overpriced annuities and other heavily-promoted products and services that promise to relieve them of the angst and insecurity of investing for their own futures.

While investing can indeed be all of that for many people, it doesn't have to be. I know, because over the past 40 years that I have been actively investing for my own retirement I have developed an alternative way to think about investing, an approach that (1) emphasizes things that we as investors have more personal control over, and (2) does not require as "heroic" an achievement in terms of earnings or stock performance as typical growth-oriented strategies.

About ten years ago here on Seeking Alpha I began to call my strategy the "Income Factory" in order to focus attention on the actual job I expect my investment portfolio to do. That job is to produce a constant "river of cash" - i.e. income - in the form of dividends and cash distributions, that can then be re-invested in new securities, whose job in turn is to provide additional income in the future. As that new income is re-invested and begins producing even more income, my river of cash continually grows.

Through re-investment and compounding, the cash build-up will increase year after year at a fairly predictable rate, depending on the percentage yield our securities are paying us. The cash output from our "factory" will double, and then re-double, and then re-double again continuously over the course of one's lifetime. A 10% yielding portfolio doubles and re-doubles about every 7.2 years. An 8% yielding portfolio doubles every 9 years, a 7% yielding portfolio every 10 years, etc.

Notice we haven't said anything about our securities' market prices going up (or down). That's because our portfolio's output (i.e. the cash it produces, that is constantly re-invested to produce more cash, etc.) does not depend very much, if at all, on the growth rate of its individual securities. And long term it is the cash income our investments produce that creates and determines it real "economic value. "

It is the re-investment and compounding that provides the growth in the income stream, not any required growth in the market value of the assets in the portfolio. The portfolio will, of course, grow in value over time, not because the individual securities rise in price, but because there are more of them, as we use the cash we receive monthly or quarterly to buy more income-producing assets to add to our factory.

Growth Without Growth Stocks

For those of us who grew up in an investing environment where market appreciation was the be-all and end-all, embracing our income strategy's "growth without growth stocks" philosophy can be a big step, mentally and even emotionally. To make the leap of faith required, it is helpful to spell out and understand how growth actually occurs in a traditional investment portfolio.

First, we should note that the goal of most long-term investors (including me), regardless of what investment strategy we follow, is to earn an "equity return" averaging about 8% to 10% per year. We pick that target because 8-10% is approximately what returns on stocks have averaged over the past century. Some equity investors do better than that, others do worse, but if someone can match that average or even come close to it over a lifetime of investing, they (and their dependents and eventually their heirs) should be pretty happy later on when they reach and surpass retirement age.

The big question is, "How to achieve that 8-10% return?" Return, or "total return" as it is often called, has two components: cash received (dividends or distributions paid by your securities) plus market price appreciation or depreciation. Cash received is real. Market price appreciation (or depreciation) is theoretical ("paper profit or loss") and only becomes real when you sell the security and harvest the gain (or loss).

In traditional investing, you buy stocks that typically pay dividends of anywhere from 1% (sometimes zero) to 4 or 5%, and then depend on the company to make up the difference between that and your 8% or 10% target by increasing its earnings and dividends from year to year by the amount of the gap. The lower the cash dividend a company pays, the more its stockholders are dependent on future growth to reach their target earnings level. That's why a company that pays a paltry 1% or 2% dividend had better have serious growth prospects to make up the difference. A mature company, like a major utility or industrial "blue chip" that pays a more generous 4-5% dividend, has less of a gap between its dividend rate and its stockholders' 8-10% income target, but it is still expected to make up that 4-5% difference in growth year after year.

With our income-based strategy, we don't have a "growth gap" to worry about since re-investing and compounding the high cash distributions we receive achieves our total return target rate without requiring any additional market price growth. Our overall "factory" will in fact be worth more over time, not because prices of the individual securities grow, but because we can constantly use our cash income to purchase more of them, thus expanding the factory.

To better understand this, think of a real factory. When Ford Motor builds a new automobile plant, the only ones who care about what the plant is actually "worth" - i.e. what Ford could sell it for - from day to day or month to month are the accountants. Everyone else at Ford focuses on how many cars and trucks the plant produces, and how to increase that output going forward by re-investing, adding new machines, etc.

The market value of its plant is not relevant to Ford, since its business isn't buying and selling factories, it's making and selling cars. When we embrace an income-focused strategy, whatever we call it, we are acknowledging that our long-term investing goal is to create an income stream for ourselves. Owning stocks, bonds, funds or other investments is a means to that end, which is creating the continually growing river of cash that we can retire on, or use for other long-term goals. The portfolio (i.e. "factory") that produces that river of cash obviously has a very real economic value to us. But the price the market attaches to our portfolio from day to day or even month to month is largely irrelevant to us as long-term investors. (Obviously if we are going to need the principal within a shorter time period, to buy a house or pay major bills, then this is not an appropriate strategy and we should focus on capital preservation rather than long-term growth.)

Advantage #1: Cash Income Growth During Downturns

Three features of this strategy are especially attractive. One that is somewhat counter-intuitive is that an Income Factory's earnings stream actually increases faster when stock markets are flat or dropping than when they are rising. This is difficult for some people to accept, even after we demonstrate it mathematically, since it flies in the face of our natural tendency to always assume that rising stock prices are a positive and make us wealthier.

The reality is that, for an income investor, your income stream doesn't drop just because stock prices do, so your river of cash buys more when securities have dropped and are "on sale" than when they rise. By being able to buy even more new securities (machines for our factory) because their prices have dropped than you would have been able to if prices were flat or had risen, your compounding rate is higher than it otherwise would be. The extra 0.5% or 1% you pick up by re-investing through down markets over many years can eventually add tens of thousands of dollars of additional income. When Einstein said (reportedly although never confirmed) that "compound interest is the eighth wonder of the world" this is what he would have been talking about.

Advantage #2: Sleep Better Through Market Turbulence

The second feature I like about our income-focused strategy is the greater sense of security it gives us during periods of market turbulence. It is hard for many investors to sit through market slumps or bear markets and only collect the 2 or 3% current yields that typical "growth" portfolios pay, while watching market prices fall. Our strategy, by employing investments and asset classes that pack a full equity return level of 8% to 10% into their cash distribution, makes it psychologically easier for investors to "keep the faith" and NOT feel the urge to get trigger happy and bail out or take defensive actions that might seem like a good idea - at first - but be costly over the long term.

In Charles Ellis's classic book on investing, Winning the Loser's Game , the author compares investing for many people to amateur - not professional - tennis, where he says most points are LOST through bad shots as opposed to being WON as a result of good shots. Ellis shows how this is also true in golf and even in war, where avoiding doing the wrong thing is the key to success much more than actually doing the right thing. In investing, doing the "wrong thing" typically involves losing one's nerve and selling out at what turns out to be a low point or even the bottom of a market slump. Such mistakes are often compounded by then "being on the platform and missing the train" when market prices turn up again, as history has shown us they invariably do.

The difference of seeing, feeling and touching the cash each month that you can reinvest to create your own income growth, and especially to be able to do it all through the downturn itself, provides a sense of control that helps Income Factory investors fight off the impulse to "do something" that can involve turning temporary paper losses into permanent real ones.

Numerous studies demonstrate that buying quality stocks and holding them through thick and thin over many decades is the most effective way to achieve stock market success. But history shows many investors do NOT have the will forces and intestinal fortitude to buy and hold through market downturns. In this way, a high yield income strategy suits the psychological and emotional needs of many investors, as well as meeting their long-term financial objectives.

Advantage #3: "Non-Heroic Investing"

My other favorite feature of our income-focused strategy is that it allows, even encourages, what I call "non-heroic" investing. Think about the traditional "dividend growth" stock that pays cash dividends of 3-4% (or less) and has to then grow at 5 or 6% each year to make up the difference for an overall 8-10% growth rate. Since our entire economy has only grown at an average 3% per annum for the past 75 years , we know most companies can't be growing at almost twice that rate, unless they are like the children of Prairie Home Companion's mythical Lake Wobegon, who were all reported to be "above average."

That means a typical growth investor is expecting all the stocks in his or her portfolio to have "above average" growth compared to the rest of the economy. Otherwise, why would their stock prices grow any faster than the economy at large? That to me is "heroic" investing, where you are expecting the securities you buy to substantially outperform their competitors and the economy generally. For that to happen, they have to be great companies and you have to be a great stock-picker.

Securities in our high-income portfolios don't have to outperform. All they have to do is keep on making the interest and dividend payments they already make. I consider that "non-heroic" investing. If it were a horse race, the heroic investments that expect above-average growth over time are the equivalent of betting on horses to win the race, or at least place or show, meaning they have to do much better than the average horse in the field. Our portfolio's horses only have to finish the race, i.e. stay in business and make the interest and dividend payments they currently do. Which is the safer bet? Betting on specific horses to win, place or show, or betting on the entire field of horses to just finish the race?

Thinking Inside or Outside the Box?

By now you may be asking: "Sounds good, but if it is so obvious and straightforward, how come nobody else thought about it?"

Fair question. I think the answer is that it is easier to think "outside the box" about something if you have never been put "inside the box" to begin with. I never had any formal training in investing, and never learned about traditional investment strategies until later in life. By then I'd already been an international banker and learned about credit and risk from the perspective of a lender, not a stockholder, so I was totally comfortable with the idea of making money via "fixed income" payments (i.e. that stayed the same and never grew) rather than through stock price appreciation. For me it is all about math. Which stream of payments will grow faster or more reliably, either through heroic efforts on the part of the company to constantly increase its cash flow over time, or through relatively non-heroic efforts by companies that merely maintain already high-yield current cashflow levels?

Later I did a stint as a journalist at a financial magazine, and learned how to write about complicated financial topics in plain English that non-experts could understand. Hence my interest in using simple analogies like "Income Factory" or "betting on horses to merely finish the race instead of having to win, place or show" to explain the difference between growth investing and an investment strategy based on reinvesting and compounding cashflow.

After that, I spent my third career in the financial markets working on products to assess the risk in corporate loans, private placements and other non-public securities, which opened my eyes even further to the risks and opportunities outside the traditional equity mainstream, especially in the credit markets.

Finally, my experience during the "great crash" of 2007-2008 demonstrated, in my own portfolio and in the financial markets generally, how so many healthy assets that kept on pumping out cash flow just like the Energizer Bunny still dropped in market value to 60 or 70 cents on the dollar. This seared into my consciousness the idea that market price and paper profit (or loss) often have little to do with the real economic value of an asset, and that ignoring market prices while you keep your head down and continue to clip your coupons and re-invest through the storm can be critical to long-term success.

That's why most of my writing, as well as my personal investing, focuses on high yielding securities that generate most of their total return in cash that you can touch and feel, as well as reinvest and compound. That provides an element of personal control over my own wealth-building, and lets me sleep better at night during turbulent periods like the past year.

Readers who want to check out this sort of strategy for themselves may wish to consider high-yielding asset classes, like senior secured loan or high yield bond funds, like Barings Corporate Investors ( MCI ) or Ares Dynamic Credit Allocation ( ARDC ), closed-end equity funds like Liberty All-Star Growth ( ASG ) or Reaves Utility Income ( UTG ), or Business Development Companies like Ares Capital ( ARCC ).

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