Clients used to brag about their dividend stocks, like electric utility PG&E, to advisor Ken Winans. Now they're asking for his help.
Investors thought PG&E dividends were money in the bank. But instead, the California power utility slashed its dividend from 4% to 0% in late 2017. And in January, it filed for bankruptcy protection. PG&E is the sixth-largest U.S. bankruptcy ever, topping even the failed energy firm Enron, says New Generation Research. Shares are down roughly 70% — just this year.
"There are a lot of people who were so focused on the dividend payout from PG&E that they just wouldn't sell it. So they took this massive hit ... their principal is so low (now) they won't ever get it back," said Winans, a financial advisor at Winans International in Novato, Calif., not far from PG&E's headquarters in San Francisco.
PG&E is just the most dramatic example of the perilous situation income investors are in. And that situation calls for an upgraded approach to dividends and income investing. Smart investors today tend their income garden rather than simply buy and hold a high-yield stock and pray it will work out.
Income is hard to find, just as many retirees are looking for it. Rapidly retiring baby boomers seek cash flow to supplement retirement income from other sources like Social Security. Many see income-producing assets as a ballast if the aging 10-year-old bull market runs out of steam.
The problem is that the places investors look for income aren't working as well as they used to.
Navigating Perils In Income Investing And Dividend Stocks
Falling interest rates and dropping dividend yields make income from the usual sources scarce.
Following three cuts to short-term interest rates by the Federal Reserve this year, you'll get next to nothing by hiding out in "safe bets." The yield on the 10-year Treasury is down to 1.74%, about half of what it was just a year ago. That means popular bond exchange traded funds, tracking the broad market including high-quality corporate bonds, yield just 2.7%. And if rates rise, bond investors will lose money. That's causing some pros to call bond ETFs a bad idea.
Don't think you can put savings to work, either. The average national average savings interest rate is just 0.99%, says Bankrate.com. And yields on three-year certificates of deposit don't even crack 2%. That's not enough to stay ahead of the long-term inflation rate of roughly 3.2%. And it's barely enough to keep up with the historically low inflation rate of around 2% in recent years.
Cash sitting in brokerage accounts usually gets zilch.
It's a similar story with dividends. Companies are paying record cash dividends and are on pace to set a new record in dividend payments in 2019. But dividend yields (annual dividends divided by stock price) aren't budging as the market itself is soaring. The yield on the SPDR S&P 500 ETF Trust, the largest of its kind, is just 1.77%. All things held equal, dividend yields fall as stock prices rise.
The money isn't made from holding the SPDR S&P 500 for dividends. The real money is from the market's 25% rise.
That's why holding lagging stocks just for their dividends won't work. Yes, packaged foods company Kellogg pays a healthy 3.5% dividend. But the stock is also down nearly 24% from its high in July 2016 as consumers shift toward fresher food.
Was the dividend really worth it?
A New Income Investing Approach
Some investors seeking income might settle for lower returns. Others are exploring riskier choices.
Chasing yield comes with dangers, especially if too little attention is paid to the big picture. Trade disputes and changing consumer tastes disrupt seemingly stable companies, like Kellogg. And threats of higher corporate taxes are a possibility going into an election year. That's not to mention the question of whether corporate profit growth will pick up in 2020 or languish.
So, investors go out on an income limb to reach for yield alone. Total return, dividends plus stock-price gains, is a better goal.
This approach to income means broadening the definition of what it means to be a dividend stock investor. It's likely better to buy shares of a growth company, which may have a lower dividend. Then, as needed, you can sell some shares for income and still be ahead if the stock rises.
Stock Price Gains Trump Dividends
Dividends are an important part of total returns. They account for roughly a third of the S&P 500's long-term total returns. But they're the smallest part. Stock gains are how investors make money over time.
Take Microsoft. It's in the information technology sector, not known for its stability. But this technology stock is in a different class.
A growing percentage of Microsoft's business is more utility-like. Subscribers to its Office productivity software pay a monthly fee, giving the company a recurring revenue stream. Also, companies and governments sign up for long-term cloud computing services. They'll be loathe to cancel or switch to another provider.
Microsoft, too, is one of just a handful of companies with AAA credit ratings. And the company sports a sky-high 91 IBD Composite Rating, meaning it rates in the top 9% of all stocks in this broad measure of fundamental and technical performance.
Given Microsoft's growth outlook, shares of Microsoft are highly durable. Shares are up in the one-, two- and five-year periods. Over the past five years alone, shares tripled in value. The stock is up 47% just this year. On top of all this, you get a dividend yield of 1.4%.
Here's an example: Invest a million dollars in Microsoft and the $14,000 annual dividend isn't all that impressive. But when you're up $470,000 on the stock in just one year, you can afford to sell some shares for income if you need to. Building a portfolio of growth companies can generate capital gains that will dwarf dividends over time.
Consider Apple. It, too, is turning itself into a sort of technology utility for consumers. Many consumers automatically upgrade to the newest phone and are on payment plans. Apple's push now is in services, most of which charge by the month. Apple stock, too, is steadily rising and is up 62% this year. And the 1.2% dividend yield is just a bonus.
Look Beyond The Dividend Yield
True, these yields on Microsoft and Apple are below that on the S&P 500. But these cash-rich companies likely will boost their dividend payments, not cut them. Microsoft pays 51 cents a share a quarter in dividends, up 64% in just five years. Apple's dividends are up by a similar amount.
And that's why Cresset Wealth Advisors' Chief Investment Officer Jack Ablin says investors should focus on dividend increases, not just yield for income investing. For instance, Ablin likes ProShares S&P 500 Dividend Aristocrats ETF, despite it yielding just 1.9%. The ETF owns 58 stocks that increased dividends in each of the past 25 years.
"The best way to capture yield these days is from solid companies that have a strong history of dividend increases," he said. "That way, the income you receive will keep pace with inflation, should it reemerge."
Right Strategy For REIT Dividends
Real estate investment trusts are often touted as relatively stable sources of outsize dividends. But while REITs make a compelling income-generating choice, there are methods to finding the best options based on fundamentals and technical measures.
Chasing yield is dangerous among REITs, too. The most egregious example is Macerich, a Santa Monica, Calif.-based mall operator. Like many real estate stocks, Macerich touted a high dividend yield in early 2019: 6.9%. That's much higher than the 3.8% yield of SPDR Real Estate Select Sector ETF (XLRE) in January.
But chasing that dividend hurt. While shares of XLRE rose 25% this year, Macerich's dropped 37%. Holding that stock for a dividend, you lagged the S&P 500 by 60%.
"A lot of the usual suspects, like REITs and utilities, have been picked over, leaving few opportunities," said Ablin. "I've never seen REITs as expensive relative to the cash flow they generate."
Similarly, utilities can be an excellent option for yield. The Utilities Select Sector SPDR ETF yields 2.9%, putting it just behind REITs and energy stocks for income. But as PG&E investors found, some ways are better than others to find yield even in utilities.
Other Paths To Income Investing And Dividend Stocks
But advisor Winans thinks investors willing to do security-level research can find durable yield, too. That's also true with looking for yield from bonds. Winans likes select high-yield corporate bonds that are misunderstood by ratings agencies for income investing.
For instance, Winans likes bonds from long-standing manufacturing companies such as printing company R.R. Donnelley. The company's debt maturing in 2020 yields 4.8% annually. Investors willing to own bonds maturing in 2022 can get north of 5.3%. And R.R. Donnelley has been cash flow positive from operations every year since at least 1989. "We have to go back and redefine what is a risky bond," he says.
He also likes preferred stock, special dividend-paying shares with superior rights to assets over common stock in the case of a bankruptcy. Winans chooses individual preferred shares for his clients. But there are exchange traded funds that own baskets of preferred stock. The Invesco Preferred ETF owns more than 250 positions and yields 4.9%.
But one thing Winans doesn't like is chasing yield. Especially now.
"There're a lot of people who just look at yield," Winans said. "That's a huge mistake."
Follow Matt Krantz on Twitter @mattkrantz
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