7 High-Yield Dividend Sin Stocks

The following originally appeared on Kiplinger’s as 7 Dividend-Rich Sin Stocks to Buy Now.

Pop culture has always loved the bad boy. From James Dean’s Jim Stark in Rebel Without a Cause to Harrison Ford’s Han Solo of Star Wars fame, everyone roots for the lovable rogue. But that’s generally not true in the stock market, where “sin stocks” or “vice stocks” often get the stink eye.

Investors, and particularly large institutional investors, have reputations to manage. Pensions and endowments, in particular, increasingly have environmental, social and corporate governance (ESG) mandates that prohibit them from investing in industries that are politically incorrect or deemed to be socially harmful.

In the past, this has generally meant vice stocks such as tobacco, alcohol, tobacco, gambling and even defense companies. (No one in polite company wants to be branded as a merchant of death.) But today, the net is cast a little wider. Oil and gas stocks are now personae non gratae in many ESG-compliant portfolios, as are opioid-producing pharmaceuticals. Companies with a lack of diversity on their boards of directors are also often singled out.

Of course, if we take this to an extreme, nearly any industry could find itself blacklisted. Coca-Cola (KO) and PepsiCo (PEP) contribute to the obesity epidemic. Twitter (TWTR) and Facebook (FB) have become mediums for hate speech, and Alphabet (GOOGL) tracks a scary amount of data on its users that could be used for nefarious purposes.

The point here is not to justify bad behavior by companies or knock the idea of socially responsible investing, however. If you find a company’s products or business practices objectionable, there’s nothing wrong with excluding it from your portfolio. But a sin stock that one person finds objectionable might be personally fine to another. Some of the best stocks of the past decade included companies that glued people to their sofas and stuffed them with carbs.

Today, we’re going to look at seven of the best sin stocks to buy now. Betting against the least ESG-friendly of stocks isn’t without its risks. But if you’re willing to dip your toe into sectors that are politically incorrect, the rewards can be substantial. And most of these picks offer value pricing and/or significant dividend yield.

To keep reading, please see 7 Dividend-Rich Sin Stocks to Buy Now.

How NOT to Run a Business

I’ve known Jeff for nearly 40 years. Everyone needs that one friend that has your back unconditionally; the person you’d call if you ever found yourself in a real mess. The guy who knows where the bodies are buried and can keep a secret.

Jeff’s that guy.

Unfortunately, Jeff runs an absolute nightmare of a business. It may actually be the single worst business I’ve ever seen in my life. (Don’t worry, he won’t be upset when he reads this. He actually helped me write it and agrees with me wholeheartedly.)

Jeff scours the country looking for industrial machinery that is unloved and underutilized, usually in the old Rustbelt of the upper Midwest. Generally, the sellers are eager to get rid of it, so they sell it to him for a song.

Sometimes the machines need a little tender loving care to get them back to peak condition. No problem. Jeff has a mechanic in his shop with the hands of a craftsman who can fix anything and make it as good as new.

Once the machinery is ready to go, Jeff finds a buyer, usually in a high-growth market like Dallas, and makes the sale, sometimes raking in gross profits of a couple hundred percent or more.

Unlike the stock market, which is global and efficient, the market for used industrial equipment is ridiculously fragmented and inefficient. The sellers tend to be in one part of the country, and the buyers are usually half a continent away. There is no centralized market, and supply and demand vary wildly by region, as do prices. So, a clever trader can essentially find risk-free profit opportunities to buy low in one market and sell high in another.

I’ll give you an example. Jeff recently closed on the single best trade of his career. He picked up a Cemco MVB-84 vertical boring machine at an auction in San Angelo, Texas for a whopping $52 dollars. This is an eight-foot long by eight-foot wide by 4-foot tall, 3,200-pound solid piece of machinery that should be worth a couple thousand dollars in scrap value alone, and he bought it for less than the price of my monthly phone bill.

He just sold it in Oceanview, California for $14,000, plus a $1,300 delivery fee.

That’s a 26,823% return on his initial investment.

So far, it sounds good. It’s a value investor’s dream!

Not so much…

Have you ever tried moving a 3,200-pound piece of metal? Would you have the foggiest idea how to even start?

It also took him two full years to sell it. And for all he knew, it might have taken a lot longer than that. Meanwhile, it sat in his shop, taking up space. Would you have 64 square feet of floor space to store something like that, potentially for months or years?

Jeff’s business enjoys fat returns. But those returns are wildly sporadic, and they require major up-front capital. He needs a warehouse. He needs trucks. And he has to pay his mechanic even when the workload is slow.

And good luck getting financing. How eager do you think your bank would be to use a 20-year old Graco Mark V Texspray 1.25 GPM industrial airless paint sprayer as collateral on a loan?

The business is also completely dependent on Jeff’s expertise in the machinery he trades. It involves constant price research and untold hours on the phone and on job sites, sizing up the market. Without Jeff, there is no business. It would literally be worth zero.

I wish my friend the best of luck. I hope that as old men, we can sit in our rocking chairs and have a good laugh about all of this. But there is no way in hell I’d ever want to invest the way he does.

Using poor Jeff as an example of what not to do, let’s look at the conditions to look for when starting a new business.

Make it Asset-Light

Jeff’s overhead is the bane of his existence. Renting a large warehouse and owning a fleet of trucks isn’t cheap. High overhead costs like these perpetually drain his cash flow and limit his flexibility while also making it hard for him to cut his losses and move on to something new.

I started my first business on my kitchen table with a laptop and a bootlegged version of Microsoft Office. It ended up being a failure, but that’s ok. I was able to cut my losses early and move on to the next project, which was more successful. I wasn’t constrained by large sunk investment costs. If I had a shop full of expensive equipment, it would have been a lot harder to walk away to find a better opportunity.

Make it a Business, Not a Job

Jeff’s business is entirely dependent on his skill and expertise. It would be extremely difficult to train someone else to do what he does, and it’s not scalable.

Compare this to something like a McDonald’s franchise. In the early days, the owner might need to take a hands-on approach in running the restaurant. But once the system is in place and the managers trained, the owner can walk away and move on to other projects. The business will essentially run itself. All good businesses are scalable systems that don’t depend exclusively on the labor of the owner.

If Jeff Bezos of Amazon.com fame hadn’t built a system, he’d still be selling books out of his garage. 

Run it with Other People’s Money

Jeff can’t get financing for his business. Banks don’t understand what he does, and they don’t consider his equipment to be attractive collateral. This means he has to rely on retained earnings or really expensive or dodgy non-traditional lenders to grow his business.

Compare that to the hypothetical McDonald’s franchise or to a piece of rental real estate. Banks love to lend on excessively generous terms for businesses like these because they understand them, can model them, and trust the value of the collateral.

If your business is extremely asset-light, you might not need financing. But it’s always good to have access to it, just in case.

Back to my buddy Jeff, he’s recently started a new business building custom barbecue smokers. It doesn’t quite meet my criteria for being asset-light, and financing is still difficult. Though this business is at least scalable. He’s looking at hiring workers to build the product while he focuses on sales.

At the very least, I’m looking forward to sampling the product!

Investing for First-Time Parents

My good friend Al, who I mentioned earlier this week, recently became a dad for the first time at age 41.

He’s brave to get started at that age. I thought I was a little on the old side when my son was born, and I was only 32. Those sleepless nights hit you a lot harder the older you get.

But I digress.

In honor of Al’s newborn daughter, I’m going to answer some common financial questions for parents or grandparents of young children. If you’re the responsible sort who likes to plan. This one is for you.

Should I Save for College in a 529 Plan or Something Similar?

The short answer is “yes.”

The longer answer is a bit more nuanced.

If you have excess cash on hand, then, by all means, open a 529 college savings plan, particularly if the kid is young. 529 plans are similar to a Roth IRA or 401(k) plan in that there is no immediate tax break for the contribution, but all capital gains, dividends, and interest grow tax free and enjoy tax-free withdrawals — as long as they withdrawals are used for qualified educational expenses. The younger the kid, the more that tax-free compounding matters.

If the kid is already a teenager and starts college in a couple of years, there’s not a lot of value in stuffing the cash into a 529 plan, as you’re just going to be taking it out again in short order.

But let’s say you’re starting early. Even then, I’d argue that investing in a 529 plan only makes sense if you’re already maxing out your 401(k) or any other retirement plan.

Here’s why…

Your 401(k) plan gives you an immediate tax break, giving you more cash today to invest and compound. If you save diligently early, you won’t need to save as aggressively later in life because time was on your side.

I wrote about this in 2018, revisiting Richard Russell’s classic piece “Rich Man, Poor Man.”

Russell showed that a young worker who invested $2,000 per year in his IRA starting at age 19 and stopping at age 25 would end up with a larger portfolio in retirement than a worker that started investing $2,000 per year at age 26 and continues to do so until age 65. If you don’t believe me, check the math.

By the time your kids are in college, you’ll presumably be at the peak of your career, earning more money than you were when they were born. You’ll be in a better position to help them out of current cash flows. They would also presumably have access to student loans, which you could help them pay back if you wanted.

Under current tax rules, you can also take penalty-free distributions from an IRA or Roth IRA to pay for educational expenses, though not from 401(k) plans. I don’t necessarily recommend you do that, but it’s an option if you need it.

So, again, you should absolutely contribute to a 529 college savings plan if you have the cash flows to do it. But this only makes sense if you’re already maxing out your 401(k) plan.

Should I Buy a Bigger House for the Baby?

Probably not.

As a general rule, people buy more house than they need. It’s nice to have space, particularly when the kids get older. It lets them have their space to crank their music, play video games, and generally be a nuisance on the other side of the house, giving you a little peace and quiet.

Once you have kids, you’re also more likely to have family coming over to visit, and it’s nice to have an extra room or two to put them in.

But a larger home is a bad investment.

To start, it generally means a larger mortgage and a larger monthly payment. It means higher property taxes and insurance costs. It means higher utility bills, as you have more space to keep air-conditioned, and more ongoing maintenance expenses like landscaping and housekeeping.

Also, in my experience, nature hates a vacuum.

If you have more space, you’ll feel pressured to fill it up with new furniture, appliances, larger TVs, artwork, etc. All of that costs money.

I’d love a bigger house, and if my budget allows for it I’d like to upgrade sometime in the next year or two. But up until now, I’ve intentionally kept my housing costs low relative to my income. That’s given me more cash to invest and to spend on things I really enjoy like travel.

It’s better to live modestly and have extra cash to play with than buy a house you can just barely afford and sweat about your finances every month.

In Tokyo, the average family lives in an 800-square-foot apartment. I couldn’t live like that. But I don’t need a 4,000-square-foot McMansion either. And neither do you.

Do I Need Life Insurance?

I’d argue most new parents need at least a little life insurance.

In my family, I have a lot more than my wife does because that’s how the numbers worked out. If I were to croak tomorrow, she couldn’t realistically replace my income. So, I have enough life insurance to at least get the kids through high school and college were something to happen to me.

If something were to happen to my wife, we wouldn’t have a salary to replace. But I’d have to hire someone to take care of all of the domestic responsibilities she handles. At a bare minimum, I’d need a nanny during the workweek.

One of my good friends makes an above-average income, but so does his wife. Either of them could continue to live their current lifestyle indefinitely were the other one to drop dead. They’re exceptionally conservative and live well below their means. I’d argue life insurance would be a waste of money for them.

In your case, spend a little time figuring out what exactly it is you need to insure. You might like the idea of leaving your widow and children with millions of dollars to play with, but that’s not free. The premiums on a policy like that are punishingly expensive. Over-insuring can be nearly as bad for your financial health as underinsuring.

So, make sure you get an amount of life insurance that protects you against the unknown, but not so much as to bleed you dry paying the premiums.

Supersize Your Retirement Account

At the age of 40, my friend Al really hit a sweet spot in his medical career.  He now puts close to $140,000 per year into his retirement accounts — tax-free.

That might sound impossible given that the contribution limit for a 401(k) plan this year is just $19,500.

But it is doable if you know what you’re doing.

My advice today is only relevant if you’re over 40 and earn a high income of at least a couple hundred thousand dollars as a business owner. If that’s not you, don’t fret. Simply maxing out your 401(k) every year will get you well on your way to financial freedom.

But if you happen to over 40 and are enjoying a nice run in your business, you have options that are simply not available to the rank and file.

OPTIONS TO MAX OUT YOUR ACCOUNT

Al has a 401(k) plan, just like you and me. And he maxes his account out every year.

But he also pairs his 401(k) plan with a good old-fashioned defined benefit pension plan and gets to dump in an extra $100,000 as a result.

These are how the numbers shake out.

As I mentioned earlier, the current maximum salary deferral in a 401(k) plan is $19,500. That max gets bumped up to $26,000 if you’re 50 or older — though my friend Al is not.

Additionally, he’s able to stash away up to 6% of his salary via profit sharing, which also gets put in the 401(k) plan. The IRS caps the salary you can use in the calculation at $285,000, making his maximum profit-sharing contribution $17,100 for 2020.

It’s worth mentioning that his income is much higher than $285,000, but the IRS limits the salary you can use for matching or profit-sharing purposes to that figure.

Between the 401(k) salary deferrals and the profit-sharing, he’s able to shield $36,600 from the taxman in 2020.

And now let’s get to the fun part.

THE ART OF SUPERSIZING

He supersizes his account with an additional $100,000 by contributing to a defined benefit pension plan. If he was older and closer to retirement, that number could actually be a good deal higher.

Traditional defined benefit pension plans are a nightmare for companies to administer and can be wildly expensive. This is why most large companies have opted to drop them and switch to defined contribution plans like 401(k)s.

But you wouldn’t necessarily mind the burden of funding a pension plan if you were the plan’s only participant and all the benefits went directly to you. And that’s exactly how this arrangement works.

With the help of a professional, Al created a pension plan in which he is the only participant. Under current actuarial assumptions, he’s able to contribute about $100,000 per year, all tax free. When the plan reaches a value of approximately $3 million, he’ll have to stop making new contributions. At that point, he can simply shut down the plan and roll it into a traditional IRA plan to avoid the hassle of administering the pension.

If any of this sounds complicated… it’s because it is.

Don’t try setting one of these up without professional help because mistakes can be costly and result in tax penalties. The good news is that there are plenty of companies that specialize in setting up these kinds of arrangements, and the costs generally aren’t unreasonable.

A COUPLE THINGS TO KEEP IN MIND

First, the existence of the defined benefit plan slightly reduces the amount of money you can stash into a 401(k) plan. Between salary deferrals and profit-sharing, you can put up to $57,000 into a 401(k) plan in 2020, or $63,500 if you’re 50 or older.

Under my friend Al’s arrangement, he can only contribute $36,600. But he can dump the extra $100,000 into the defined benefit plan, bringing his total to nearly $140,000.

So, unless you’re wanting to put more than $63,500 into your retirement plan, it doesn’t make sense to mess with the defined benefit plan.

Again, this isn’t something you’d want to try alone. You really need a professional actuary to verify the numbers lest you get yourself into a real tax mess.

But if you’re looking to really supersize your retirement savings, this is the single best way I’ve ever seen to do it.

Some Things Get Better With Age

Some things get better with age. Wine, whiskey, a properly humidified cigar…

Other things… not so much. Take my knees and rotator cuffs, for example. Against all better judgment, I joined an over-40 men’s basketball league, and we had a game last night. We won… and it was a blast. But I’m really wishing I had iced my knees and shoulders after the game. I’m feeling it this morning.

It was worth it. But rather that focusing on my decrepit knees, I’d rather add other item to the list of things that actually get better with time: dividend growth stocks.

I enjoy a high yield as much as the next guy. But focusing exclusively on yield exposes you to the very real risk of losing ground to inflation over time.

The Fed’s goal is to keep inflation at around 2%. Now, we could split hairs about their calculation methods, and I think it’s fair to say that the “real” inflation rate experienced by most Americans is significantly higher than that. But let’s be generous and pretend the Fed’s 2% inflation target is reality.

Like interest, inflation compounds. So, over 10 years at 2% inflation, your purchasing power will decline by 22%. Over 20 years, it’s nearly 50%.

We’re talking about losing half your purchasing power over 20 years… even under a wildly conservative estimate of inflation.

So, bonds, preferred stock and high-yield (but no-growth) dividend stocks might pay you a fantastic income stream today. But over the course of a retirement, you run the real risk of having your retirement standard of living degraded.

Now, let’s compare that with a proper dividend growth stock.

Realty Income (O) is a REIT specializing in high-traffic retail. Think the local gas station or pharmacy.

The REIT generally raises its dividend 4% to 5% per year, and it’s working on a string of 89 consecutive quarterly dividends hikes.

Realty Income is not a particularly high yielder at today’s prices. It’s dividend yield is a modest 3.8%. But let’s imagine you bought the REIT five years ago. Your yield on cost (or the annual dividend today divided by your original purchase price) would be a much more attractive 5.7%.

Now let’s pretend you bought Realty Income 10 years ago. Your yield on cost would be a whopping 11.9%.

Now let’s get really crazy and assume you bought Realty Income 20 years ago. Your yield on cost would be a gargantuan 22.4%.

Yes, you’d be making more than 22 cents per year for every dollar you invested in Realty Income. That’s the power of dividend growth.

I’m not recommending you go run out and buy Realty Income today. Personally, I think the shares are a little too expensive to justify buying with new money. I’d recommend waiting for a significant pullback.

But I bring this up to show you that there’s more to income investing than simply grabbing the highest yield you can find. I even have a name for that. I call it “yield whoring,” and I consider it a vice that’s detrimental to your financial health.

A good income portfolio should have a mix of high-yielding investments and lower-yielding but faster-growing dividend stocks. Ultimately, it’s the only way you’ll stay ahead of inflation in a long retirement.