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Forget Yield; Dividend Growth is the Metric that Matters

Income investors had a little scare in May and June.  Bond prices took a tumble and dragged down assets that have come to be viewed as bond substitutes—including popular dividend-paying stocks, MLPs and REITs.

Now that the dust has settled and the income markets have regained some semblance of normalcy, let’s take a step back and review the case for income stocks.  With the Fed’s quantitative easing eventually coming to an end and with bond yields likely to rise in the years ahead, does it still make sense to look to the stock market for income?  Or might investors be better off buying and rolling over a bond ladder to meet their income needs?

Let’s take a look at the numbers.  Consider the options you had as an investor ten years ago.  In 2003, the 10-year Treasury yielded 3.97%.  We’ll be generous and say 4% to keep the math simple.  A million-dollar portfolio invested in Treasuries would have paid out an income of $40,000 in the year you bought it…and ten years later, it still would have paid you $40,000 per year on your original purchase price. (Math purists will point out that the yield to maturity calculation is a little more complicated than that, but it’s close enough for our purposes here.  We’ll assume you bought the bonds at par and that capital gains are a moot point.)

Over the ten year life of the investment, you would have received $40,000 per year.  Of course, $40,000 went a lot further in 2003 than it does in 2013, but we’ll get to that a little later.

Now, let’s do the same math on one of my favorite REITs—Realty Income ($O).

I chose Realty Income for a very specific set of reasons.  First, in 2003, its dividend yield—at 3.5%—was close enough to the 10-year Treasury yield to make these two viable competitors for the would-be income investor’s portfolio.  Secondly, as a low-risk, triple-net retail REIT, Realty Income is a prime example of a stock that has come to be viewed as a “bond substitute” by income investors.

So, how did Realty Income stack up?

The math here is a little more detailed, but I’ll do my best to keep it simple.  A million-dollar portfolio invested in Realty Income at the beginning of 2003 would have bought you 29,516 shares paying $1.17 per share in annualized dividends.  That works out to $34,534 in income in the first year—or about $5,500 less than the 10-year Treasury.

But this is where it gets fun.  Unlike the bond, Realty Income actually raised its payout every year.  By 2013, those 29,516 shares were paying out $2.18 per share in annual dividends.  That works out to $64,345 in annual income—or $24,345 more than the interest from the bond.

In 2013, Realty Income sported a dividend yield of 4.8%, which isn’t shabby.  But your yield based on your purchase price would have been a much more impressive 6.45%.  And remember, we haven’t said a word about capital gains; we’re focusing purely on the cash payout, which is ultimately what pays your bills in retirement.

Stepping away from REITs, let’s take a look at two widely-held blue chips that have more or less tracked the market over the past ten years—Johnson & Johnson ($JNJ) and Wal-Mart ($WMT).  I included both of these names for one critical reason—both paid comparably low dividends back in 2003.  Yet despite paying a modest yield at the time, both had been serial dividend raisers for a long time—and still are.  Their stock prices have had wild swings over the years, but their dividends have been a source of rock-solid stability.

In 2003, Johnson & Johnson and Wal-Mart yielded 1.5% and 0.65% in dividends, respectively.  A million dollars invested in each would have paid out $15,296 and $6,538.  That stacks up pretty poorly in comparison to the $40,000 you could have received in bond interest by investing in Treasuries.

But let’s fast forward ten years.  Those original million-dollar investments in Johnson & Johnson and Wal-Mart would be paying you $49,244 and $34,144, respectively.  Wal-Mart’s total cash payout is still a little lower than the payout from the Treasury note, though it rose by more than a factor of 5—and will likely keep rising at a blistering pace for the foreseeable future.   And again, this says nothing about capital gains—or about the reinvestment of dividends, which would have boosted the number of shares you owned and thus your ultimate payout.

Income on $1 million invested in 2003 Income in 2013 on original 2003 investment
10-Year Treasury  $40,000  $40,000
Realty Income  $34,534  $64,345
Johnson & Johnson  $15,296  $49,244
Wal-Mart  $6,538  $34,144

 

What lessons can we learn from this?

Dividend growth matters far more than current yield.  When building an income portfolio, accept a lower payout today in the interest of generating a far bigger payout tomorrow.  As in so many other areas of investing, delayed gratification has its rewards.

I’ll leave you with one final point on inflation and taxes.  The first is obvious.  Prices rise over time, and the only way you can avoid getting progressively poorer in retirement is to have an income stream that at least keeps pace with inflation.

Finally, depending on how you are invested (IRA vs. taxable account), taxes will play a role in your “take home” income.  If investing in a taxable account, you will pay 15-20% on your dividend income, depending on your income bracket and whether the dividends are “qualified.”  Bond interest is taxed as ordinary income, meaning you could be paying a substantially higher rate, depending on your tax bracket.

Disclosures: Sizemore Capital is long O, WMT, and JNJ.

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Sizemore on CNBC Asia: “Japanese Equity Market at Extreme Risk”

Watch Charles Sizemore chat with CNBC’s Oriel Morrison about the Japanese markets and the potential for a full-blown capital markets meltdown.

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Up Close and Personal with Charles Sizemore, Manager of the Dividend Growth Portfolio

Covestor produced the following video featuring Charles Sizemore, the manager of the Dividend Growth Portfolio and three other models at Covestor.

For more information, see the Dividend Growth Portfolio’s profile page, which includes performance and recent portfolio moves.

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The Biggest Mistake of Warren Buffett’s Career

Warren Buffett is a hero to many investors, myself included.  His record speaks for itself: 18.3% annualized returns in Berkshire Hathaway’s ($BRK-A) book value over the past 30 years compared to just 10.8% for the S&P 500.  And his returns in the 1950s and 1960s, when he was running a much smaller hedge fund, were even better.

Mr. Buffett is also quite generous with his investment wisdom, sharing it freely with anyone who cares to listen.  But as with most things in life, failure is a better teacher than success.  And Mr. Buffett has had his share of multi-billion-dollar failures.

You want to know the biggest mistake of Buffett’s career?

By his own admission, it was buying Berkshire Hathaway!

Everyone assumes that Buffett’s decision to buy Berkshire Hathaway was a typical Buffett stroke of genius.  Nothing could be further from the truth.

We like to think of Warren Buffett as the wise, elder statesman of the investment profession, but Buffett too was young once and prone to the rash behavior of youth.  And Berkshire Hathaway was not always a financial powerhouse; it was once a struggling textile mill.

Buffett had noticed a trading pattern in Berkshire’s stock; when the company would sell off an underperforming mill, it would use the proceeds to buy back stock, which would temporarily boost the stock price. Buffett’s strategy was to buy Berkshire stock each time it sold a mill and then sell the company its stock back in the share repurchase for a small, tidy profit.

But then ego got in the way.  Buffett and Berkshire’s CEO had a gentleman’s agreement on a tender offer price.  But when the office offer arrived in the mail, Buffett noticed that the CEO’s offer price was 1/8 of a point lower than they had agreed previously.

Taking the offer as a personal insult, Buffett bought a controlling interest in the company so that he could have the pleasure of firing its CEO.  And though it might have given him satisfaction at the time, Buffett later called the move a “200-billion-dollar mistake.”

Why?  Because Buffett wasted precious time and capital on a textile mill in terminal decline rather than allocate his funds in something more profitable—in his case, insurance.

By Buffett’s estimates, had he never invested a penny in Berkshire Hathaway and had instead used his funds to buy, say, Geico, his returns over the course of his career would have been doubled.  Berkshire will still go down in history as one of the greatest investment success stories in history, of course.  But it was a terrible investment and a major distraction that cost Buffett dearly in terms of opportunity cost.

What lessons can we learn from this?  I’ll leave you with two quotes from Buffett himself:

“If you get into a lousy business, get out of it.”

“If you want to be known as a good manager, buy a good business.”

In trader lingo, cut your losers and let your winners ride.  Holding on to a bad investment wastes good capital and mental energies that would be better put to use elsewhere.

Thank you, Mr. Buffett, for sharing your failures with us.  Your willingness to do so is one of the reasons we love you.

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This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities.