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.

Rules for a Trade-Up House

I’ll admit I have houses on my mind these days.

After seeing my friend Alan’s new home – complete with its four-car garage and Hugh Hefner grotto – my wife is bugging me to upgrade. And while I’m not crazy about taking on a major new expense, she makes valid points. Our two boys are the proverbial bulls in a China shop, and they’ve pretty well trashed our existing place. So even if I don’t buy a new house, I’m probably looking at tens of thousands of dollars in repairs and remodeling. And a little extra square footage wouldn’t be a bad thing.

We’ll see. If the right house comes along at the right price, I’ll likely join the millions of my predecessors that got suckered in the trade-up game. Or, I might resist the urge and continue on in my broken-down hovel for another couple years.

This brings up some questions on when and how to trade up. Last week, I really drove home the point that your house is not an asset. It’s an expense and should be viewed as such.

So, today we’re going to continue this conversation. We’ll call it “The Rich Investor’s rules for upgrading your house.”

Rule #1: Retire with a Paid-Off House

I consider this rule the single most important to your financial wellbeing. You do not want to start your retirement with the responsibility of a mortgage.

Once you’re retired, your income stops. You no longer have the ability to work overtime or earn that year-end bonus that helps you wipe the credit card balance clean. You have to live off of Social Security and off of whatever dividends and income your portfolio throws off.

Your expenses in retirement will be higher than you planned. It’s inevitable. And if you let your expenses get out of control early in retirement, you risk depleting your assets and then being forced to move in with your kids later. So, do whatever you need to do to ensure your mortgage is paid off before you retire. That potentially frees up several thousand dollars per month and gives you more flexibility.

So, if you’re thinking of upgrading, do the math. If you’re 45 and planning to retire at 65, will you be able to pay off your trade-up home in 20 years?

If that’s not realistic, then don’t upgrade or do so with a cheaper house. That beautiful home with the perfectly manicured lawn might be a trophy at 45, but at 65 it will be an albatross around your neck.

Rule #2: The Three-Year Rule

This rule is a bit more extreme, but I like it. I have a colleague in Houston that runs a large wealth management practice, and his rule for a trade-up home is simple: If you can’t pay it off in three years, don’t buy it.

The Three-Year Rule is obviously unrealistic for the young couple struggling to save for a down payment on their starter house. But that’s just it. We’re not talking about your starter house. We’re talking about an optional upgrade that you might want but that you certainly don’t need.

It’s important to note that you don’t necessarily have to pay off the house in three years. You just need to be able to pay it off in three. If you choose to keep the mortgage and invest your cash somewhere more profitable or stash it in a 401(k) or IRA, that’s perfectly fine. The Three-Year Rule is more about setting a practical spending limit than on keeping a specific timeline.

Rule #3: Watch Out For Taxes and Expenses

Let’s say you’re disciplined and get your mortgage paid off. Good for you! That’s a major financial milestone.

But your homeowner expenses don’t stop with the mortgage. You also have to pay property taxes, insurance, maintenance and possibly more frivolous things like HOA dues and landscaping.

So, consider your neighborhood closely. If your kids are already out of high school, paying the property-tax premium for a house in a good school district might not be necessary.

Likewise, some houses are far more expensive to insure than others due to their proximity to flood zones. And some neighborhoods have outrageously high HOA dues that are used to pay for services you might not want or need.

You might be able to skimp a little on maintenance, cleaning and landscaping. But once you’re moved in, you’re stuck paying taxes, insurance and HOA dues for as long as you own the property. So, be sure to take those numbers into consideration before you buy.

There’s nothing wrong with splurging on your dream home. It’s your money, and you only live once. But if you bite off more than you can chew, that dream home is going to end up being a financial nightmare for you.

Don’t Chase Yield

When looking at low-priced stocks, how can you tell the difference between solid value stocks and the dreaded value traps?

The answer: value stocks eventually recover, while value traps do not.

I realize that my answer is no more useful than Will Rogers’ advice — “Buy stocks that go up; if they don’t go up, don’t buy them” — and that is precisely my point.

Identifying value traps ahead of time isn’t easy.

Value traps are stocks that look cheap on paper. But rather than eventually recover to a “normal” price, they just perpetually stay cheap, or even get cheaper.

There are any number of reasons why a company becomes a value trap.

The Change into a Value Trap

Perhaps the company has an entrenched board of directors that is eroding company value.

Or perhaps a founding family has a stranglehold on the company and won’t let go.

More often than not, stocks become value traps due to crumbling fundamentals. The stock price may look cheap, but that’s only because the lousy financial results haven’t been released and the price is accurately anticipating the worst.

In the income world, value traps tend to take a very specific form, and it’s only gotten worse after nearly two decades of exceptionally loose monetary policy.

I’m referring to yield chasing.

If a 5% yield looks attractive, then surely a 10% yield is twice as attractive!

Well, it could be.

Those kinds of opportunities do pop up from time to time, and I look for them in Peak Incomeevery month. But if something looks too good to be true, you can bet that it likely is.

The numbers back this up.

Dartmouth Professor Kenneth French broke the market down into six sub-portfolios: stocks that don’t pay a dividend and then five quintiles ranked by dividend yield. He calculated the returns on each of these six buckets going back to 1928.

No DividendLowest Dividend QuintileSecond Lowest Dividend QuintileMedian Dividend QuintileSecond Highest Dividend QuintileHighest Dividend Quintile
Annualized Return8.49%8.90%9.82%9.60%11.53%10.54%
Standard Deviation33.14%22.62%19.14%20.57%20.97%23.81%
Growth of $1 $1,671 $2,546 $4,580 $5,117 $21,610 $9,757

Not surprisingly, stocks without dividends had the lowest returns and the highest volatility. Non-paying stocks are often garbage and have garbage returns.

This is where it gets interesting…

The best-performing stocks aren’t actually the highest yielding ones. That distinction belongs to the next quintile down.

The highest-yielding stocks actually had lower returns and higher volatility than the next quintile down.

So, high-yield stocks — but not highest-yield stocks — tend to be the best performers over time.

Why Is the Yield So High?

As investors, we’re drawn to high yields like moths to a flame.

But incredibly appealing high dividends are generally only made possible by one of the following scenarios:

  1. The stock pays out substantially all of its income in dividends and there is no possibility of significant growth. This is often true of tobacco stocks.
  2. The stock is highly leveraged and, thus, at risk to any unexpected shifts in Fed policy. Closed-end funds and mortgage REITs can fall into this trap.
  3. The stock is paying out a “return of capital” in addition to the regular dividend, or simply returning your original investment back to you. This is common with certain oil and gas trusts.
  4. The market is pricing in a steep dividend cut and the current high yield you see is about to go up in smoke. This is a typical red flag for companies in distress.

The first, second, and third situations aren’t necessarily bad so long as you know what you’re getting into. You’ll likely lose ground to inflation over time, and that is a legitimate concern. But it’s not philosophically different than a bond.

It’s the fourth situation you really need to watch out for.

When you see an abnormally higher dividend on a stock… beware. There are times when the market just flat-out gets it wrong and a high-yielding stock is a bargain. But, more often than not, a high and rising yield is a sign of distress.

So, if you question whether a company’s dividend yield might be too high and signaling trouble ahead, a quick-and-dirty first step of your analysis should be to simply look at its dividend yield over time. If the current yield is significantly higher than in years past, something is likely amiss.

You should also give the dividend payout ratio a look.

The dividend payout ratio is the percentage of the company’s profits that it pays out in dividends. For example, if a company earns $1.00 per share and pays a dividend of $0.80 per share, its payout ratio is 80%.

As a general rule, the lower the payout ratio the better because it means the company has more of a cushion. A company payout out 100% of its earnings as dividends leaves no cash on hand for growth projects or for emergencies.

As a general rule, I like to see a payout ratio of 70% or less.

There are some caveats to this, however.

Sometimes a company has larger-than-usual write-offs that cause its earnings to get depressed in the short-term. This can make the payout ratio look abnormally high.

So, if you’re evaluating a company and you see that its payout ratio is getting awfully close to 100% (or even higher than 100%), do a little extra digging to see if the company had some sort of temporary setback. If it looks reasonable to assume that earnings will be high enough in the coming quarters to more than cover the dividend, don’t sweat it.

Also, certain types of stocks have quirky accounting that makes the payout ratio meaningless. For example, REITs and MLPs both have exceptionally high depreciation charges that depress their earnings on paper but don’t actually burn any cash. When analyzing these kinds of stocks, you’ll need to do a little extra digging. But for your typical stock, the dividend payout ratio is a simple metric to gauge how safe the dividend is, and the ratio is usually calculated for you on popular financial sites like Yahoo Finance or MarketWatch.

There’s a lot to digest here. But here’s the gist of it: Ignore the siren song of high yields when it comes to mainstream stocks and look for sustainable and, preferably, growing dividends instead.

It requires a little patience, but it’s more likely to give you safety in retirement.

How Much House Is Too Much?

I had dinner at my friend Alan’s house earlier this week. You could call it a mini-housewarming party. With a baby on the way, he and his wife decided to upgrade their house in anticipation. They’ve finally settled in, and I was their first non-family guest.

It might as well be a castle.

Four-car garage, swimming pool that resembles Hugh Hefner’s grotto, and a media room with better equipment than an actual movie theater… He cranked up the volume to show me what it could do. Three days later and my ears are still ringing.

It has a wine cellar, and a kitchen that would make a three-star Michelin chef jealous.

In the study, there is a secret door behind the bookshelf that leads to a hidden room, like something from a Batman movie.

There are houses. And there are houses. This one was the latter.

The Dream House

Now, you could argue that a house like that is nothing more than a vanity project; Alan would agree. He knows the entire project is ridiculous. No one needs a house like that.

But he’s done fantastically well in his career and could afford it. He made a 30% down payment in cash, and he’ll be reducing the mortgage further when his old house sells.

At his income level, he could pay down the remainder of the mortgage in two or three years without stretching his budget. This is a toy for him. He’s earned millions, and he can’t take it with him. So, he might as well have a little fun with it.

This raises larger questions for the rest of us: how much house is too much?

Before I answer that, we need to establish the first law of homeownership: Your house is not an asset.

I repeat: Your house is not an asset.

It generates no income for you, yet it generates plenty of expenses: taxes, insurance, utility bills, landscaping, the pool guy, the technician to fix your state-of-the-art home theater system when something goes wrong… These are expenses that can potentially bleed you dry.

Sure, your home equity has cash value. But you can’t extract it without selling or mortgaging your house.

Your house is an expense, and you should view it through that lens. Every dollar you tie up in your house is a dollar you can’t invest and use to grow your wealth.

To calculate how much house is appropriate for you, it’s probably easiest to back into the number.

Calculating the Cost of Your Home

Make a tally of your spending priorities — retirement savings, college savings, capital to start a business, day to day spending money, etc. — and subtract that from your household income. Give yourself a little wiggle room. You don’t want to be agonizing over a $4 purchase at Starbucks because you’ve made your budget unrealistically tight.

Once you’ve figured out how much you think you can afford as a monthly payment, knock off another 20%. You probably forgot a few expenses, and, again, you don’t want to be strapped for cash every month when the mortgage payment comes due.

If you have $10,000 per month left over, good for you! Go buy a mansion. You can afford it.

If you have $2,000 per month left over, then that’s your budget. End of story.

Trying to stretch it to buy a larger house is only going to cause you stress, and your home shouldn’t be a cause of stress. It should be a place you go to escape from stress.

As for the dollar price of the house you can afford, that’s going to depend on a couple factors, such as taxes and your area and mortgage rates. But if you know the size of the monthly payment you can afford, there are plenty of online calculators that can do the math for you and calculate the house price. As an example, you can check out NerdWallet’s calculator.

The point is, don’t buy more house than you can comfortably afford.

While I’d love to have a Hugh Hefner grotto like my buddy Alan — and I might very well buy one someday — I’m far more comfortable living more modestly and being able to max out my retirement accounts and spoil my kids.

The Next Ten Years

As we close out 2019, it’s time to look ahead to see what we can expect from the stock market over the next decade.

I want to be crystal clear here… there is no perfect, foolproof stock market indicator. No one knows with any degree of accuracy what the market will do over the following year.

If such an indicator did exist, it would become useless the minute it was discovered. Every trader in the world would start trying to front run it.

Any concept of the perfect indicator is fundamentally flawed because the stock market is not a machine. The market is nothing more than a collection of people buying and selling, and those people aren’t always rational. You can’t build a rational model to predict the behavior of irrational actors. You’d have better luck trying to predict the next popular hair style for teenagers or the next trendy Millennial buzzword or dating app.

But while there is no perfect indicator, there are a few that have a reasonably good track record of predicting stock returns over the next decade.

One of my favorites is the cyclically adjusted price-to-earnings ratio (CAPE) — also called the Shiller P/E ratio after Yale professor Robert Shiller.

An Indicator to Guide You

The CAPE takes an average of the past 10 years of company earnings and compares it to today’s prices. There’s nothing sacred about a 10-year average, and I’ve seen plenty of variants that use other timeframes. But 10 is a nice round number, and in any given 10-year period we’re likely to have seen a boom, a bust, and everything in between.

Using Shiller’s data, Barclay’s recently ran the numbers back to 1926 to see how the market performed over the following 10 years starting at various CAPE levels.

Not surprisingly, the more expensive the CAPE, the worse the returns were over the following 10 years. Any value investor would tell you the secret to market success is buying low and selling high.

The question is, of course, where are we today?

Where Are We Today?

The S&P 500 is trading at a CAPE of 29.4 at today’s prices, putting it in the most expensive bottom bracket.

If history is any guide — and, admittedly, we don’t have a lot of data points here as the market only got that expensive one other time in the late 1990s — we’re in for a rough decade.

The worst-case scenario has stocks falling 6.1% per year over the next decade, and the best case has stocks rising 5.8%. I think that’s a pretty reasonable range.

If we avoid a deep recession and the Fed somehow manages to pull a rabbit out of its hat and keep pumping money into the financial system without causing inflation, then it’s not unreasonable for us to hit the top end of the range.

But if the wheels come off — if investors lose faith in the Fed and the foundations crumble — the lower end of the range is also very realistic.

As the baseball-player-turned-philosopher-king Yogi Berra said, “It’s tough to make predictions, especially about the future.” Yet we’re going to do it anyway…

What’s to Come in 2020

I think the most likely outcome is something in the ballpark of 2-3% per year.

We’ll get some kind of recession and a maybe a mild bear market or two.

But Fed stimulus, low bond yields, and a dearth of opportunities anywhere else will keep the bottom from completely falling out.

Still, I don’t know about you… 2-3% per year isn’t going to work for me.

I need better returns than that.

Luckily, I don’t see that being a problem in Peak Income.

I target high-yielding investments with cash payouts of 5-10% and sometimes significantly more than that.

So, even if the stocks and funds I recommend see zero price appreciation (which would be very unlikely), the yield alone would make them attractive.