Warren Buffett Really Rained on the Parade

This piece originally appeared on Money & Markets.

A lot of value investors came out of the woodwork to buy the dip in March and April following the coronavirus rout.

One was conspicuously absent from the party: Berkshire Hathaway’s Warren Buffett.

Buffett is a hero to generations of value investors. In fact, he’s one of my heroes.

One glance at his returns will show you why. From 1964 to 2019, Mr. Buffett grew Berkshire Hathaway’s by an almost absurd 2,744,062%. Over the same period, the S&P 500 returned 19,784%.

In past crashes, Buffett has always swooped in and bought the dip. He certainly did in the last crisis when he bailed out Bank of America, Goldman Sachs and General Electric, making himself billions in the process. The is the man whose self-described secret is being “greedy when others are fearful and fearful when others are greedy.”

But this time around, Buffett chose to sit on his hands. His cash hoard actually grew to $137 billion at the end of the first quarter from $128 billion at year end. At today’s prices, about 30% of Berkshire Hathaway’s market value is just the cash in the bank.

But not only is Buffett not buying. He’s actually selling. The Oracle of Omaha dumped $6.1 billion in stock in April, including his positions in American Airlines, Delta, United Airlines and Southwest Airlines.

This should be sobering to anyone with money in the market.

You can take comfort being in the market when Mr. Buffett is buying. Buffett isn’t always right, and like a lot of value investors he’s often early to the party. But buying by Buffett is that ultimate seal of approval… and that reassuring pat on the shoulders that says it will be all be ok.

In His Own Words

As always, Buffett was eminently quotable at the Berkshire Hathaway annual meeting this past weekend. But one quote really stood out. On why he hadn’t put his cash to work, Buffett said:

“We haven’t done anything because we don’t see anything that attractive to do.”

Furthermore,

“This is a very good time to borrow money, which means it may not be such a great time to lend money.”

There are several takeaways here.

The first is a point that I made last month: Even after the March tumble, stocks aren’t cheap. In fact, they’re still priced a lot more like a market top than a market bottom.

The second takeaway is that bonds aren’t exactly a screaming buy either. As Buffett put it, this isn’t such a great time to lend money.

In a normal, functioning market, interest rates reflect risk. You get rewarded with a higher interest rate for accepting greater credit risk and a longer time to maturity. But in its attempt to save the system from collapse, the Fed has massively distorted the bond market. Interest rates no longer reflect the risk being taken but rather the price at which the Fed is willing to buy.

Now, make no mistake. This isn’t a Fed-bashing hit piece. I understand why the Fed opened the floodgates the way they did, and I don’t think they had much of a choice if we are to be honest. Had the Fed not backstopped everything, we likely would have seen the financial system fail.

But that doesn’t mean we get a free lunch here. We will pay for the Fed’s move with lower bond returns, lower long-term growth and possibly with nasty inflation a few years down the line.

So, What Should You Do?

So, stocks and bonds are both expensive. Fantastic. What are we supposed to do?

I have one recommendation out of Buffett’s playbook. Most of us don’t have $137 billion laying around, but keeping a little more cash than usually on hand would seem like a good idea.

It also makes sense to prune your portfolio a little. Buffett dumped his airlines because he doesn’t have a good read on when their situation improves.

But at the same time, you don’t have to sell everything. Buffett still has a portfolio full of blue chips like Apple (AAPL), Coca-Cola (KO) and American Express (AXP).

I’d also add one final recommendation that the Oracle might disagree with. I think it makes sense to own a little gold. You don’t have to get carried away, but putting something like 5% of your net worth into precious metals gives you a degree of protection from currency instability should the Fed’s bailout efforts take a wrong turn.

The 60/40 Portfolio is Dead

The following first appeared on Money & Markets.

Responding to rumors that he had taken ill and died while on a speaking tour in Europe, Mark Twain told The New York Times: “The reports of my death are greatly exaggerated.”

Well, I don’t want to “greatly exaggerate,” but I think it’s fair to say that the 60/40 portfolio is dead. Or at the very least, it’s going to be on life support for a while.

It had a good run.

According to Vanguard, a portfolio invested 60% in stocks and 40% in bonds generated a compound annual return of 8.6% going back to 1926. That’s a stretch that includes the Great Depression, World War II, the stagflation of 1970s, the tech bubble and bust, and the 2008 meltdown.

It’s a portfolio that has clearly survived the test of time. And it’s easy to assume that it will continue to post numbers like these indefinitely.

Unfortunately, that doesn’t seem likely.

I’m no permabear and this isn’t an anti-buy-and-hold hit piece. I’m generally the optimistic sort, and when I err it’s usually on the side of being too aggressively invested, rather than too conservatively. But the numbers here are pretty straightforward. And they don’t look great.

Breaking Apart the 60/40 portfolio

We’ll start with the 60% invested in stocks, using the S&P 500 as a proxy.

As I wrote last month, the S&P 500 never got truly cheap during the coronavirus bear market. Yes, the market dropped 35% in record time, which brought it down to something closer to “fair value.” But at no point did it ever approach anything close to the valuation lows seen in previous bear markets.

Furthermore, those lows were short-lived. The market ripped higher in April, and today the S&P 500 is essentially at breakeven for the past 12 months.

The S&P 500 is trading at a cyclically adjusted price-to-earnings ratio (“CAPE”) of 26.5 today. If history were any guide, that would suggest annualized returns over the next decade to be close to zero.

Now, I’m the first to admit that historical comparisons should be taken with a grain of salt. Interest rates are lower today, which means that, all else equal, stock prices should be higher. The S&P 500 is also dominated by capital-light tech companies that should, all else equal, trade at higher valuations than clunky industrial firms.

I get all of that, which is why I think the S&P 500 will generate halfway decent returns over the next decade. But I still expect those returns to be lower than the historical average.

All About Bonds

But let’s say I’m wrong. Let’s say that it really is different this time and for reasons I can’t currently imagine, we really are in a period of permanently higher stock prices.

I actually don’t consider that idea to be crazy. Stranger things have happened.

But even if stock prices continue to push ever higher, there’s a big, gaping black hole where bond returns used to be.

The 10-year Treasury today yields 0.63%. A more diversified basket of bonds, such as the iShares Core U.S. Aggregate Bond ETF (NYSE: AGG) yields a little better at 2.6%. We’ll be generous and use that as our return assumption.

If we invest 40% of the portfolio in bonds, yielding 2.6%, and stocks generate 10% — which is generous given today’s valuations — that gets us a portfolio average of 7%.

That’s not all that bad. But again, it also assumes the market continues to perform in line with past returns, which is a stretch.

Let’s say instead that the stock market returns 5% per year going forward, rather than 10%. That knocks the returns of a 60/40 portfolio down to just 4% per year.

And let’s say the value investors are right and that stocks are priced to deliver essentially zero returns over the next decade. That knocks the return of a 60/40 portfolio down to just 1% per year.

This is why I really believe the 60/40 portfolio is dead, or at least dead for the next decade.

Again, this isn’t a bear hit piece. I’m not forecasting the stock market goes to zero or even that we retest the March lows. Maybe we do, maybe we don’t. Who knows.

Regardless, this should be a wake-up call. If your retirement planning “needs” an 8% return to be viable, you might need to consider working longer or cutting back some expenses.

You may also want to be a little more creative in your allocation. You can leave a good chunk of your investments in a 60/40 portfolio but also carve out some space for active strategies or for alternative investments, including gold or other precious metals.

But the worst thing you can do is carry on as if nothing has changed. Whether or not the 60/40 portfolio is dead, it’s certainly not priced to deliver the sorts of returns we’ve all become accustomed to.

Why Dividend Growth Matters More than Raw Yield

A high dividend yield is nice.

A high dividend growth rate is ultimately better.

When Ray Dalio speaks, people tend to listen. Dalio is the billionaire founder of Bridgewater Associates, the largest hedge fund management company in the world. And it seems Mr. Dalio has a lot to say these days.

Back in January, Dalio said that “cash is trash” in a CNBC interview, and he repeated that sentiment earlier this month, saying that COVID-19 stimulus measures would eventually ignite inflation and that cash would “not be the safest asset to hold.”

I’d agree and would add that bonds — which pay a fixed coupon rate — aren’t much better.

This reminds me of one of my favorite income metrics: yield on cost.

How Yield on Cost Works

The yield on cost is the current annual dividend or interest income divided by your original purchase price. This isn’t going to be a meaningful metric for a short-term trader, but it’s something every long-term income investor will immediately understand and appreciate.

It’s best explained by example. Let’s compare the yield on cost between a hypothetical 30-year junk bond yielding 5.5% trading at par and Realty Income (O), one of my very favorite income stocks. Realty Income also happens to yield 5.5% at current prices.

We’ll start with the bond: $10,000 invested in the bond will produce exactly $550 per year in income in Year 1. But by year 30, it’s still producing exactly $550 per year. Your yield on cost is no different than your current yield. (We’ll also just ignore the likelihood that a company issuing a junk bond goes bankrupt long before we hit the 30-year market. Work with me here!)

Now, let’s compare that to Realty Income. Since going public in 1994, Realty Income has raised its dividend at a 4.5% compound annual rate. Just for grins, we’ll assume that dividend growth is a little slower over the next 30 years and compounds at just 4%.

In Year 1, a $10,000 investment in Realty Income also pays $550. But after 10 years of compounding at 4.5%, that annual payout jumps to $854.13 per year. After 20 years, it grows to $1,326.44. And after 30 years, it grows to $2,059.92.

$854.13 represents a yield on cost of 8.5%.

$1,326.44 represents a yield on cost of 13.3%

And $2,059.92 represents a gargantuan yield on cost of 20.6%.

Now, there are a couple things to keep in mind here. Yield on cost compares the current payout to the original purchase price. It takes no account of the current stock price, which also would presumably rise over time. Compare that to a bond again. The best you can ever hope to get from a bond at maturity is its original par value.

Also, 30 years is a long time to own a stock and might not be realistic for all investors. I’ve personally owned Realty Income for over 10 years and would like to own it for another 20 years. But I also bought the shares when I was a spry 32 years old.  Had I bought the shares having already reached retirement age, the 30-year yield on cost would be a little ridiculous.

And finally, it’s important to remember that dividends can cut just as easily as they can be raised. We’re getting a stark reminder of that this year due to the COVID-19 business disruptions. Goldman Sachs estimated last month that S&P 500 dividends would drop by 25% this year.

So, you’ll still want some cash and bonds in your portfolio, particularly if you’re in or near retirement. But if Dalio is right, and cash really is destined to become trash, you’ll want to own assets that throw off income streams that keep pace with inflation.

Should I Open a Roth IRA Right Now?

If your income is temporarily depressed due to COVID-19 disruptions, this might be a good time to open a Roth IRA or do a Roth conversion.

The following article first appeared on Money & Markets.

William Roth, the late U.S. senator from Delaware, should have his face on Mt. Rushmore.

OK, that might be a bit of an exaggeration. He probably doesn’t belong in the American pantheon with the likes of Washington and Lincoln. But as the sponsor and namesake of the bill that created the Roth IRA, Roth certainly has a special place in U.S. history for American retirement savers.

The Roth IRA — its cousin being the Roth 401(k) — can be thought of as the mirror image of the traditional IRA or 401(k) plan.

Traditional retirement plans give you a tax break in the year you make the contribution and allow for tax-free compounding of all capital gains, dividends and interest. You pay taxes as ordinary income when you eventually take the funds out in retirement, and you’re generally required to start taking distributions after the age of 70 ½.

In Roth accounts, you get no current-year tax break. But all investment gains likewise get to compound tax free. All distributions after age 59 ½ are tax free, and – importantly – there are no required minimum distributions, or RMDs. You can let the account grow tax free until you croak, if that suits you, and let your heirs spend it.

So should you open a Roth IRA right now?

That depends.

Most financial planners naturally gravitate toward the Roth accounts, but I take a more nuanced view. Depending on your income level, your other assets, and your retirement planning, a traditional IRA or 401(k) might be a far better option.

Let’s say you’re in the prime of your career and you find yourself in a high tax bracket. Furthermore, you know that once you stop working, your income will drop significantly and you’ll be in a lower bracket. And in any event, you’re going to need these retirement funds to fund your living expenses when the day comes.

Well, if that’s you, you want the tax break today. You should go with a traditional 401(k) or IRA.

Now, let’s say you’re young and you’re in a low tax bracket. Or let’s say that, for some reason, you find yourself in a lower tax bracket than usual. Perhaps your spouse is out of work or you had business setbacks that have temporarily depressed your income. Or, let’s say you already have a nice nest egg set aside to fund your retirement and you’re looking more to leave a tax-advantaged gift to your children or grandchildren.

In any of these cases, the Roth IRA right now or 401(k) is the way to go.

Converting to a Roth IRA

2020 is a strange year, to say the least. With the Covid-19 lockdowns disrupting business, many people are writing it off as a lost year altogether.

But crisis years like this give us the opportunity to make the proverbial lemonade out of lemons. If you are truly in dire financial straits, you shouldn’t be putting money into a retirement account at all. You should be staying liquid in cold, hard cash.

But let’s say your income has taken a hit but that you also have sufficient savings to get through this without distress. In that case, you have options. You can make Roth contributions to your 401(k) or IRA this year and go back to making traditional contributions once your income rebounds and you find yourself in a higher bracket again.

Or, if you want to make a major planning move, you can convert your existing traditional IRA or 401(k) to a Roth IRA right now. Depending on the size of your account, this could land you with a massive tax bill. So you’ll really want to do the math to figure out of this makes sense for you. But if your income is in the toilet this year due to virus disruptions, it very well could make sense.

Also, note that not all company 401(k) plans allow for a Roth conversion. This is something you’ll need to discuss with your plan sponsor.

Are Dividend Stocks Still Worth Owning?

The following first appeared on Money & Markets.

I probably don’t need to tell you 2020 has been a rough year for the stock market. Even after a spectacular rally, the S&P 500 is still down close to 20% on the year. And frustratingly for a lot of income investors, high-yielding dividend stocks generally thought of as “safe” were some of the hardest hit.

I should know. I have a portfolio full of them, and some are still down more than 50%.

From 5% to 7% is considered a really high yield for dividend stocks these days. But is it worth risking a 50% decline in order to squeak out a single-digit yield?

I’ll answer my own question with an emphatic “yes.”

And to prove my point, I’ll use one of my very favorite long-term income machines, Energy Products Partners (NYSE: EPD). Enterprise owns one of the largest networks of natural gas and natural gas liquids pipelines in the country. It has an excellent management team.

Enterprise Products is an MLP and pays “distributions” rather than “dividends.” But for our purposes here, that’s a distinction without a difference. Enterprise Products is a dividend stock, and a fine one at that. The MLP yields a whopping 11.3% and has raised its payout every year since 1998.

Still, it’s been a rough road for this pipeline blue chip. The stock got slapped down during the 2015-16 oil crash and then was utterly obliterated during the March coronavirus meltdown and corresponding collapse in energy prices.

Today, the shares trade at 2010 prices.

dividend stocks

An investor holding Enterprise Products over the past 10 years — through one of the most explosive bull markets in history — wouldn’t have earned a single red cent … unless, of course you consider reinvested dividends. Taking into account reinvested dividends gives us a very different picture.

During one of the most difficult decades in history for energy-relative stocks, Enterprise Products managed to return about 127%.

dividend stocks

Sure, that’s a lot less than the S&P 500. But that’s not the point here. The takeaway is that high-dividend stocks can still be fantastic investments even during extremely rocky periods.

Consistent dividend payers are getting harder to find these days. Already, about 5% of the stocks in the S&P 500 have reduced or eliminated their dividends since the onset of the coronavirus scare, and we’re not done yet. The longer the lockdowns stay in effect, the more dividend cuts I expect to see. Goldman Sachs recently forecast that S&P 500 companies would spend 23% less on dividends this year.

So, you shouldn’t just buy a stock based on its yield and hope for the best. You need to be confident that the business supporting the dividend is healthy and sound.

As an interesting aside, the single biggest buyer of S&P 500 stocks over the past decade has been the companies themselves. It’s debatable exactly how much of the market’s epic run since 2009 was due to buybacks alone, but it’s safe to say it was substantial.

S&P 500 companies bought back $5.5 trillion of their own stocks between 2009 and 2019.

That’s trillion. With a T.

That represents about a fifth of the entire market cap of the S&P 500.

With a given pool of investors fighting over a shrinking pool of available stock to buy, prices had nowhere to go but up.

That came to a screeching halt with coronavirus. Companies are rightly hoarding cash. And Congress has effectively banned buybacks for any company taking federal assistance (which they should have!) Goldman Sachs expects buybacks to fall by about 50% this year.

One of the biggest drivers of stock returns — buybacks — is going to be on ice for the foreseeable future. This actually makes dividends all the more important. If we can’t depend on general asset price inflation, then we’ll have to settle for getting paid in cold, hard cash.