Sometimes it’s about life’s little reminders. No matter how passionate we are about something, no matter how fundamental this something is to our lives, a new question can prompt us to revisit that very thing and spark new discussion. This is precisely what happened to me recently, thanks to a question I received from a listener to my Money Matters radio show.
Spoiler alert: Changing this one perspective may be the most important thing you ever do as an investor.
Before we get to the matter at hand, let’s do a quick review. You all know that I am a huge proponent of income investing. Over the years, I’ve discussed the power of generating income from your investments in articles, speeches, radio shows and in my book, You Can Retire Sooner Than You Think. As a refresher, this income comes from a variety of sources, such as dividends that come from stocks (primarily large-cap stocks), distributions from publicly traded real estate (or real estate investment trusts (REITs)) and energy pipeline companies, and interest on a variety of bonds.
Here’s the question that prompted me to return once again to the principles of income investing:
“Wes, I know I’m supposed to own stocks and bonds, and I own a mix for safety – let’s call it 50% in bonds and 50% in stocks. Now, with bond rates still so low, if I can find stocks that pay more in dividends than bonds pay in interest (and my stocks have more upside potential), then why wouldn’t I own 80 or 100% in stocks?”
It’s a great question that gets to the heart of income investing. Let’s dive in.
Overall, my answer to the question is a “Yes.” But, as with anything in investing, a specific answer depends on a handful of critical factors. The first component is that you own stocks where the income payout is safe. You can accomplish this in two key ways – diversification and quality.
By using a diversified mix of stocks in different industries, you should be able to garner some level of safety in the overall level of dividends you receive. It’s crucial to remember that a given industry can get crushed in an outsized way, as banks and financial companies did in 2008, which led them to cut their dividend payouts.
Historically speaking, high-quality blue-chip companies have weathered downturns and operated profitably even when faced with adverse economic conditions, thereby establishing a long record of steady and dependable growth. The keywords I want you to focus on are “high quality.” Some blue chips earned the moniker, but at some point, took a turn, leaving their internals and financial health in a less than “high quality” condition.
When we say, “high quality,” we’re looking for companies that have great free cash flow (FCF, meaning the operating cash flow), FCF yield (the amount of cash generated after all operating expenses relative to its debt adjusted value), strong return on investment capital (ROIC, which gives you a sense of how well a company is using its money to generate returns), and low net debt. At Capital Investment Advisors, we say, “Do they make a profit?” and have they been growing their dividend at a steady clip? All of this matters when assessing quality.
The next component of our “yes” answer is whether you can focus on the income payout, or cash flow that happens only four times a year, and ignore the share price, where daily bouncing can lead to constantly readjusted prices on the stocks you own – and your portfolio as a whole. While these ups and downs make sense to the logical part of your mind, they can play havoc with your emotions.
To focus on income and ignore price, you almost have to train yourself not to care (or not to look at) the minute-by-minute or day-by-day price fluctuations. You have to replace the “constant checking in” with a once-a-month or once-a-quarter look at all of the income payments you’ve received.
It’s a funny thing; psychologically, the stock markets and nearly all financial firms were built around the factor of price. News media outlets provide reports on price. So, the entire system is honed in on the very thing that provokes the most emotion. If you believe everything you read, hear or see on the internet, you’d be convinced that it’s a price world, not an income world. But, this is only part of the investment equation. Still, it’s easy to lose sight of the income piece. After all, nobody reports on the 287th dividend paid by PG today of 47 cents.
So, financial firms, news, and media put so much emphasis on price, that they don’t really allow you to handle that much risk, or better said volatility. The ups and downs – sometimes extreme – of the price will happen even with the high-quality companies we’re talking about. With some amount of discipline, however, you can mentally short-circuit the predominant focus on price by keeping your eye on the income.
Returning to our caller’s question on bonds: Remember that we own bonds not for their massive interest today, but for their security in the “P-word” – price. Generally speaking, when we pair the stable price of bonds in a 401k or investment account with the volatile price of stocks, it can dampen portfolio value swings. So, there’s also this peace of mind on the price point.
With all of this being said, we also know that, over time, stocks have been the best hedge against inflation. And if you can find a way to focus your attention on income, rather than price, it may help you up your stock exposure. This could increase what you earn in both income and total return over time.
All of this information leads us to our bottom line, and in its essence, it’s a simple one: Total return = growth + income. Growth gets all the flashy attention, while income is filed away as dull and boring in today’s world. But, if you shift your focus to income, chances are you’ll sleep better than if you’re constantly and frantically checking in on price.
If you want to give this approach a try, and truly train yourself to focus more on stock dividends than stock price, it’s possible that you could not only increase your overall income (as many stocks pay more than bonds today), but you could also have an opportunity at more long-term growth than you would if were overly heavy in bonds.
Now, don’t get me wrong; I still very much believe in having a balance of many asset classes. But, a large reason for that balance is to dampen volatility. If you can change the way you look at your portfolio, then it may give you more tolerance for equities, provided they are the kind that you can count on for long-term stability.
Bear in mind that even the highest quality dividend stocks can have substantial price fluctuations, influenced by the overall market’s movement. Still, if the income they pay doesn’t go down, then, by nature, these high-quality dividend-paying companies should experience price restoration eventually. So, if you can really practice this concept, it could lead not only to more prosperity but also a calmer ride along the way.
