Co-produced with Treading Softly
When looking to invest in the market, investors will create many goals for themselves. They want to beat the S&P 500 (SPY) or generate more returns than their favorite famous investor. Perhaps, they copy the style of well-known names like Warren Buffet or Peter Lynch. But no matter how you slice and dice the market, two key aspects are at play:
- price movements; and
- dividend payments.
Here at High Dividend Opportunities (HDO), we focus on controlling our dividend payments first and thus are income investors. We also practice opportunistic value investing, which provides capital appreciation. This has propelled our average annual total return of 16% from inception to date.
Why do we focus on dividends? It is simple. Dividends are extremely powerful. They are the only means of return that are guaranteed as once a dividend hits your brokerage account, that return is locked in. It cannot be retracted by market selling or by management. Future payments can be impacted, but not those that have already been received. As investors, short-term price swings are not our concern. Each dividend receipt boosts our total return and time is on our side.
This is what differentiates traders and investors. Investors have a long-term mindset and they buy and hold for extended periods of times. Whereas, speculators and traders buy now to sell in the near-term after an anticipated price change. Shorts on the other hand focus on falling prices. We are not unfamiliar with shorts and swing traders commenting on our posts about how X security is a bad choice because of a 1-2 month price change, they seem to forget who we are! We invest with a 2-3 year mindset.
A Brief History Lesson
Today's market has often written off the power of a high-yield dividend pick. They deem it as "risky" or "gambling", while all the while they plow money into companies with negative cash flows hoping its price will rise. Which to you sounds like investing and which sounds like gambling? If you base your investment on the hope that a price will be at a premium when you sell, you're the gambler.
Dividends have long been part of the market. In 1250, the first dividend was paid out by Société des Moulins du Bazacle - a French bank. Since then dividends have been seen with growing importance. In the 1600's, both the East India Company and Hudson Bay Company paid steady, large dividends. At one point the Hudson Bay Company paid a special dividend equivalent to 50% of its share price. While the East India Company over its 200-year lifespan paid a dividend worth 18% of its total capital each year.
Dividends provide regular and steady income, and also reduce the sequence of return risk as we have highlighted previously.
Dividends Take A Little Return A Long Way
When you take your dividends and reinvest them you unlock the power of compounding. Take for example, the S&P 500. The return is impressive when you consider just the price movements:
Data by YCharts
But when you stack in the dividends and reinvest them, the returns seen are even more spectacular:
Data by YCharts
Why? Because routinely reinvesting the dividends allow that added capital to be put to work. Remember, any return in the market is comprised of two parts, dividends and price movements. Let’s take another example, Coca Cola (KO):
Again, the difference is stark. Dividends, whether constant or growing, strongly outperform no dividends. KO's dividend yield has remained below 4% its entire existence:
Meanwhile, interest rates have vacillated strongly over time:
As well as inflation rates:
If an investor does not hold any dividend-paying securities and reinvest those dividends, their securities are losing real buying power each year versus inflation. Essentially, a $100 bill has steadily lost value when compared to the costs of living. Dividends provide inflation protection in their simplest form. Dividends, however, are much more powerful than simply offsetting the draining impact of inflation.
Dividends Provide Strong Psychological Protection
The average investor strongly underperforms the market:
Why is this? Investors and traders naturally panic when the price of their holdings drop and refuse to sell when their investments appreciate and move above fair value. This means they often buy high and sell low - the exact opposite of what they should be doing. This leads to regular underperformance versus the market in general.
The regular receipt of dividend income provides a steady sense of comfort and a reality check. Investors can know that the short-term swings are a prime time to reinvest in a security, especially if there is no fundamental change driving those price movements.
Each dividend payment is an infusion of cold hard cash and a boost to the total return of your portfolio.
This is the key aspect of the psychological benefit of dividends. Investors over time should learn to look at the long-term perspective instead of momentary swings. The routine regular dividends provide a steady stream of returns flowing into your portfolio versus hoping that your securities stay floating at a premium when you sell. Remember the charts above? The total return dropped, even when dividends were being reinvested, but bounced back stronger and higher due to the dividends being effective amplifiers of total returns.
Take It One Step Further Now
Dividends are not limited to simply being an anti-inflation tool or a psychological safety blanket. They can be the power source driving your portfolio higher and farther than before. You see this is where investors step off of investing in low yielding investments and into the realm of Immediate Income Investing. Welcome to our home. Our model portfolio yields between 9-10%, allowing you to have guaranteed returns of 9-10% before any price appreciation. Hold that portfolio for 2 years? Boom! 20%. 3 Years? Wazwow! 30%.
"Whoa now!" say the naysayers, "What about your price movements?!"
Good point. However, immediate income investors don't look to sell investments unless they're overpriced now, or the thesis is broken. They are also extremely careful and diversified as they invest in the market. We strongly encourage holding a minimum of 40 individual securities - it's our Rule of 40. Any single security that collapses will not destroy your portfolio and your income stream will steadily rebound and recover.
Take our model portfolio. It yields 9-10% but has seen average annual returns of 16%. So we have achieved 6-7% capital appreciation on top of our yield returns. We don't need to best every investor or the entire market. We just need to keep investing in and picking solid dividend-paying investments to keep our strong returns chugging along.
Investors dependent on price movements are always looking for the next Amazon (AMZN), Apple (AAPL) or Netflix (NFLX). These companies see strong price returns but more often than not, linger. This means that to see the same returns, you have to gamble on the “next big one” to keep your returns moving along. It sounds stressful, right? It is. Most investors can't keep it up, otherwise every investor would be wealthy. The stress-free part of being an immediate income investor using our Income Method is that you don't need to be the best, or keep hitting home runs. You just need to keep doing what you have been, finding stable dividend-payers.
Build A Core Group
We've mentioned "core holdings" a few times in our articles lately. These are securities you can depend on, rarely need to check up on, and will see regular income from.
We like PIMCO Dynamic Credit Income Fund (PCI) which yields 8.2% and pays a monthly dividend along with annual special dividends. Furthermore, Vermillion (VET) yielding 14% and EPR Properties (EPR) yielding 6.4% would combine to make for a very stable, steady core of holdings. They all pay monthly and need almost zero monitoring.
VET recently saw a price drop due to investor concerns being overblown after a refinery issue in France. However, they recently highlighted their dividend coverage and Capex coverage from free cash flow.
Source: VET Slides
Using these three holdings as a portfolio by themselves - something we would not suggest - but are doing for illustrative purposes, you can see the income outperformance versus the market:
Source: Portfolio Visualizer
Note we said income outperformance, while VET brings the overall performance down price-wise, its dividend income remains strong as ever. While backtests serve a valuable rule, HDO members know we didn't invest in VET until this year.
What Are You Going To Do?
Dividends are available in different amounts from a broad range of securities on the market. They negate the impact of inflation and provide psychological protection versus selling low.
Taking the big step into income investing has made retirement possible for many investors who otherwise would've starved on low sub 3% yields. You have control with so many brokerages offering commission-free trading to decide if you want to gamble on securities prices or invest for steady dividends.
While you decide, our family of investors will continue to enjoy our dividends as they pour in!
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