The Three Components of Stock Market Return

I was reading an article in Kiplinger’s Magazine something unusual caught my attention. I haven’t seen it talked about very much (if ever) in personal finance circles.

Did you know there are three components of stock market return? If you invested $100 in a stock index and it is up to $120, it’s always because of one or more of these three things. This can be very helpful in looking at how the stock market has performed in the past and might perform in the future.

The Three Components of Stock Market Return

1. Dividends

The easiest component to explain is dividends. Many companies pay out dividends as a way to share profits with investors. Some investments like Real Estates Investment Trusts (REITs) pay investors almost all their profits in dividends. It’s not unusual to get checks each year that add up to 8-10% of what you invested. In these cases, the other two components that I’m going to cover typically don’t contribute much.

There are also companies, often tech companies, that pay no dividends at all. With these companies, you are hoping that the other two components work to make your investment grow in value.

Finally, there are companies in the middle. They pay out a little dividend, but they also benefit from the other two components. Most companies fit in this range.

Dividends are usually the smallest component of the three. Overall, they don’t change that much.

2. Price-Earnings Expansion

Seasoned investors recognized that heading and know it’s about Price/Earnings Ratio (or P/E). For those who are newer at investing, this is the stock price divided by the company’s earnings. Generally, you want to pay as little money (low stock price) for the most amount of earnings. That way the company can pay out bigger dividends or use those big earnings to invest in new businesses that grow.

Back when I started investing in the mid-1990s, the average P/E ratio was between 15-20. During the internet investing craze around 2000, it jumped to 43, before the stock market crashed – and it went back to about 15. In late 2020 it was between 35 and 40. Recently, it’s come back down to around 25 as companies are making more profits and the stock market has gone down a bit since the start of the year.

When the stock market in the internet craze went up a lot, people made a lot of money on price-earnings expansion. Those were craze days when Amazon was losing money and people were investing in because they had a cool sock puppet. Remember when Webvan blew billions of dollars trying to set up a grocery delivery service – clearly that was an idea that would never catch on, right? My roommate would joke that it should be called I could give examples all day.

Back then many of those tech companies didn’t make real earnings. Investors lost patience and the big gains in the stock market disappeared in the crash. The P/E expansion from 15 to 43 when back down to 15. If you happened to sell at the height of that expansion, you would have made a great profit on your investment. In a related thought, I want to borrow your crystal ball.

Recently, the P/E got to 40 again, but the market hasn’t crashed. It went down about 10%, earnings went up, and the P/E is still a little high at 25. One of the reasons why the stock market is up is simply because people are willing to pay a higher price (25 P/E) than typical (15 P/E). Instead of the bubble bursting like in 2000, it feels like the air is getting let out a little slowly.

3. Earnings per Share Growth

Remember that story for the last section? It seems like Amazon decided that it would rather make money. They’ve done a tremendous job of it over the last 20 years. If you were an investor you didn’t see the P/E expansion. In fact, the P/Es were very high when it was just barely turning a profit. Instead, the explosion in earnings has meant that the P/E has gone down. People are willing to pay a much higher price because they are getting great earnings.

Amazon is also an example of a company that doesn’t pay dividends. If you have been a long-term investor in Amazon you’ve made a lot of money and probably aren’t that worried about not getting dividends.

Putting the Three Components Together

What happens when we take all the components and combine them? Dividends are important over the long run, but they don’t significantly move the market.

The other two things, P/E expansion, and earnings growth move the market. When the P/E is above 40, it’s a long shot to expect further P/E expansion. It seems more like to expect the P/E to go down towards its norm between 15 and 20. That would cause the market to go down and you to lose money in your investment. At a P/E of 25, the stock market isn’t too high right now. I could see some P/E expansion or some P/E contraction. The P/E may also not move at all. My best guess is that the market isn’t going to skyrocket from P/E expansion where it is now.

On the other hand, companies are doing well with earnings. I don’t have a good handle on whether they can continue to do better. The United States Gross Domestic Product is very good, so maybe corporate earnings will continue to go up.

As I saw the P/E of the general market get high, I decided to be more defensive. I bought iShare’s HDV, which is a high-dividend ETF. It has a lot of household names that make money because people need to buy their products and services. It also has a P/E of around 18 – historically it is very average and more likely to expand than contract in my opinion. Over the last 6 months, the Vanguard’s Total Market ETF (VTI) has lost about 7%. Over the same time, HDV is up 7%. Getting defensive has turned out to be a great move lately.

Once I started to break down investing into these components it got a little easier for me where things might be headed as far as the return on investment goes, and adjust my decisions accordingly. I think it’s important to note that I didn’t sell and exit the market. I simply moved some of my money to a place that I felt would work out better given the valuations and trends.

Income Investing: How to Generate Cash Now

If you are looking to make income by investing your money you are not alone. For the 73rd straight year, our savings account is earning an interest rate of zero. Yours are probably doing the same. The Federal Reserve has dropped the Federal Funds Rate to 0.25%, which in layman terms means that you aren’t getting paid much interest in your savings accounts. Fortunately, this also means that some of your loans may be charging less interest.

Over the last couple of weeks, I’ve been talking a good friend of mine who is a little older than me… kind of like a big sister. We think alike on many things. In some ways it is almost like talking to myself, but a “me” with ten years of more life experience.

Lately, we’ve been focusing on investments to create income. We’re both in a fortunate situation where income is steady despite COVID-19. Since we aren’t traveling, going to restaurants, or buying much gas for our cars our spending is way down. That leaves us with a little more money to invest than we’d normally have.

At the same time, the stock market continues to be near new highs. I’m worried that stocks are priced too high, especially when corporate profits are likely to be so low. Many, many people seem to be worried about that. For this reason, I’m looking for investments that tend to be safer. I’ll return to my usual growth investing when the pricing is better. In the meantime, I’ll continue to stay invested, but stay conservative.

Many people moving into their 30s and 40s find that they have more responsibilities (i.e. children). It makes sense to have investments that generate income. That income can be used to supplement your salary now or to help phase out your job in the future.

If you could generate $50,000 in cash from investments, you could probably retire, right? Of course, your answer depends on your spending, assumes no inflation, and has a bunch of other messy details.

So in this world of (close-to) zero interest rates, how do you generate income?

Income Investing: How to Generate Cash Now?

This is a refresh of an article from 2015. While I have been talking with my big sister about this topic again, I also participated in this this Twitter conversation with Financial Pilgrimage. Specifically, he asked, “Where can you invest your money passively these days for a 3% return or greater besides stocks?”

I don’t want to discount stocks because they are a viable option… perhaps the most viable option. Let’s start there and branch out.

Dividend Stocks for Income

For most of my investing life, I never looked at dividends. I forgot that people once bought stocks to create income. Companies would pay out profits to shareholders and shareholders could use that money, to… well… buy stuff they need. It was a good little system. I speak of it in the past tense because many companies stopped paying dividends and instead kept the money to grow profits and raise their stock prices. In reality, dividend investing didn’t go away, I was just too wrapped up in tech stocks (which rarely pay dividends) and index investing (set it and forget it) philosophies.

In 2020, I’ve focused more on dividends. I like the idea of companies paying me money even if the stock market is crashing. I’ve mentioned that I’m managing stock market risk and removing tech risk from my portfolio with dividends. Specifically, I’m buying iShare’s high dividend ETF (Symbol: HDV). It has many big companies that you’ve heard of. It also pays a dividend of more than 4%.

Another thing that I like about dividends is that they are very tax efficient. Qualified dividends can be taxed at 0% at reasonably high-income brackets (~$75,000 for joint filers). If you make less than $400,000 qualified dividends are taxed at 15% a year. (This is overly simplistic for the scope of this article. Please see your tax professional for more information and advice.)

Unfortunately, due to COVID-19, corporate profits have dropped. Some companies can no longer afford to pay the same dividends they did in the past. That’s why I like the ETF approach. It spreads that risk over a lot of companies.

If you want to take a more hands-on approach for potentially bigger gains, you could look at making passive income with dividend kings. If you prefer to get higher dividend gains without hours of research, I recommend Sure Dividend’s newsletter. That link to the newsletter has a special discount rate and in full disclosure, I make a few dollars if you sign up for it.

Find a Strategic Investment Balance

The credit for this idea goes to my aforementioned big sister. She had mentioned that she was looking at the Vanguard LifeStrategy Income Fund (Symbol: VASIX). It’s a conservative blend of 20% stocks and 80% bonds. Historically, it doesn’t go up or down a lot. Since it was created in 1994 it has had annual returns of 6.26%. It’s 1-yr, 3-yr, 5-yr, and 10-yr returns are all between 4.95% and 6.82%, which gives you an idea of how consistent it is. During the big stock market crash of 2008, it lost about 15% of its value. That’s very good when traditional stock investments lost 50% of their value.

This could be an option to park some medium-term money that you may use in 2-4 years. I’m interested in this because it achieves my goal of staying invested, while still providing some protection in the case of a big market crash.

Income from Real Estate Investment Trusts (REITS)

This is really a special case of the dividend stocks above. However, the profits are generated by real estate – which can move in a very different direction than the rest of the stock market. REITS are traded as stocks and have to pay 90% of its taxable income as dividends to shareholders. The end result is that you can earn 4-7% in dividends. However, like a stock, their value can go up and down.

My favorite way to buy REITS is with Vanguard Real Estate ETF (Symbol: VNQ). It’s easy one-stop shopping with a company, Vanguard, that I trust.

Getting Income from P2P Loans

In the past, I’ve recommended P2P loans. They haven’t worked out as well as I have expected. A few days ago the top P2P loan company, Lending Club, announced that it closing down its lending platform.

I had been steadily pulling my money out of Prosper and Lending Club for the past few years. Prosper is still around and it may be a good fit for getting a passive 3%+ return on your money.

Skip Income Investing: Pay Down Your Mortgage Instead

One of the readers of the Twitter thread mentioned an obvious way of getting 3% for many people… paying off a mortgage. That’s a guaranteed return on your money, which may be valuable to you.

I’ve been against this for years because I’ve always felt that I can make 8-10% by investing in the stock market. Over the long run that has worked out exactly as planned. However, his stock market feels different and I’m not sure what has happened in the past is going to continue for the next 10 years.

I’ve mentioned over the last few weeks that we are doing a 1031 exchange – selling one real estate property and buying another one. Because we formed a corporation, the bank is charging us a 4% interest rate. Not only that, but it readjusts every 5 years – it could be 7% or more in 2020. I didn’t know this when we went down the 1031 exchange path. Now, I’m much more interested in paying down this mortgage quickly.

The downside of paying down your mortgage is that you are effectively locking yourself into that 3% (or whatever your interest rate is) return for the long term. Also, in this case, you aren’t creating investment income. Instead, you are reducing debt, which, while different, can be effectively the same.

Get a High Interest Savings Account

Derek of Life and My Finances mentioned that Lake Michigan Credit Union has a 3% Max Checking account.

I didn’t like the requirements of direct deposit, 10 debit card purchases a month and 4 logins to their website. The direct deposit it a one-time change with your work, which hopefully isn’t too difficult. Derek mentioned that using services like Mint and Personal Capital count towards the logins. That leaves 10 debit card purchases a month. If you are still buying coffee shop or Starbucks each day, this may be easy.

For me, making the 10 debit card deposits would be difficult. I also know that I would forget or not be able to keep track of for several months of the year.

Final Thoughts on Income Investing

I think the best plan is to combine multiple of the above suggestions. A portfolio of 35% HDV, 35% VASIX, 10% VNQ should provide some long-term hopefully, safe gains. The remaining 20% of your money could be used to pay down a mortgage and invest in a high-interest savings account.

This wouldn’t survive a big market crash and still make 3%, however, it would probably not lose too much and put you in a position to make 5-6% most years.

This article was originally published on Mar 2, 2015 at 10:45

What is Yield on Cost?

Yield On Cost
I don’t know if Glow Finger Guy knows what yield on cost is.

I’ve seen the term “dividend yield on cost” come up a couple of times recently. I’m new to looking at dividend investing, so I hadn’t come across it before. I’ve been focused on growth. My investing has almost always been in a retirement account and with very broadbased ETFs. I consider myself a Boglehead. It’s sad about Jack Bogle passing away last year (By the way, I have found that Dead or Kicking is a fast-loading site to get quick answers on well… the obvious.)

I don’t expect that will change any time soon, but I’m starting to look more at qualified dividends for taxation purposes.

The concept of a dividend yield (or any other yield) is something that (I think) most investors understand. For example, if a bank account pays you 1% interest, it’s a 1% yield. You give them $10 for a year and you get 10 cents. It doesn’t sound much with such small numbers, but through the power of compound interest it can add up to a lot of money over time. The concept of a dividend yield isn’t different than an interest yield except that it involves the money a company pays you for owning its stock. You can even reinvest dividends just like compound interest in a bank account.

That’s enough of a primer (or review depending on your knowledge) on what yields are. Now we can get to:

What is “Yield on Cost”

This is simply what you paid to own the stock in the first place. Let’s say that 10 years ago you paid $100 to buy a share of a company called “Acme.” At the time, Acme paid a 3% dividend yield. You made $3 a year. To make the math simple, we’ll pretend that you didn’t reinvest it. Instead you bought some Pokemon cards at the local 7-11.

Ten years later (now), Acme is selling at $200. Using the rule of 72 that is entirely possible – it would have grown 7% a year over each of those 10 years. Let’s also assume that Acme still pays out the same 3% dividend yield. However, 3% of $200 is $6 now. Your effective dividend is $6 on a cost of $100. So your yield on cost is 6%. Of course 10 years of inflation eats into the buying of that, but it is still nice growth.

Here’s a real world example of a stock that I own: IBM. In late October 2018, IBM accounted it was acquiring Red Hat. It sent the stock tumbling from $150 to around $115. IBM has paid a very strong dividend for quite a long time. At the time it was paying around 4.2% (roughly $6.28 a share a year). With the stock tumbling to $115, the yield would have jumped to 5.4%. Investors were likely concerned about IBM’s ability to pay its dividends given the acquisition.

Today, only about 14 months later, IBM is back to around $150 a share. They’ve even raised the dividend a bit. If you had bought IBM during that time, your yield on cost would be around 5.65% ($6.48 on a cost of $115). Investors buying it today, enjoy only a 4.3% yield. In this case, a timely purchase significantly increased the yield on cost so quickly that inflation is mostly irrelevant.

There are a couple of lessons to take away here:

  1. Buying quality companies with solid yields on dips can pay off.
  2. Buying the same types of companies and holding on to them for a long time can pay off as well.

The question is often, what counts as a great company? I like IBM, but a lot of professionals do not. I may be biased by love for their old PCjr that helped teach me how to program.

Strong companies that have a long history of dividend growth are often called dividend kings. The best place I know to get great updated information on these companies is Sure Dividend’s newsletter. It does cost some money, but for people who are investing significant amounts of money, it isn’t much and can save investors a ton in research. That link to the Sure Dividend newsletter has a special discount rate. (In full disclosure I make a few dollars if you sign up for it.)

Final Thoughts on “Yield on Cost”

I know that this may get confusing. Sometimes reading a “wall of text” isn’t the best way to learn. I found a 4-minute YouTube video with an explanation at least as good as mine:

I don’t know the makers of the video, so I can’t vouch for whether they are good financial advisors. However, if you are a visual learner, this may be right for you.

At the end of the day, the biggest thing to know is that investing money today can buy a big income stream down the line.

How To Avoid High Dividend Yield Stock Scams

sliding stockThis is a guest contribution by Bob Ciura at Sure Dividend. In the interest of full disclosure, I have not received any compensation for this article. However, they have provided a discount for Lazy Man and Money readers to their newsletter with thousands of subscribers. If you decide to sign up, I would earn a small commission.

It is easy for investors to be lured by stocks with tantalizingly high dividend yields. Running a stock screen could produce multiple high-yielders that look great on the surface, but later turn out to burn investors with dividend cuts.

To be sure, these are not companies operating fraudulent business models. Instead, these are stocks that are “scams” in that they look appealing on the surface due to their high dividend yields, but are actually quite risky because their dividends are unsustainable.

Here are a few things investors should watch out for to avoid unsafe dividend stocks.

What To Look For

High-yield dividend stocks are naturally appealing, especially for investors who rely on income from their portfolios such as retirees. This is particularly the case in an environment of low interest rates. As a result, investors might instinctively gravitate toward stocks with the highest dividend yields. But this is often a mistake.

Stocks with lower dividend yields are far less interesting from an income perspective, but dividend sustainability is a trade-off all investors should be willing to make. To find sustainable dividends, investors should focus on high-quality businesses with manageable debt levels and sufficient dividend coverage. We believe these are likely to be much better investments over the long-term.

With all this in mind, here are three specific reg flags that could indicate a stock is at risk of a dividend cut.

Red Flag #1: Dividend Yield Exceeds 10%

At Sure Dividend, we generally classify a stock as “high-yield” if it possesses a dividend yield of 5% or more. As the S&P 500 Index currently yields 1.8%, a stock with a 5% yield towers above the broader market. But it is actually possible to find stocks with even higher yields of 10% or more. These extreme high-yielders are very attractive by comparison. The trouble is, many stocks with abnormally high yields are mirages.

As a stock price declines, its dividend yield rises. For example, a stock that trades for a price of $100 per share, with a $5 annual per-share dividend, will have a 5% dividend yield. But if the stock price falls to $50 per share, and the company pays the same $5 per-share dividend, the dividend yield is now 10%.

But this is a potential red flag. Plunging share prices are often the result of deteriorating business fundamentals, such as revenue or earnings-per-share. It is important for investors to remember that in order for a company to maintain its dividend payment to shareholders, it must generate the necessary earnings to support the dividend.

Companies that are experiencing declining earnings may not have the ability to maintain their dividend payouts. For this reason, extremely high dividend yields are often a sign of danger. Their sky-high yields are an indication that investors are no longer confident in the sustainability of the dividend payout.

An example of this is oil and gas royalty trusts. We are highly skeptical of many oil and gas royalty trusts’ ability to maintain their dividends over the long run. Therefore, we recommend investors take a cautious view of royalty trusts such as Cross Timbers Royalty Trust (CRT). Despite sporting a yield well above 10%, CRT receives our lowest score for Dividend Risk. Royalty trusts have finite lives due to their limited reserves, and are also extremely vulnerable to falling oil prices, which make them highly unattractive in our view.

Red Flag #2: Excessive Debt Burden

Shareholders are below debtholders within a company’s capital allocation priorities. This is important for stock investors to remember, because common shareholders get paid dividends only after a company’s interest expense is paid. If a company carries an excessive level of debt, it could jeopardize its ability to pay dividends to shareholders.

This is why investors should always analyze a company’s balance sheet before buying its stock, to make sure its debt load is not a hidden danger. There are many cases of highly indebted companies reducing their dividends because of debt. After all, a company that cannot pay its debts is in danger of bankruptcy. For example, the oil price decline of 2014-2016 forced many over-leveraged oil producers—particularly among the Master Limited Partnerships—to cut or eliminate their dividends.

A more recent example of this is occurring among mall-based Real Estate Investment Trusts, or REITs. The REIT business model involves utilizing debt to purchase properties, which are rented out to tenants. But the prolonged erosion in mall traffic in the U.S., exacerbated by the e-commerce boom, has caused multiple over-leveraged REITs to cut their dividends, such as CBL & Associates Properties (CBL).

For this reason, we remain wary of Whitestone REIT (WSR), which currently has a high dividend yield of 8.5%. But it also has a projected dividend payout ratio above 100% for 2019, and an alarming level of debt. The company had a debt-to-EBITDA ratio of 8.4x in 2018, well above the healthy industry norms of 4x-5x. And while it aims to reduce its leverage ratio to 6x-7x by 2023, this is still an excessive level of debt. Unless its cash flow recovers dramatically—which seems unlikely given the troubles facing the retail industry—its debt level is a major red flag as far as the dividend is concerned.

Red Flag #3: Dividend Payout Ratio Above 100%

As mentioned earlier, a company can only pay a dividend if it generates enough profit to do so. No company can continue to pay more in dividends forever if its payout exceeds its underlying earnings. At some point, either the company needs to generate higher earnings to support the dividend, or the dividend must be reduced.

A recent example of this is Vector Group (VGR), a holding company with business interests in tobacco and real estate. Vector Group appeared to be an attractive dividend stock, as it has offered a nearly 10% dividend yield for the past several years. But in each year from 2014-2018, the company’s dividend distributions to shareholders exceeded its earnings-per-share, leading to a dividend payout well in excess of 100%. Because of this, Vector Group recently notified investors it will reduce its dividend by 50% in 2020.

A similar danger could be in store for shareholders of B&G Foods (BGS). B&G Foods is a consumer staples company with food brands including Green Giant, Cream of Wheat, Ortega, Mrs. Dash, and others. But the company’s weakening financial results over the past several quarters resulted in an elevated dividend payout ratio. B&G’s growth strategy of the past several years consisted heavily of debt-fueled acquisitions. However, its spending spree saddled the company with a large debt burden. Interest expense consumed nearly half the company’s operating income over the first three quarters of 2019. In that time, it distributed $1.425 per share in dividends, but generated earnings-per-share of just $1.01. All of this means the dividend could be at risk of a cut.

Final Thoughts

Avoiding dividend cuts should be among the highest priorities for income investors. Not only does a dividend cut immediately result in less dividend income, but dividend cuts are frequently accompanied by further declines in the share price. This leads to the dreaded “double whammy” of less dividend income, and a loss in principal value.

To help in this regard, investors can focus on a few key metrics to judge whether a company’s dividend is sustainable. While there are never guarantees that a stock will not cut its dividend, performing additional due diligence of these three red flags can go a long way towards reducing the potential risk of a dividend cut.

[Editor: I’m back to give you one more reminder of the Sure Dividend discount for Lazy Man and Money readers.]