IN THIS ISSUE: How wonderful would it be if your investments paid you rent for owning them? Imagine that. Your investments, regardless of increases and price drops, would pay you monthly, quarterly or semi-annually. This is the reality of dividends and Cash Flow investing. In this issue of Tactics, John Nicola explains how a dropping stock price could mean extended value.
In 2007 one could replace the word cynic with irrational investors and have a reasonable description of the year’s investment markets.
Let’s imagine that at the end of 2006 there was an investor who had but one investment. It was a well-run apartment building which was worth $2-million. It generated an income of $100,000 peryear after expenses. With a lot of work and some reduction in vacancies, he increased that income to $110,000 by the end of 2007. He began to think that perhaps now would be a good time to sell, become more diversified, and look for investments that do not occupy so much of his time. After all, there are only so many times that unplugging toilets at five in the morning is exciting.
He has a trusted friend who is a licensed realtor and he asks him to list the building with the idea of selling to the highest bidder. One month later his friend visits to tell him the following:
“Fred (all apartment owners are named Fred – remember I Love Lucy?), I have some bad news. I listed your building and received five bids for it.”
“So why is that bad news, Bob? There are five investors competing for my building!”
“Because, Fred, the highest bid is $1.6- million and the lowest is $900,000.”
“That can’t be right. The building earns 10% more than last year. Mortgage rates are about the same and the economy is decent – what gives?”
If you think as Fred does and cannot understand how the price of an asset can fall by 20% to more than 50% while its income remains the same or increases, then welcome to the wacky world of equity markets.
Here is a smattering of companies whose shares were punished last year while each was able to maintain or increase their dividend distributions.
It is always possible to rationalize why these “corrections” occur.
- The U.S. housing market will cause a severe recession
- Banks are exposed to more subprime/ABCP (Asset Backed Commercial Paper) risk that is not yet priced into their stock price
- Real estate has peaked and price drops for REITs were to be expected
In each of these there is enough truth to make a rational investor make irrational decisions, and over the last 12 months that has happened.
As Russil Lea wrote in our last newsletter: Cash Flow is King. Every quarter we provide all of our clients with statements that show them the total returns of their investments with us and the diversification of their asset allocation.
Without doubt, measuring returns and asset allocation are important in managing wealth; but arguably both are less important than building a portfolio that generates a growing and tax-efficient cash flow.
Many of you have said to me that you do not require a current cash flow from your investments and therefore you might be better off looking for investments that have “growth” potential – i.e., sacrifice current cash flow for greater price appreciation.
Our argument is that it is sustainable or growing cash flows that create higher prices for your assets. The more cash you generate now, the easier it is to diversify and buy assets whose prices many be temporarily distressed (such as the ones noted above).
If you have any doubts about the importance of dividends with respect to total returns and rational investor behaviour, consider the following facts:
- From 1990 to 2007 the price appreciation of the S&P 500 was 279%. Once you include the impact of dividends, that changes to 556% (double the value). This was during a period of time when dividends were considered passé. (Nothing to do with the fact that the value of management’s stock options is based on price appreciation vs. total return.)
- For the S&P TSX the price appreciation was 269% in the same period and 449% with dividends. Given the resource base we have and the fact that income trusts were not in the index for most of this period of time, this is to be expected. Nevertheless, still a large difference. If we look at the S&P TSX 60 (closer to the S&P 500), the total return is up 556% against a 331% price appreciation.
- Since 1950, the annual increase in dividends has been 5.6% and in only six years (1 in every 10 years) has the dividend income dropped. And even then by not more than 6.2% in any one year.
- Stock prices are three times more volatile than dividends (based on S&P 500 price and dividend figures between 1950 and 2001, source www.globalfindata.com).
In the end, dividends to me represent the rational discipline of a well-managed company while price is the cumulative effect of us all as the irrational poorly behaved investors that we are.
So that brings us to the two new reports Nicola Wealth Management has developed. Both provide new information for all of our clients regarding the cash flow their portfolios have generated historically and what we can expect as we move forward.
This report shows a summary of the 12-month rolling average cash flow by quarter since the end of 2003 (for those who had accounts at the beginning of 2003) or 12 months after your accounts were open. The 12-month rolling average smoothes out those cash flows that sometimes are paid either quarterly or annually. There is an additional report which shows which assets are generating current distributable cash flow and how much that was in the last 12 months. History suggests that these cash flows are much more stable than asset prices.
As the name suggests, this is a forward-looking report which provides an estimate of the cash flow that may be realized in your account over the next 12 months. We strive to have at least 50% of your long-term total return be generated from cash flows in the form of dividends, rents and interest. This report shows where we expect to see that cash flow come from and in what amount.
You will also see some assets that do not generate cash flow at all. This does not make them inferior assets. There is some argument for acquiring assets that are all about long-term price appreciation (land vs. incomeproducing buildings would be the real estate equivalent). You will also notice, however, that those assets that have been acquired primarily for growth reasons are usually less than 25% of the entire portfolio. Cash flow still dominates.
We hope these new reports will provide some perspective on your portfolio and help you focus on those areas that really affect long-term wealth building:
- Prices will always fluctuate more than income, and that is especially true of publicly traded markets.
- In order to buy well, we need the assets we want to acquire to drop in price (at least for a while).
- In order to acquire those distressed assets, we need cash flow being generated from a well-diversified portfolio, thus allowing us to sell some “winners” as we buy some “losers”.
So just for a minute let’s go back to poor Fred. What’s he going to do now? Of course he could feel depressed about selling his building and getting, at best, $400,000 less than a year ago, or…
- He could feel elated that he can now buy another building for twenty percent less than a year ago. Mortgage rates are the same so this is his chance.
- With two buildings he will have more cash flow than before, so he decides to hire a property manager and let them unplug the toilets.
- He then takes Ethel out for dancing lessons with Ricky and Lucy at some new Cuban place.
And all is right with the world.