Despite their uptick in recent months, interest rates in most developed markets remain at historically low levels. This unprecedented low interest rate environment has led some investors to engage in a practice commonly referred to as “reaching for yield:” taking on more risk (i.e. possibility of permanent loss) just to stand the chance of getting the same return as before. Of course, no investor will admit to reaching for yield, just as not many people swimming next to you will volunteer that they are swimming naked. As Warren Buffett has remarked so insightfully, it’s only when the tide goes out that you discover who’s been swimming naked.
So, which equity income strategies make sense for investors to pursue in the current low return environment without falling into the trap of reaching for yield? To help us better understand this issue, I recently spoke with Marty Leclerc, founder and portfolio manager of Barrack Yard Advisors. Marty, who is a 30-year veteran of the investment management business, has long believed in the importance of dividends and other yield-oriented strategies to compounding wealth. In fact, one of his five enduring principles upon which he founded his investment firm is that dividends do matter. However, unlike many other investors, Marty does not blindly seek out high-dividend yield stocks or other income-oriented strategies that do not take into account underlying fundamentals and risk considerations.
I’m pleased to share from my conversation with Marty Leclerc the below excerpt on equity income and yield strategies in the current low return investment environment. Among other topics, Marty discusses which yield seeking investments he is avoiding, and which he is pursuing, what types of companies he looks for to generate yield, and why dividends are essential to compounding wealth. The full interview with Marty Leclerc is available in The Manual of Ideas Members Area.
Marty Leclerc on How to Get Equity Income But Avoid Reaching for Yield:
Says Marty Leclerc:
“So, the intensely interest rate sensitive investments like bonds and preferred stock, REITs, and highly indebted companies those things we avoid at all costs. Where we’re looking for income is three areas:
One is buying these sort of blue chip companies that pay good dividends that are out of favor. Examples in the U.S. might be a DuPont [DD] right now, maybe a Cisco [CSCO]. In Europe, it would be maybe Deutsche Boerse [Xetra: DB1], Vivendi [Paris: VIV], companies like that.
Secondly, we in the U.S. very much like the energy infrastructure story. With the revolution in drilling technology, the shale revolution, there is going to be a volume expansion in hydrocarbons produced in this country. And they have to move the product. And right now, rails and barges are moving it, but it’s not the best option. The best option is to use pipelines. So, although we typically like to only buy companies that generate excess cash and lots of it, infrastructure assets like the MLP pipelines and so forth, we’re willing to own those for the income, at least in the intermediate term. And what we liken it to is in the early 1980s the electric utility companies in this country were issuing lots of debt and equity in order to build out the infrastructure and they had to treat investors sweet for quite a while. And the same story I think applies here. So, I don’t know if I would buy these pipeline companies which pay dividends of 7%, 8%, 9% in the midstream assets, I wouldn’t own them for 30 years but I think for the next 3-5 years the ones that were around before the Great Recession most of them increased their dividends during the Great Recession. So, I think that’s a reasonable place for retail American investors to look at. Unfortunately, there is some sort of funky tax issues with it because they are master limited partnerships. But that’s a reasonable area.
And then the third area that we would have investors look at is deep in the money covered calls against companies you wouldn’t mind owning anyway. And here we sit in 2013, in April, and one of the problems in the options market is that volatility is muted and also interest rates are low. As a consequence of that there aren’t juicy premiums out there. But if a stock falls a little bit out of favor, there’s a little bit of volatility around it, and so even in this environment you can buy some companies that maybe you get, we’re finding 13-18% of downside protection. And if the company gets called away in the next seven or eight months, your annualized return is somewhere around 10%. So we think that’s also a reasonable way of going.”
Marty Leclerc on What Types of Companies He Looks for to Generate Yield
“We view any investment without a growth component as being a value trap. So, we not only want to own a company that pays an attractive dividend but we want to own a company that has a history of growth. Now, if you look at the market right now, any stock yielding more than 3.5% or so is something that’s probably out of favor if it has positive cash flow.
It’s not rocket science. You want to own companies that generate strong cash flow, that have a history of reinvesting that cash flow in a decent manner, that have money left over to pay a competitive dividend. And, by necessity, that means you’re going to end up owning a stock that’s probably selling at ten, twelve, thirteen times earnings which I think is a reasonable valuation if it’s a real business, a real company that has a low probability of suffering from a paradigm shift.
So, what we want to do is own companies that sort of worst case are going to grow their earnings over the next five to ten years by 5% or so [p.a.] which is average for American companies that survive. And if we can pick up a dividend of 4-5% and we are paying ten, twelve times earnings, then we figure that we have a good shot of getting a 10% or 12% return over time if we are patient.”
Marty Leclerc on the Importance of Dividends to Compounding Wealth
“First of all, if you look at the Ibbotson reports and any number of these reports, one of the things you find is that 40% of the return of the U.S. stock market in any event, comes from compounding dividends. So, clearly if you’re not investing in dividend-paying stocks, you’re giving yourself a bogey relative to those that do.
The second thing is that creative accounting can hide a lot of things, but cash is for real. And one of the things I might mention is over the last ten years the sort of scandal stock, the Enrons, the Worldcoms, and more recently maybe the Chesapeakes of the world, the thing they had in common – apart from negative cash flow – was that they didn’t pay a dividend. So that’s key.
And then the third thing is that as an owner of a business, I just have this thing that I think you should get paid to own a business. So, you put those three things together and to us it’s a compelling case for enabling you to compound money better than just by owning an asset that does not pay a dividend.”