Saturday, November 9, 2013
What's your biggest concern for your finances and the stock market going into 2014?
Most investors are worried about inflation and how it will undermine the income they receive from their investments.
Inflation has been called "the thief that robs us all." Among its biggest victims is the income investor.
The yield you generate from your investments must outpace inflation. Otherwise, you're losing money. There's not much you can do about the rate of inflation, but the assets you choose can protect you from it.
Dr. David "Doc" Eifrig has six different and easily tradable assets he likes to recommend. We'll walk you through the basics of each of these different income vehicles, how they work, what to look for, and what each asset can add to your portfolio...
The Asset: As a stockholder, you hold a partial ownership in a business. The assets of that business can be all sorts of things: property, equipment, or other hard assets. It can own patents on technology or valuable brand names (like Coca-Cola).
Regardless, all dividend stocks share one big similarity – their ability to produce earnings. Pay attention to the history and safety of these companies' dividend payments (and the potential for these payments to grow)... and increasing wealth follows from there.
The Price: The share price for a dividend stock is easy to find on Yahoo Finance.
When it comes to dividend stocks, the most important numbers to consider are the market cap – the value of a company's outstanding shares – and valuation metrics, like the price-to-earnings ratio, price-to-book ratio, and price-to-cash-flow ratio. We prefer companies with larger market caps and valuation metrics that are lower than the market averages.
The Income: Stocks provide income in the form of a dividend. Remember, you own a share of the business. If the business makes enough money, it can choose to reward shareholders with a dividend payment. Of course, many stocks don't pay a dividend. Instead, they keep the earnings and reinvest it in the business.
When searching for income in dividend stocks, you must consider how safe the dividend payment is. Big blue-chip stocks rarely reduce their dividends. But when they do, it's seen as a sign of weakness... and the share price often tumbles.
To avoid getting caught with a dividend-cutter, we look at things like the "dividend payout" ratio – the percentage of earnings that a stock pays out in dividends. As a rule of thumb, we like to see companies in this category maintain a payout ratio of less than 50%. That offers enough breathing room for the company to survive an economic downturn or a slump in sales without needing to reduce its dividend payment.
Like any income investment, the yield on a stock is calculated as the yearly income (dividend in this case) divided by the current share price. So a stock that pays $1 in annual dividends and trades for $25 offers a 4% yield.
The Asset: When a corporation needs money, it often issues bonds to borrow that money. As individuals, we usually think of debt as a liability. But to the owner of the debt, that debt is an asset. So for bonds, the asset is an interest-bearing loan to a corporation from us.
The basic bond arrangement is simple. The company borrows a specific amount (called the face value) and pays interest on that every year (called the coupon rate). At the bond's end date (called its maturity), it pays back the face value.
Let's say a company can borrow $1,000 for five years at a 10% coupon rate. Each year, it will pay $100 in interest. At the end of the fifth year, it will pay back the $1,000.
While stocks can be affected by sales, earnings, growth, and new products... only one thing matters for bonds – whether the company can pay you back.
That's why solvency – the company's ability to meet its expenses – is the most important measure for bond investors. If things go wrong and the company declares it can't pay its loans, bondholders become owners of any assets the company has... and receive the proceeds from any bankruptcy to recoup losses. This is a huge advantage over people who just own shares of the company's stock, since they are guaranteed (and usually end up with) nothing when the company goes belly-up.
But corporate bonds don't default often. Since World War II, just 3% of bonds have defaulted. If you follow the news on bonds, it might seem like they are complex. That's because a bond's price fluctuates over the course of its life.
The Price: Since a company can have dozens of different bonds, finding specifics is a little more complex than for stocks. Anyone can look up bond prices from FINRA.
Since bonds trade after they are issued, investors can change their attitude about bonds over time. So a company may issue a bond at $1,000. However, a year later, investors may be more fearful of a bankruptcy. They won't pay as much to own the bond. Now the bond may only be priced at $900.
This is where the important concept of yield-to-maturity comes in. Take a five-year bond with a face value of $1,000 and a 10% coupon rate. (Remember, the company pays that same coupon rate no matter where the price of the bond goes.) As long as the price of the bond stays at $1,000, bond investors will earn a 10% yield.
But if the price drops to $900, investors will still receive the same $100 interest payments and the same $1,000 at the end... but they can put in a smaller investment upfront. The new investor's "yield to maturity" is now around 13%.
Yield-to-maturity considers the interest payments and final price and relates them to the current price of the bond. You won't need to calculate yield-to-maturity on your own. It's provided by any site that tracks bond data. But you can see the formulas here.
The Income: Once you own a bond, you simply collect the regular coupon payments (which are usually paid twice a year). Barring bankruptcy, the income a bond will generate is determined ahead of time, as long as you hold the bond to maturity.
The Asset: Just like a corporate bond, a municipal bond's asset is a loan. But in this case, it goes to a municipality – either a local or state government.
The historical default rate on municipal bonds is virtually nil. While triple-A-rated corporate bonds (the highest rated) have a cumulative default rate of 0.52% from 1970 to 2006, triple-A-rated municipals have zero defaults. Further down the scale are Baa-rated municipal bonds – which are still considered investment-grade – just 0.13% defaulted. Compare this with corporate bonds, 4.6% of which defaulted.
Critical to the safety of muni-bond investments... municipalities have the power to tax, unlike corporations. Analysts who predicted large numbers of municipal defaults often forget this. You shouldn't think of municipalities and their balance sheets like businesses.
Some municipal bonds are considered "general obligation" bonds, meaning the city owes on the bonds no matter what. In these cases, the true asset is a loan secured by the municipality's power to tax.
Others are "revenue bonds" tied to a specific asset. For example, bonds can be issued to build a new baseball stadium. Then, the revenue the stadium generates goes toward paying off the bonds. These bonds can be considered riskier since bondholders are at the stadium's mercy. But as with all bonds, in case of a default, bondholders would still be able to recoup some of the losses, unlike shareholders in corporations.
The Price: Like corporate bonds, you can find current prices of municipal bonds on FINRA.
The Income: Muni bonds have nearly identical features to corporate bonds. Only one calculation is different... and it's what makes municipal bonds more attractive.
Most municipal bonds are tax-exempt. At a minimum, you don't have to pay federal income tax on the income you receive. And if you hold municipal bonds issued in the state where you live, you don't have to pay state taxes on them, either. That makes munis a great asset for creating wealth...
Imagine you have $1,000 to invest and the choice of a corporate bond or a municipal bond. Let's say the corporate bond pays 6% and the municipal bond pays 5%. It looks like the corporate bond is more attractive. But to correctly compare them, you need to consider the tax implications...
If your tax rate is 28%, the municipal bond actually pays the same as a corporate bond yielding 6.9%. So the muni bond actually offers the higher yield. That 6.9% is called the "tax-equivalent yield."
Real Estate Investment Trusts (REITs)
The Asset: REITs invest in real estate and pass the rental income on to shareholders.
REITs are not the same as a company that manages real estate. They have a unique corporate structure designed to more closely simulate a direct investment in real estate. To qualify as a REIT, a company has to fulfill several requirements. For our purposes, two are the most important...
The company must derive 95% of its income from dividends, interest, and property income (rent). And it must pay at least 90% of its income to shareholders as dividends.
In exchange for meeting these requirements, the company doesn't have to pay corporate taxes on most of its earnings.
In this sense, buying shares of a REIT entitles you to virtually the same income as if you were able to buy the properties and hire a property manager... except you get to avoid the headache of operating a property.
To think about REITs, you have to think like a landlord... How are rental rates trending? What's the vacancy rate? Are property prices rising?
REITs come in all shapes and sizes: residential, retail spaces, office spaces, industrial, and campus housing, for instance. REITs also exist in assets that you might not consider real estate at first glance, like mortgage REITs, which hold a portfolio of mortgage-backed securities. As the borrowers who took out these loans pay down their debt, the payments get passed through the REIT back to the shareholders. As you can see, REITs offer a lot of opportunities for investors to turn assets into income.
The Price: REITs are traded just like any stock, so you can find their prices on Yahoo Finance.
You should compare the market cap to the value of the REIT's assets. Traditionally, REITs trade somewhere around two times book value. That means a REIT with $1 billion in real estate assets will often have a market cap of around $2 billion. The difference is due to the fact that the assets can generate income and because the book value – a company's assets minus its liabilities – is usually lower than what the properties could truly be sold for.
The Income: The income from a REIT comes in the form of dividends. Like a stock, this is usually paid on a quarterly basis.
But judging the safety of the income from a REIT is a bit different. Rather than focusing on earnings, a REIT is better judged by its funds from operation (or "FFO"). FFO shows how much money a REIT earns from its rental fees.
Master Limited Partnerships (MLPs)
The Asset: Master limited partnerships (MLPs) are similar to REITs. They have a favorable tax structure that gives investors nearly direct access to less liquid but income-generating assets.
In the case of MLPs, the IRS has a list of "qualifying assets" that are allowed. The most common items relate to energy and natural resources like oil pipelines, refinery services, and natural gas storage.
MLPs also pay little to no corporate taxes as a reward for passing income on to shareholders.
Typically, MLPs work like a toll road. Pipelines transport a commodity for a fixed fee without worrying about production rates or commodity prices. It's a simple way for an asset to generate cash.
The Price: Current prices for MLP shares are available anywhere you can get stock quotes, like Yahoo Finance.
The Income: MLPs typically pay income in the form of quarterly distributions. Eyeing up economic activity and competition surrounding the particular assets will give you a good idea of where income levels could be headed. For instance, with the natural gas boom in the United States, the income derived from natural gas pipelines has risen.
When judging the safety of MLP income, cash flow trumps earnings. In particular, MLPs report a statistic called "distributable cash flow." This is the amount of cash flow that the partnership can pay to shareholders after paying to maintain the equipment.
The Asset: Preferreds are considered hybrid securities since they have some characteristics of bonds – for example, they deliver fixed-income payments to shareholders – and some characteristics of stocks.
Preferred shares are a form of debt that trade on public stock exchanges. They are highly liquid securities and can be easily bought and sold, just like common stock.
But preferreds also represent bond-like security. Preferred-share holders have claims against the assets of the companies (should bankruptcy happen), like a bond. Although their claim is a lower priority than those of traditional bondholders... it's a greater measure of security than common-stock shareholders have. (Their claims come at the end of the line.) However, most preferred shares lack voting rights, something common-stock shareholders do enjoy.
The Price: You can find prices for preferred shares on Yahoo Finance. You always want to compare the current price to the callable price. If a company can buy back its shares for $25 (the callable price), you wouldn't want to pay much more than $25 for them.
The Income: The quoted coupon yield can vary from the true yield, which is calculated as yield-to-maturity. For preferreds, "yield-to-worst" is a similar measure. When preferreds are callable, they typically have a provision that prevents them from being called until a specific date.
So while a preferred may pay a 6% dividend on shares it issued for $20, since the price can fluctuate, an investor can earn a different yield. In the case of a preferred share, yield-to-worst is the most useful way to calculate what you can truly earn. The yield-to-worst considers the current price, the dividend payments, and the possibility that the company will call the shares at the first chance it gets.
Companies don't always call their preferreds right away. It typically depends on if they have the cash or what prevailing interest rates are. But this yield-to-worst provides a "worst-case scenario" estimate of what sort of yield we can expect.
Most folks simply buy an income-producing asset and hold it. There's nothing wrong with that approach... Buying and holding an excellent company that pays healthy and increasing dividends is one of the surest ways to get rich in the market. We stand by that...
If you'd like to learn more about "trading for income," click here.
Date Range:10/31/2013 to 11/7/2013
Date Range:10/31/2013 to 11/7/2013