Letter to Our Clients - June 2011

June 2011

 

Dear Clients and Friends:

It has been a long time since my last letter. I try to send out letters only if I have something worth reading. I hope you find this to be so.

We have been busy. In addition to our “normal” work of wealth management/planning, and portfolio management, we have been attending conferences and engaged in conversation with institutional money managers from a wide range of organizations.

This letter is prompted because of the most recent conference I attended, the annual Morningstar Investment Conference in Chicago.

The keynote speaker was Bill Gross, who has almost rock-star status among investment professionals. It is my understanding that he is the largest manager of publicly traded bonds. When asked where is the best place to obtain investment returns over the next few years, he said – not bonds, but dividend-paying stocks. Well, that was a surprise, as most investment managers favor the kind of security they manage.

Later there was a panel with three other high-profile bond managers with long and successful track records. When asked the same question, the three of them said they felt the best investment opportunities for the next few years were – not bonds, but dividend-paying stocks, preferred stocks, and publicly traded master limited partnerships.

This is not meant to suggest investors should change the percentage of their holdings now in bonds, even if that percentage is zero. The main role that bonds play now is to generate more “yield,” that is, cash-flow, than money markets, while helping to protect an investment portfolio from the dramatic swings such as those that the stock market delivered 2000 to 2003, and 2007 to 2009.

It does mean that we cannot look at the “average” returns of bonds over the last 5, 10, 20 or 30 years and expect to receive performance remotely close to that. Why? Because bond prices were at their highest in the early 1980’s, and have been dropping ever since. This has allowed bond portfolios to benefit from cash-flow greater than is available today, and it has resulted in appreciation of existing bonds. When interest rates are close to zero, as they are today, cash-flow is significantly lower, and there is – basically – no appreciation potential. About the best one can hope for is to stay even with inflation.

Money market accounts, and short-term Certificates of Deposit, are the safest way to lose (real) money. If inflation is at 3%, and an investment is earning, say, 0.5% (one-half of one percent), then the account is losing purchasing power of 2.5% per year. So, while it may feel “safe” when looking at the month-end statement, it is losing spending value year over year.

Stocks, as we all know, are “riskier.” They go up and down. Some stocks, like Enron, disappear. But a well-diversified portfolio of stocks offers potential for long-term growth, and an opportunity to outpace inflation.

Real estate has some stock-like characteristics. But, despite what enthusiastic real estate investors have said at the peak of their market, real estate values go down also. A difference is that stocks are liquid. A publicly traded stock can usually be sold at a moment’s notice. This is a huge difference between a stock and a piece of investment real estate.

There are many different ways to view stocks, but for our purposes here we will compare two types of stocks, those that pay a “meaningful” dividend and those that do not. (Meaningful in this investment environment is, for us, a 2.5% yield or higher.)

First, a reminder. What is a “stock”? It represents an ownership share in an operating business. In fact, one who owns a stock owns an asset. This is important. We will discuss this in a future letter.

Some businesses choose to share their net income by paying their stockholders a dividend. Think of a local utility. Other businesses use all their income/cash-flow differently. Some re-invest in their businesses, in order (they hope) to be even more profitable. Others will buy back shares from the public in order to reduce the number of shares outstanding, in the hopes that will make the remaining shares more valuable. Personally, I think paying dividends and re-investing in the business makes sense. I think share re-purchase is an imprudent use of cash-flow, and generally companies that have done this have bought back shares at the highs of the market and thus wasted their available cash. But, they never ask my opinion.

As an investor, if you own companies that do not pay meaningful dividends, you are absolutely depending upon the market to reward that company by having the stock price go up. Such a stock can, to some extent, be compared to raw land. You get no cash-flow until you sell. This kind of stock investing looks attractive in strong markets, such as 1982 to 2000. It does not work so well when the market drops, or when it runs sideways for extended periods of time.

As an investor, if you own companies that pay a meaningful dividend, you are receiving cash-flow AND you have the potential for price appreciation. Usually dividend-paying stocks have not gone up as much as non-dividend stocks in strong markets, but they usually have not gone down as much either. As I like to say, “we want to get paid to own the stock.” And, generally dividend-paying stocks increase their dividends as their profit increases, which can provide a way to outpace inflation.

Dividends can serve two purposes. If you are needing or wanting your investments to help with your expenses, the dividends can serve as a source of cash-flow, much like bond or CD interest. If you do not need current cash-flow, the dividend cash-flow can be used to buy more assets – more stocks, or more bonds, or more of whatever best meets your investment objectives.

The fundamentals have not changed. Stocks offer more potential and yet are subject to significant changes in investment value. Other types of investments may feel “safer,” because they might have little or no fluctuation potential, can fail to earn more than the inflation rate, resulting in a real loss of purchasing power. The longer one’s anticipated life span, the greater is the impact and danger of reduced purchasing power.

We cannot avoid risk. We can only recognize the different kinds of risk, and then manage our resources and our behaviors to accommodate these risks.

Please contact Ted or me if you have any investment-related questions, and contact our Operations Department (Linda, Veronica, Becky or Traci) if you have any administrative needs. Thank you again for the opportunity to work with you.

Best wishes,

Robert K. Haley, JD, CFP®, AIF®