This week I’m asking you to forget everything you know about investing.
Instead, think about your investments as if you were a farmer. And on your imaginary farm there are only chickens and eggs. The chickens are stocks, and the eggs are the dividends they produce.
How is this exercise useful?
Investors haven’t been able to make money on cash or bonds this year. And stocks have been gyrating, with all sorts of concerns — economic stagnation, social strife, central-bank interference. It’s time to re-evaluate the importance of stock dividends.
In last week’s Money and Markets column, I promised to reveal a strategy that conservative investors can use to lock in enduring profits in even the most volatile markets.
For risk-averse investors, certainty is paramount. Dividends represent the proverbial cash-in-hand, pay-me-now component of total portfolio returns. To explain how dividends benefit investors, I’m going to call upon an analogy developed by former colleague Jim Garland about chickens and eggs, mentioned above.
|Egg farmers can teach you how to cut the stress of stock market investing.|
You have two choices for your agricultural enterprise: You can be a chicken farmer or an egg farmer. Chicken farmers are focused on the price of chickens. Egg farmers raise and care for their chickens to benefit from the eggs they lay.
Many investors act like traders and treat their stocks like chickens — they go to the market to buy and sell them every day. Stocks are the assets they currently own but plan to sell someday to pay for college educations, a second home or for retirement. Those investors are chicken farmers.
There is a different group of investors who want to live off the income from their capital. Those people are egg farmers — the recently retired professional couple; the widow who has just received a significant lump sum payment from a life-insurance policy; an entrepreneur who has recently sold his business and wants to pursue other interests; or a daughter who has received an inheritance and plans to use the money as a supplement to pay day-to-day expenses.
Many income-oriented investors (egg farmers) are deluded by what they see on TV, the Internet and in the newspapers. They mistakenly believe they’re chicken farmers.
Wall Street’s White Noise
Who can blame them? Market pundits bombard investors with an endless flow of information, telling them the only thing they should want to do is buy and sell chickens. How often does The Wall Street Journal report on the value of the Dow Jones Industrial Average? Every day. How often does it report on the aggregate dividend income from the Dow? Only once or twice a year. The popular media is for chicken farmers.
But risk-averse investors know dividends are one of the three components of total investment returns in the model that I described in my May 1, 2013, Money and Markets column.
So to help risk-averse investors (egg farmers) maintain their sensibility amid all the nonsense about stock prices, I’m going to describe a different way of looking at the financial markets.
Many experienced investors are familiar with Modern Portfolio Theory and CAPM, or Capital Asset Pricing Model. If not, you can reference my April 10, 2013, Money and Markets column in which I explained that CAPM serves as the basis for most modern investment strategies.
But on our imaginary farm, we use a model called CEPM, or the Chickens’ Egg Production Model.
I’ve presented it here in chart form.
It’s remarkable how closely the CEPM chart fits the stock market over the past 50 years. Over that time, stock prices have been volatile — especially during the past decade — with the overall long-term trend being up. Moreover, dividends have also moved upward but along a smooth and steady trend line.
The CEPM tells us two important things about common stocks. The first is that stock prices (or chicken prices) are unpredictable and volatile. The other is that dividends (or egg prices) are predictable and stable.
For good reasons, chicken farmers worry about chicken prices. To a chicken farmer, whose first thought on waking every morning is “Should I buy or sell chickens today?” risk is closely related to price volatility.
On the other hand, the waking thought of an egg farmer is: “How many eggs will my chickens lay today and how many will they lay in the future?” For an egg farmer, risk reflects the health of the flock (or the stocks in the portfolio).
Market values matter only to egg farmers because a growing dividend stream requires a growing nest egg (pun intended). And “risk” means “events that threaten dividends.” There is no “maximize returns at a prudent level of risk” mumbo jumbo.
Consider the wonderful consequence of this view — stock-price volatility doesn’t matter to egg farmers. In fact, volatility provides an opportunity to add new chickens to the flock at reasonable prices.
Conversely, chicken farmers (like most investors) worry about market declines.
Dividend Payers Only
Using the CEPM as a guide, there is no need to own any non-dividend-paying stocks, or roosters. You can feed, cajole and even squeeze a rooster, but you’ll never get any eggs out of him. Similarly, you don’t want to own any mature cyclical stocks, like auto companies, because their dividends go down just as much as they go up.
Moreover, regular dividend payers not only pay you the income stream you want, they also provide a valuable tool for monitoring their health. Corporate directors, as insiders, approve dividend payments. They know more about their company’s health than anyone.
Their dividend declarations are the only “inside information” on which you can legally trade. Directors don’t like to cut dividends. They don’t even like to cut the growth rate of their dividends, so when they do, it’s a red flag about a company’s future.
What about performance? The S&P 500 Dividend Aristocrats index is up 21 percent this year, compared with 19.6 percent for the benchmark S&P 500 Index. Since the beginning of 2003, the dividend index has jumped 217 percent, beating the S&P 500’s 140 percent increase.
It’s hard being an egg farmer in a chicken farmer’s world, but it sure can be a lot less stressful. And more profitable.
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