the income investor’s decision–maximize current income or maximize total return

Suppose an investor can choose between two stocks:

–stock #1 has a current dividend yield of 5%, but no prospects of either earnings or dividend growth

–stock #2 has a current dividend yield of 3%, and will likely grow both earnings and dividends by 10% per year.

Let’s assume that we’re in a world where we can make long-term predictions like this with a very high degree of confidence, and that neither stock has any special risks associated with it.  Yes, these are unrealistic assumptions, but I want to make a point about the expected income stream.

Which do you choose?  In this case, investor preferences are the key.

the income stock

Someone who wants to maximize current income would probably choose the stock with the higher yield.

Why?

Figure out how long it will take for stock #2 to grow its dividend until it matches the current yield of #1.  The answer is seven years.  How long will it take for the holder of #2 to receive the same amount of current income as he would by holding #1?  Eleven years.  Eleven years to breakeven by choosing stock #2 is too long to wait, in my view.

the total return stock

Suppose our investor makes his choice today and that each stock is trading at $100 a share.

Over the next seven years, stock #1 will pay out $35 in dividends and #2 will pay out $28.40.  The difference is $6.60.  However, the earnings for company #1 will be the same as they are today, while those of #2 will have doubled.  By year 11, when the cumulative dividend payments of the two will be equal, the earnings of #2 will be almost 3x the starting level.

For the total return of #2 to exceed that of #1, all that’s necessary is that the huge increase in its earnings generate a rise of 6% in its stock price over that of #1.  In the US stock market, if events play out according to our assumptions, that’s as close to a sure thing as ever happens.

That’s not an iron-clad guarantee, however.  Just as important, it’s also not clear when any relative price gains will happen. That’s not such a good thing if you need the money by a certain date.

the point being…

…if you’re interested solely in income, it takes an awfully long time for a fast grower to overcome the influence of the starting point of its higher-yielding rival.

don’t forget about portfolios!

There’s no law that says that anyone has to make the all-or-nothing choice I’ve outlined above.  You could consider buying some of each and hedging your bets.  Of course, any diversification will mean lower current income for a period of time.

back to the real world: today’s dilemma

Stock #1 is a close as you can get in the equity world to a long-term bond.

At some point, not this week, and maybe not for two years, the Fed will determine that the current economic emergency is over and will begin to raise short-term interest rates from today’s zero.  It will have two targets.  One is to make rates positive in real terms (i.e., higher than the inflation rate, which is currently about 2%).  The second, which it wrote about a couple of months ago, is to get them to around 4.5%.  That’s right, 4.5%! 

The effect on the 30-year Treasury, which is currently yielding 2.60%, will be big–and negative.  As yields rise, bond prices adjust by going down.

During past periods of rising rates in the US, stock prices have generally gone sideways or up.  That’s because the signal for the Fed to begin to raise rates is that domestic economic growth is high–and accelerating, which implies accelerating profit growth for publicly traded companies.

So the growing profits of stock #2 give it a chance to avoid going along with Treasuries.  Stock #1 has no such defense.  The only thing it has going for it is a current yield that’s 2x that of the long bond.

I don’t think this is a worry for right now.  But pure income seekers who hold high-yielding stocks are probably in the same boat as holders of government bonds.  So they face the same portfolio rotation issues that bond investors will, when rates eventually begin to rise–or, more likely, somewhat sooner than that, when markets begin to anticipate rate rises.

I think this makes the practical decision between #1-like stocks and the #2s much more complicated now than it would normally be.