Robert Rhodes of Rhodes Holdings LLC made one of his usual astute comments about my post last Thursday on utility stocks. In this post, I’m going to elaborate on my view of buying stocks for their income.
Financial planning guides often mention that when selecting a stock because of its dividend, one should consider not only its current yield but also the potential for the payout to grow. My impression is that the authors don’t just want to steer us away from too-good-to-be-true extremely high current yields, which are most often a sign that the market thinks the dividend is likely to be cut sharply or even eliminated. I think they also believe it’s better for investors to pick a stock with, say a 3% current yield and the possibility of 8% annual growth in the payout vs. a stock with a relatively secure 6% yield and no dividend growth potential.
For a Millennial, who arguably has no business getting involved with income stocks, the expert advice is probably correct. In contrast, for a senior citizen looking for income-generating investments to support retirement, the 3% yield + the promise of growth is certainly better than Treasuries. But for a seventy-something a good argument can be made that the 6% current yield is the better choice. At least, that’s what I’ve thought until very recently.
The handy-dandy rule of 72 tells us that a 3% yield growing at 8% per year doubles in nine years (72/8). It takes that long for the payout to equal the 6% dividend of the non-grower. This also means someone who buys $100 worth of the 3% yielder collects $40.50 over the nine-year period, assuming the payout increases at a uniform rate. The person who chooses the 6% yielder collects $54. It takes the former another two years+ to draw even in terms of total income received.
Put a different way, the superiority of the 3% yielder with growth doesn’t come into bloom until over a decade after purchase. That’s a long time. It hasn’t been clear to me that financial planners fully appreciate how large/long the shift in income is away from the period a senior citizen may be young and healthy enough to enjoy the money.
Capital gains? In theory, the steady-state 6% yielder has significantly less capital gains potential than the 3%er. But who knows? Arguably the senior citizen is more concerned with preservation of income than in making capital gains. It’s also possible that the sprier utility won’t be able to sustain profit expansion for such a long time.
my change of heart
As I wrote last week, the negative effects of years of downward regulatory pressure on utility rates in mature areas, and the consequent corporate response of cutting maintenance/replacement are starting to become apparent. It’s no longer clear to me that the dividend payments of no-growth utilities are as rock solid as I’ve been assuming. So, yes, there’s a chance that the fast grower will slow down in short order. But I now think there’s also a good chance that mature utilities will be forced to divert large amounts of cash flow away from shareholders in order to shore up creaky infrastructure. So the mature utilities may be much riskier than they appear.
And that is a risk (mature utilities diverting cash flow from dividends to pay for maintenance, which would be better for their rate paying clients but bad for investors of their dividend paying stocks). Rating that risk (getting the risk coefficient? and multiplying that by the average decrease in stock price when that happens) would be interesting. I bet it still comes out in favor of the high dividend.
Thanks for the compliment.