Rule of Thumb Financial Advice Can Be Dangerous

Vivian Brownlee was a widow who inherited stock from her husband. He was an astute investor who had the wherewithal to invest in a little company out of Omaha that owned a textile mill. The investment was pretty humdrum, at least on paper.

Who wants to own a textile mill? Even in the 1970s, most saw it as a dying business. It was already clear that all the work was moving offshore.

But Vivian was retiring and wanted a monthly income. Her textile stock didn’t pay a dime of dividends. What a bunch of cheapskates…

So she decided to meet with a local broker for some advice on her retirement strategy. She didn’t know anything about stocks after all. “This guy’s a professional. He should know what to do,” she thought.

The broker had never heard of the stock Vivian’s husband had bought, so he did a little research. After running some numbers, the broker excitedly broke the news to Vivian. She was rich.

“You must sell this right away and put all your money into all these different stocks and bonds. They’re safe. It will pay you regular interest and dividends. This stock pays nothing.”

Sounds like a reasonable retirement strategy on the surface, doesn’t it? Get the most out of your money that you can. Isn’t that what people try to do in retirement? Maximize their income and minimize their risk?

Today, I want to examine the idea of this myth a little further. Let’s start with a little tutorial about dividends and distributions.

Dividends vs. Distributions: Don’t Get Distracted By Them

In most cases, dividends are paid out of company earnings on a quarterly basis. Microsoft pays a fixed quarterly dividend. So, it’s the same amount until next year when it can be increased. Microsoft has a history of increasing its dividend every single year. This is something we like to see. Exchange Traded Funds (ETFs) and mutual funds can also pay dividends.

Generally, distributions are paid out monthly, but they can also be paid quarterly. A distribution is a little bit more than a dividend. In other words, a distribution is the dividend PLUS some principal or return of your capital.

Limited partnerships commonly pay out distributions. These trade as stocks and are commonly oil and gas companies and Real Estate Investment Trusts or REITs. Some of these vehicles are designed solely to pay out money on a regular basis to shareholders. Thus, they are quite popular. These typically have higher rates than regular dividend stocks but the returns can vary widely. A commonly held one is Energy Transfer Partners or ET. According to Yahoo Finance, the ET rate is 6.43% today. That’s pretty good, but remember that’s not only a dividend. It’s a return on your money.

So dividends and distributions are not the same thing. But financial websites such as Yahoo Finance and MSN Money don’t know that. They are aggregation sites that cannot distinguish between the two. It’s all lumped together, and this can be problematic for the average investor.

But wait! There’s More… Special Dividends Can Indicate Something Very Important

A special dividend is paid when management decides to pay a one-time payment in addition to its regular dividend. Costco recently did this. They had so much money built up they decided to give it back to shareholders. Some companies do that pretty regularly. Microsoft has rewarded shareholders multiple times with very large one-time payments.

This means that the company creates more cash than needed to reinvest back into the business. It’s a sign of a capital-efficient business. Sometimes these payments will show up in the dividend rate calculation on financial websites. It really isn’t a regular dividend, but again it distorts the numbers, so you really need to be careful.

Dividends and distributions alike cannot be paid without Cash Flow.

Cash flow is how much cash the business produces after it pays everything. Don’t confuse cash flow with net income. An organization’s net income does not include cash required for reinvestment. Some money has to be reinvested to be able to stay in the same place. Think of things that regularly need to be upgraded or replaced. Equipment, buildings, plus research and development to keep up with the competition. These all come out of net income. What’s left is free cash flow.

Free cash flow is what’s left after reinvesting in the business. It’s cash the company can do anything it wants with – buy another business, reinvest, buy back stock or pay a dividend to its shareholders. “Yay we’re free we can do anything we want.” At CSH we love Free Cash Flow.

Now, Back to Vivian…

Vivian pondered the broker’s advice for a while. He seemed just a little too eager. If she sold all her stock wouldn’t she have taxes to pay? She wanted a second opinion about the retirement strategy this guy had come up with. Vivian was referred to a fellow in New York by a family friend. That would be her second stroke of wonderful luck.

She took the train to NYC and met with Howard Browne. Mr. Browne was very well respected, known among many as a man of integrity — and a pretty good investor in his own right.

Turns out Browne not only was familiar with the stock Vivian owned but he knew the young man that ran the company. She showed him the portfolio the other broker was proposing. In effect, the first guy wanted her to sell all of her stock and put it into these other stocks and bonds. “For the sake of diversification,” he had said. Read more about our thoughts on diversification on our blog.

Browne laughed and said, “You don’t need me or that broker. I know this guy Buffett and he’s the savviest investor I know. Even though he lives in Nebraska.” Howard Browne advised her of another strategy. He advocated for what I call a Synthetic Dividend, and these are a great retirement strategy.

Synthetic Dividends Can Create Your Own Cash Flow Stream

A Synthetic Dividend is essentially creating your own cash flow stream. “Here’s what you do,” Howard went on. “Every year you bring your stock certificate here to me and we’ll sell enough to help fund your retirement.” He explained that the company her husband bought, Berkshire Hathaway, was already diversified. They owned 10 or 20 different businesses. “Their cash flows are robust. And you don’t have to write Uncle Sam a huge check. You pay a little every year.”

Browne’s calculation that day was probably something like this. Berkshire stock was increasing its book value by roughly 15-20% annually. (Book value is an accounting term. In simple terms, it’s an estimate of the value of the business if it were liquidated.) Considering Berkshire’s growth of 25% in book value every year, the estimate was very reasonable. And over time the stock price will approximate the growth in that accounting number. If you plotted them both on a chart, they would almost look the same. This was due to Berkshire’s robust free cash flows.

“We’ll take out 5% every year for income and reinvest the rest. Think of it as a bond with a 5% coupon that is continually growing. And I won’t charge you anything.” Browne said to Vivian. It didn’t matter that Berkshire didn’t pay a dividend. They’d make their own.

The rest, of course, is history. Vivian increased her “synthetic dividend” payment every year and had a huge bounty when she passed. She traveled and enjoyed her life. The market would fall and take the value of her nest egg down. Howard would say, “It’s okay. Let’s take your income anyway. You still own a great asset. Don’t forget that.”

If Vivian took the original broker’s advice, she would have been okay. Her income would have been stable, but probably not growing. The charities she contributed to would have carried on without her funds. And of course, we wouldn’t be telling this story. But because of Howard Browne we are. This was the best retirement strategy for Vivian.

Howard finally got paid — as executor of her $60M estate!!! And his firm, Tweedy Browne, is alive and well today. The investment firm is still family-owned and known for its discipline and free cash flow bias today.

The Distribution Problem: How Stretching for High Dividends Can Be Dangerous

Many financial advisors are stretching their clients’ portfolios today. They’re like the young broker in the story. They’re selling good investments with robust cash flows for higher dividend-paying stocks or mutual funds. They might advocate Real Estate Investment Trusts (REITs) or high yield bonds.

“I want to invest in the highest dividend stocks you can find,” one client told me.

I can run a screen and find stocks that yield 6,7, or 8%. Yeah, for real. They’re out there. Many of them are structured as Master Limited Partnerships (MLPs) or REITs. But a word of caution — stretching for high dividends can be dangerous, and it’s not a good retirement strategy.

A Warning About MLPs and REITs

Real Estate Investment Trusts (REITs) don’t have to pay any tax to the IRS. In return for this special tax treatment, they have to pay out 90% of their earnings in the form of a distribution. Master Limited Partnerships (MLPs) don’t have IRS requirements, but they do target a certain rate of distribution. So they’re essentially locked in.

Both can actually be good investments. Many MLPs are from the oil and gas sector. If you buy at the bottom of a cycle or before a cycle moves up you’ll do very well. That’s because their cash flows are rising along with the price of oil. If you buy at or near the top of the cycle you can have problems. Since they pay out most of their cash flow to investors, there’s very little left over to reinvest in the company. Management is also commonly incentivized to grow the business — and to do this they need cash.

A REIT or MLP that needs cash has two choices: either borrow money or raise more capital. Borrowing comes with more costs and can be limited by legal constraints. Raising cash is very common in the form of issuing more shares. This dilutes current shareholders and makes their investment worth less. This is a huge risk to shareholders. Management gets paid more to grow the business and the only way to do it is issue more stock. Oops, my slice of pizza just got smaller…

If you run a screen of the highest dividend-paying stocks today you might see MPLX stock, for example. It yields nearly 10%, so that looks great. However, you must look inside the numbers. Over the last few years, the number of shares outstanding of MPLX has nearly tripled from 388 million to over a billion (1,051). Why is that?

Well, MPLX was involved in a merger. They needed cash to grow. That’s okay sometimes. But if we look further, we notice that the company recently wrote down the value of some of the assets purchased in this merger. This is called an impairment charge. It simply means the assets aren’t worth as much as previously thought. Write downs happen a lot in the oil and gas sector. This increases the leverage ratio and puts MPLX in a precarious position. The liabilities have stayed the same but the assets are now smaller. Not good.

The same things happen in the REIT world. Companies become cash constrained because of the high payout ratios. Assets aren’t worth what they said they were. And boom they have to raise funds or lower the dividend payment. Either way, your investment is worth less either due to dilution or a falling stock price.

At CSH Investment Management LLC we have studied this problem and understand the risks of investing in stocks or bonds merely because of high yields. Many white papers and studies show the hidden risk of investing in the highest dividend-paying stocks. Sadly, many people still use the rule of thumb that the first advisor in our story tried to use on Vivian, as a retirement strategy. There are better ways…

While it can be difficult to find an advisor who is fully committed to helping you plan wisely, we are dedicated to being that for everyone who comes to us, because we believe everyone deserves a reliable financial partner they can trust.

So remember:

  1. The dividend rate or yield today on Yahoo or MSN doesn’t matter. Data on financial sites is not always accurate anyway.
  2. Running screens for the highest dividend-paying stocks will steer you toward certain types of investments — some of which you don’t want to own.
  3. Emphasize Free Cash Flow. Without it, dividends aren’t sustainable. Think of Microsoft — they only pay out around 40% of their cash flow as dividends. It seems likely they can not only sustain that dividend but also raise it regularly. That’s what you want to see.
  4. The dividend yield is not the same as the distribution yield. The first is paid out of net profits. The second can include principal as well. They might even have to borrow to pay for the distribution.
  5. MLPs and REITs can be good investments but you must look under the hood. Buy early in the cycle, and when the market gets frothy, sell to all the excited investors. These aren’t buy-and-hold businesses, typically.
  6. Sometimes it makes more sense to create a Synthetic Dividend. Think of a stock like Microsoft as a bond with a growing coupon.

At CSH Investment Management we have over 25 years of experience creating Synthetic Dividends for our clients. We don’t get enticed by high dividend yields. We always look deep into the numbers.

Whether you’re looking for regular income or building your assets for a retirement strategy, let us share our unique perspective on investing with you. No guarantee you’ll end up like Vivian, but it’s very difficult to succeed without knowing the playbook.

Reach Out to Us!

Give us a call at 217-824-4211 or contact us on our website.

We are obsessed with doing things well and serving our clients as if they were our own family. We’re happy to talk with you any time!