A perennial challenge
The Holy Grail for many investors has been to have their investments generate income while still achieving principal growth with enough stability to keep panic at bay when the market is turbulent. Surely today’s low yield environment makes this desire seem out of reach.
Yet, current times leave investors and their advisors even more desirous of such outcomes. Defined contribution plans have replaced defined benefit plans for all but a few, leaving individuals more reliant on their own thrift and good investment choices. Living longer with more years in our retirement amplifies the impact of our investment choices. And the safety net of social security shows signs of fraying, making the prudent person wary of reliance. Clearly, the stakes are higher than ever for both retirees and those who hope to retire one day.
The old solution: the utility of utilities
For decades, utility stocks were the standard answer to this perennial challenge. It was for good reason that advisors traditionally put so-called “widows and orphans” and other conservative investors’ savings into utility stocks: they produced income plus modest real principal growth with the relative stability that came with regulated industries. These included electric, gas and water utilities, as well as telephones in the days of the AT&T monopoly. Although US Government and AAA corporate bonds also offered income and nominal safety, the higher risk of utility stocks compared with bonds was deemed to be worth bearing, since bonds could not match utilities’ principal growth and protection from inflation.
But utilities were not immune to the reality that industries and markets can experience significant disruption. In this case, de-regulation opened the door to changes that fundamentally altered the nature of utility stocks. Seeking a better return on investment, utility companies’ management took advantage of deregulation by “diworsifying” into unrelated businesses: examples include Southern California Gas with Thrifty Drug Stores and Arizona Public Service with Mera Bank. While not all diversification turned out badly, the utilities sector was no longer a pure play on a regulated industry. This invited market speculation as some utilities pursued returns more aggressively…including Enron.
New solution: defensive yield
Nowadays, investors have to be more enterprising to get income plus growth with relative stability. The attributes investors liked in regulated utilities still exist, though not all utilities have these characteristics today, and not all stocks with these characteristics are utilities. We can systematically seek out stocks with lower volatility and higher dividend yield in any market sector, and with them build a broader, more diversified portfolio that explicitly focuses on these tried and true benefits.
The combination of lower volatility and higher dividend yield is far more powerful than either attribute alone, and produces a distinct investment strategy, much as blue and yellow produce the distinct color green. By combining these characteristics, we can mitigate (or even avoid) the pitfalls of each when used individually.
To see why, consider a strategy that focuses solely on high dividend yield, without regard for the underlying fundamentals. While that might include strong firms generating more cash than they can easily reinvest, it could also include troubled firms desperate to maintain the appeal of their stocks amid an uncertain future for earnings. In other words, high yield can translate into high volatility – adding risk to a portfolio, not the result many income seekers want.
Conversely, a strategy focused solely on low volatility may mitigate some risks, but may omit dynamic firms with strong business models with the potential for earnings growth, price appreciation and increased dividend yields down the road.
Yet low volatility and high dividends together can easily reinforce one another when dividends are sustainable, are the fruit of a fundamentally solid business, and ultimately support stock price stability. Dividends, after all, provide a base rate of real return. This is especially important in a slow growth/low return environment. Conversely, higher volatility can be a red flag for potential dividend cuts. This was demonstrated during the Global Financial Crisis, when banks (in general, a mainstay of high dividend stocks), suffered large losses and subsequently slashed their dividends.
Conclusion
We at QS strongly believe that high yield, managed volatility strategies should be the core holding of today’s income oriented portfolio. Furthermore, we believe they should receive a meaningful allocation in both conservative and aggressive, savings-oriented non-taxable portfolios.
