The Eighth Wonder - Nicola Wealth

The Eighth Wonder


By John Nicola, CFP, CLU, CHFC
  
IN THIS ISSUE: With the events of 2008 behind us and the dark clouds of a global recession looming, it’s easy to compare our current situation to the recession of the 1970’s, and even that of the 1930’s. So what can we learn from the past? Albert Einstein called compound interest the “eighth wonder of the world” with good reason. If one has a steady cash flow and has the discipline to reinvest those funds and avoid “market timing,” imagine how much further one’s investments can go. In this issue of Tactics, John Nicola explores the importance of interest, dividend reinvestment and cash flow in one’s portfolio.

 
A few weeks ago while on holiday in Maui, I had the pleasure of playing golf with a friend of mine and one his new acquaintances, Alex. Alex is a successful businessman who retired to Lahaina several years ago and basically enjoys his friends, family and golf.

However, as soon as he found out I was in the investment business, he went on a short but demonstrative tirade about the evils and stupidity of his own financial advisor (and by inference any of us who deign to offer investment advice to others) because he did not get Alex out of the market when it was “obvious” that things were going to tank.

After all, everyone knows that once markets test their 200 day moving average highs followed by the inverse of that number divided by infinity, then markets always drop by 40% (unless of course these events are preceded by Punksatony Phil seeing his own shadow on Groundhog Day). The Oracle of Delphi perfected the reading of goat entrails to determine the future, so what is the problem with these advisors?

Naturally, I retained my normal calm demeanour as I reminded Alex that I was not aware of any investors who had made a successful career out of market timing. But he was not to be mollified as he went on to point out that he was now $3-million dollars poorer with few prospects of recovering these funds in his lifetime.

Because we were playing golf and I had just met Alex, I decided that I could either try and prove my point or play the game. Since my preference was to avoid bending my putter around a palm tree, the game won out.

However, now as I look back, I realize that Alex’s response to the markets is much the same as the majority of investors and I would guess many of our clients.

When it comes to stocks, the following is true:

  1. If they go up I make money
  2. If they go down I lose money

Except of course when it is not true – which, in my opinion, is just about all of the time. In fact, it is this need to focus on price vs. cash flow (dividends) that is the downfall of many equity investors.

With that in mind, I would like to use some literary license and pretend that after our game we had the following chat over a beer.

By way of background, Alex is a healthy 72-year-old retired business owner with a relatively balanced portfolio that was (before this last bear market) 55% in fixed income and 45% in stocks. The $3-million loss on his equities means he had about $15-million in investable assets at the beginning of 2008 and now has $12-million. He knows he has more than enough funds to live on for the rest of his life, but he wants to leave a legacy for his grandchildren as well.

John: Alex, let me see if I have this correct. You’re mad at your financial advisor for not going into cash in September of 2008. Is that right?

Alex: You bet. All the signs were there. I mean what am I paying him for if all he does is leave my assets in the same things all of the time?

John: You have been an investor for more than 30 years. Up until now you have made some good money. Before now, how often did you jump in and out of equity markets?

Alex: Well, never. We agreed on taking a balanced approach, but these markets are different.

John: Alex, I agree that we are in the worst recession since the 1970’s and perhaps since the 1930’s. I will also share with you some facts about how equities work and how we feel disciplined investors should own them. But first a few questions:

  1. How much income do you make from your entire portfolio in interest, rents and dividends?
  2. How much of that income comes from the equity portion?
  3. Your equities are down 40%, but how much has the income dropped from your stocks?
  4. 10 years from now, will the companies you own be more profitable than they are now? If you do not think so, could you and your advisor identify companies that you feel will? I could ask many more questions along these lines, but I think you get the point.

Alex: I can’t tell you how much income I get from my entire portfolio, but I am pretty sure it is more than we spend. As for the equities alone, I know many of the stocks pay good dividends, but I don’t know the average yield. I do know that so far we are still getting just about the same dividends at the end of the year as we were at the beginning of the year. Perhaps a bit less.

John: Ok, Alex, what you are saying is that while markets can move quickly and violently as prices drop 40% or more, the income or dividends from these same companies appear to be far more stable. In fact, history supports that:

  • The S&P 500 index has paid a dividend each year and on average that dividend has increased by 5.2% annually, or 2% more than the CPI of 3.2% /yr. (www.globalfinancialdata.com)
  • In only 21 years were dividends reduced (so 80% of the time dividends went up from one year to the next) and on average, when they did drop, the amount was less than 10% (www.globalfinancialdata.com)
  • There were 35 years during that period where stock prices dropped, and the percentage drop was much smaller for those with dividends.
  • The volatility of the price of stocks has been, on average, four times as high as the income they generate (their dividends) since 1950.

Alex, if you invested $1,000 in 1900 in the S&P 500, that index would now be worth $139,000. That is an average return of 4.6%. If you reinvested dividends, that return would increase to just over 9% per year. Can you guess how much more than $139,000 you would have?

Alex: Obviously a trick question. I’ll guess $1-million – seven times as much.

John: In fact $13-million, or almost 100 times as much, which is why Einstein called compound interest the eighth wonder of the world. Even though the dividends only increase the average return from 4.6% to 9%, they have a far larger affect on the accumulation of wealth.

Alex: Gee, John. Thanks for that lovely piece of financial trivia. So after 108 years I, too, can be really wealthy. That means I’ll only be 180. Of course my grandchildren will be dead, but I will be able to prove out your theory. Try to remember, John, I don’t even buy green bananas.

John: And here I was thinking you were going to mellow out after I bought the beer.

My point is that if you focus on stocks as a price machine, you will live with constant volatility and you will only be happy in bull markets. Luckily for you that is still most of the time. If on the other hand you consider that equities are a very reliable asset class that generates tax-efficient, inflation-protected cash flow, then you will be able to clip coupons peacefully. And when the bear awakens from its hibernation, you will use your well diversified portfolio to “stock up” (pardon the pun) on more income-generating equities that are on sale.

This is very much about the attitude you bring to the definition of true wealth and the difference between emotional markets and rational assets.

Alex: John, you said earlier that this could be the worst recession (depression) since the 1930’s. What if it is? Stocks dropped 80% in that time frame. I am not sure I can live with that risk.

John: Not too long ago, our firm wrote a newsletter about Depression Era Investing (How Bad Is It? A Market Update), but let’s just focus on how equities performed between 1929 and 1939.

You are right in saying that the S&P 500 dropped 80% between 1929 and 1933 and it took until 1954 for the index to fully recover its 1929 level. However, the following is also true:

  • The income on a portfolio of blue chip stocks dropped about 50% from 1929 to 1933, so quite a bit less than the price and still provided a yield of 2% on the original capital invested in 1929.
  • As a result of deflation, the CPI dropped 25% in that period of time. So if blue chip stock prices dropped 50% nominally, then an investor had a “real” decrease in income of about 30%. This is still a lot, but far less than 80% and not enough to force them to sell their shares.
  • If dividends were reinvested, by 1937 an investor would have recovered 100% of their 1929 capital and (in inflation adjusted terms) they would have been up 25%, proving that dollar cost averaging can work well.
  • If an investor such as yourself had 55% in fixed income and 45% in stocks in 1929, they would have averaged a real income of about 4% per year all through the depression with little change in income. In fact, their only long-term risk was that eventually the fixed income component lost much of its value to inflation after WWII.

Alex: Ok so let’s say you made your point. What would someone like me do now?

For Alex and for our clients, here are some answers we believe will help.

 
Build an income equity portfolio.

Below are different types of income equities that work well together and can be designed to create greater or lesser risk, or more cash flow now vs. more growth in cash flow tomorrow.

Dividend Paying Stocks

  • Mature – Dividends likely to keep pace with inflation; relatively higher yields today than the overall index.
  • Growth – Dividend yields lower, but better growth prospects mean that dividend distributions will likely easily outpace inflation.
  • Preferred – Basically a form of bonds, but more efficient for taxable accounts. Current yields in Canada now run about 6-7%, which is equivalent to about a 10% bond rate for taxable accountants.
 
 
 
 

Flow-Through Trusts and Limited Partnerships:

This would include Income Trusts in Canada and Master Limited Partnerships in the U.S. The business structure pays no tax and distributes the bulk of income to investors who then pay tax on that income. Many income trusts will revert to taxable corporations in Canada in 2011 (not REITs however), but the MLPs in the U.S. are to remain as flow-through vehicle.

As with any investment, one still has to do good security analysis, but many of these vehicles are providing very high yields. The volatility of income and price is generally higher with Income Trusts and MLPs, but part of that is also because in part of that is also because they are, in effect, small-to-midcap companies.

For some resource investments, infrastructure and service companies, this structure can work well and can definitely provide attractive cash flows.

 
Other Strategies

Convertible Securities:
Available in both debt and preferred shares, convertible securities provide a usually fixed current cash flow with the right to exchange the debt or shares for common shares in the future. This, in fact, is what financial wizards Warren Buffet and Prem Watsa (Fairfax Financial) have been acquiring in this marketplace and what Maxam is doing on behalf of our own clients.

Covered Writing:
This involves the selling of options to a third party that gives them the right to acquire stock you already own at a predetermined price. In bear or sideways markets, they can be an excellent way of increasing income above what dividends alone would provide.

So back to Alex’s situation:

Compound interest works, and since there is far less risk on the income a stock pays than on its price, you can bet on the income every time. In other words, be the house and make odds work for you.

Our firm is built on the principles of cash flow investing. We seek out solid, income-producing investments and use the resulting cash flow to help mitigate the unavoidable volatility of the market.

So how has this investment philosophy performed since the “The Fall of 2008?” By the end of last year, the S&P dropped 40% and Alex’s equity exposure saw him lose 20% of his portfolio – average 2008 loss for NWM clients was 7%.” While we never want to see a negative return, we believe our philosophy sufficiently protected our clients’ wealth in a disastrous market, and that is what we are relied on to do.

In fact, a long-time client recently had this to say: “I want to reiterate to you my appreciation of your capacity to adapt and evolve as a wealth manager. And I have no illusions that you will get it right every time. It just doesn’t work that way for any of us. And when I step back and look at where we are today, I feel very grateful.”

Despite Alex’s declaration that there was an “obvious” time to get out, the truth is a good financial plan doesn’t rely on market timing. It relies on smart investing, proper diversification, and a sound cash flow philosophy.

Years from now, many investors will look back to positions they took in this period of time and find truth in that old adage: