The Dividend Mailbox

No 7%+ Yields for Us — Here’s Why

December 20, 2022 Greg Denewiler Season 1 Episode 18
The Dividend Mailbox
No 7%+ Yields for Us — Here’s Why
Show Notes Transcript

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If you spend much time managing your own money or researching companies, odds are you have been exposed to high-yielding opportunities. From stocks to bonds to real estate, there are plenty of investments out there that present themselves as quality investments while simultaneously generating large income streams.

7%+ yields seem hard to beat, but there is usually a reason why the yield is so high. In a way, the market is essentially showing the investor a blinking warning light, one that indicates that there is risk built into the price of the company. This is not to say that these opportunities don't work, just that dividend growth investors need to be wary of what they entail.

In the year's final episode, Greg answers a listener's question about prioritizing dividend growth or yield when nearing retirement age. That opens the door to examining the pitfalls of investing in high-yielding companies, where he provides a framework for analyzing the risk embedded within such investments. Later he compares Williams-Sonoma and Restoration Hardware in response to Berkshire Hathaway's recent addition of the company to its portfolio. Finally, Greg wraps up the episode with some food for thought.

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Greg Denewiler: 00:22

This is Greg Denewiler, and you're listening to another episode of The Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks and make each year's check larger than the last.


Welcome to the 18th episode of The Dividend Mailbox. So first I want to address a question from a listener that came in a few episodes ago, and it was over the topic of dividend growth versus dividend yield, which will lead us into high-yielding bonds/high-yielding stocks. What I'm going to do is give you a simple framework as a way to quickly judge the kind of risk that is embedded in them. And then we'll go into a little bit of meat. We've mentioned in the past, Williams Sonoma, that we have a position in it, but we're going to compare it to Restoration Hardware or RH because RH has made headlines recently that Berkshire Hathaway put it in their portfolio. So, we're going to look at those two. And then lastly, I'm just going to give you some food for thought because, in the end, a lot of the success for investing really centers around just having the proper attitude.


So, a few months ago we had a question come in and it relates to something that I think a lot of people think about because you hear references to this quite a bit. And the question was: “Before I retire, I have a few more years, should I focus my portfolio a little bit more towards the dividend growth side and look at maybe slightly lower yields, (just as an example, 2%), or should I look at something that is paying 3.5% but may not grow quite as fast? And then as I retire, or when I retire, at that point, do you start to tilt the portfolio more towards income?” Our answer to that is what we call our sweet spot, which is roughly between 2-4%. In that area, I don't think you really have to give up anything. You can build a portfolio and you're going to get both, because that's where you still get dividend yield, on top of that, you can still get pretty good dividend growth from that. Even all the way up to 4%, there are situations where I think you can still achieve that 6% growth per year, which is what we're really after. It's our belief that that is what you want to focus on. That's what's going to build wealth and that's what's going to help build your income longer term. We don't believe in really tilting the portfolio as you get closer to retirement or actually retire. Instead, we just want to stay in that sweet spot. It makes sense to be aware of something that maybe has more growth in it or slightly more yield, but I will tell you, as you start to approach 5%, and we're going to get into this more later, you're starting to dip into the higher yield category. And one thing you got to really be careful of there is, you're starting to give up the growth. When you're down at 4% or below, there's still a growth component that's part of that. And you have to remember that growth is both growth of the company and the growth of the dividend. And here's a really important thing that investors lose sight of all the time, those things are really the same. So, stay in the sweet spot, take both, and don't compromise that growth because that is what's going to create the wealth. As you get into higher-yielding stocks, the yield goes higher and the growth just gets lower. So, this is a great time to really start to look at what's embedded in the prices of these higher-yielding stocks.


If you've looked in the dividend space much at all, you're well aware that there's a lot out there that's targeting the higher yield sectors, where you've read or been pitched, portfolios that yield 7% or more. A lot of times they're presented as quality investments where you can really have an attractive income, and they're also trying to sell the growth part of it. So, the question there becomes, you know, is that something I should consider or is it worth looking at? I think a great way to kind of get this into perspective is to look at the corporate bond market. If you've been in the market for very long or you have somewhat of a finance background, you probably have heard about the Efficient Market Theory. As part of that is the capital asset pricing model. And when you look at that, what that implies is that theoretically, and I don't agree with this a hundred percent but it's a great baseline, for all intents and purposes, every security has the risk-free rate built into it and then there's a risk premium. All investments have a risk-free rate, and that theoretically is the same. But then the risk rate is just depending on what security is and how much risk the market thinks it has in it. And the key here is that theoretically, the market is somewhat correct most of the time. So, if you have a AA-rated corporate bond and it's roughly a 10-year maturity, that's a 4.6% yield. Well, going back to our risk-free example, most of the time that is perceived to be, in this case, a 10-year treasury, which right now has a yield of about 3.5%. So, the example here is there's an extra 1% of risk in there, and that's the implied risk that's built into the security. So not to go through this in too much detail, if you go down to an A-rated bond, you've got a current effective yield of 5%. BBB, 5.6%, and BBB is considered to be the bottom of the investment grade corporate bond scale. So, anything below BBB is considered high-yield, or the other term for it is junk. And here's what's really important: as you go down to BB, it's 6.7%, a B-rated corporate bond is a little over 8.6% and then you drop down one full credit rating to CCC and the yields jump all the way to 15%. So, here's the point that I'm trying to make: let's just say that just for an example, which I would of course never do, I've got a great stock for you that I think is a quality investment and it's got a 7% dividend yield. Well, a great way to just test the water on this is to ask yourself: “Okay, 7% if it was a corporate bond would have a rating of BB or BB-. So right away, that is not an investment-grade security. That has risk in it. And if I was talking to you and said, “you know, we've got this great stock idea and it yields 12%,” that right there tells you it's between B and CCC, and that is getting extremely speculative. This is not a quality investment. That doesn’t mean it won't work and doesn't mean that it won't produce a good return for you, but don't kid yourself, this thing has embedded risk in it. The market is telling you there's something there, you just probably don't know what it is. I may tell you it's a great idea and it may be a great idea, but you need to know and you need to realize this is not a low-risk investment. 


An additional point to this, and it's really important when you're up in the AA, single A corporate space, you have an extremely low default rate. Meaning, you hold these bonds for 10 years, the odds of them defaulting, I believe, are 1% or less when you're up there in the AA above or AAA above space. But as soon as you drop down into BB, historically those things have a 7% default rate to them. So, in 10 years, that means 7% of those bonds will default. And once you get down to a single B, the default rate jumps all the way to 20%. What you see here is the default rate is climbing dramatically, even though you're, you're only going down a notch or two in rating. As you get down to CCC, you're in default rates that are all the way up to 37%. So that means that you're getting close to half your portfolio potentially will default in 10 years. So, you just have to be really careful. You are really entering the world of speculation. There's nothing wrong with that, you just have to realize that's where you're at, and in order to get that dividend to grow, it's going to be extremely difficult.


I mean, I just want to give you one example that really kind of points this out. It's been a fairly popular stock for quite a while, and it's basically a mortgage portfolio. The symbol on it is N, as in November, L Y, and it's Annaly Capital Management, and right now it has a yield of 16%. Well, I've actually seen a few recommendations on it, and again, you know, there's nothing wrong with that because it's a great income stream. But here's just a little bit of history on N L Y. First of all, right now the dividend is $0.80 per quarter. If you go back to January 2013, it was $1.80, so that dividend has been cut by a little bit more than half. And if you look at the total return of NLY since October of 2013— And you're probably wondering, “oh, this guy's data mining, he's picking out a period that fits his story.” Well, the reason for that is that's when a lot of these dividend growth ETFs started, around that period. One of them we've mentioned before several times, NOBL, the Dividend Aristocrat ETF, it started in October of 2013. You compare it to Annaly Capital management, and the total return of NOBL, it's up 175%, while you've got N L Y, it's only up 35%. So, I don't know about you, but total return, in the end, almost always wins the race. You know, why not just stick with the more quality stuff and you've got more predictability? Because then we're going to go one step farther, and that is Bloomberg put out some data.


This is a few years old, but the example is still valid. This is basically a 12-month total return between 1999 and 2020. So, this is basically over a 20-year period. You know, these are all just different yielding investments. MLPs, master limited partnerships, where some of these higher yields do come from— and when you're looking at higher yield portfolios, a lot of times some of them, I'm not going to say all of them, but there will be some MLPs and these are like pipeline companies, different things like that. The average, dividend yield on them was 10.5%, but the worst 12-month total return rolling period, they declined -61%. And you compare that to REITs, where they had a 3.6% dividend. The worst 12-month total return rolling period was -59%. You go to the S&P 500, just as a point of reference, the dividend yield off of that was 1.6%. The worst 12-month rolling return was -43%. Well keep in mind, yeah, the dividend was much lower, so you would think, “well, maybe that should be a lot less,” well, it's got a much bigger growth component to it. If you look at preferred stocks, the yield over this period was 1.7% and they declined by -53%. Finally, I'm going to throw in the S&P 500 dividend aristocrats. They had an average dividend yield of 2.7% and they only declined— I say only— But they only declined by about 35%. That was their worst rolling 12-month total return period. So, quality does pay off, and in this case, you also get growth. 


The final thing that I want to just throw out here, it's going to be along the same line of thought, you just kind of have to wrap your head around this or think about it. There are really three ways to ramp up your yield, but the end result really ends up being the same. One of them is, as we've been talking, just going into a lower credit-rated investment. So that pumps up your yield. You get a lower credit rating, you get more yield to compensate you for the risk that you're taking. The next way is to extend maturities. If you go from 10 years to 30 years, you're going to get paid more. Well, the duration of a 30-year treasury is around 20. And what that means is if interest rates go up 1%, that bond drops 21%, plus whatever interest you earn. In 2020, that bond was earning about 1.5%. So it goes from 1.5% to 3.5% percent— two percentage points that the yield has gone up, and if you bought it in 2020— you're now down 40%. So that is just another definition of risk. It has a huge impact on the volatility of your portfolio. And then the third thing is leverage. So a lot of times these 7%, 8% investments or dividend stock portfolios, one of the reasons why they yield 7% is because they have a lot more leverage on their balance sheet. So, you get paid more for that risk. And going back a few years ago, up until just recently when they split the company, AT&T was a great example where you had a 6%, 7% dividend yield. Everybody thought they had a free lunch, “It's the perfect retirement stock.” Guess what? The total return on that thing has been anything but a great retirement stock. The simple way to think about this is that all these high-yielding stocks or investments, they're just similar to a corporate bond in how they're priced. When you're up there in the 7% plus yielding dividend investments, the annual dividend growth is, it averages about 2% a year. But when you're down there in the sweet spot of what I call, 2-3%, a little bit higher, the annual dividend growth is 9%. Just as a reference, the S&P 500, last hundred years has grown by 6%. Those higher-yielding investments, you give up growth, it's that simple. You know, “why am I getting paid more?” There has to be some embedded risk in it. That doesn’t mean you shouldn't take it, but you really need to know that, and it's not comparing apples and apples. We want growth, but we want reasonably high or high-quality portfolios and we're just not willing to compromise and go into this higher-yielding stuff. As a general rule, discipline will create wealth over time. 


I know a lot of you listen to podcasts because you're looking for ideas, and especially in the investment-oriented ones, you're trying to find something that is useful that you can invest in. And it's our goal on every one of these podcasts to give you something to take away. So, to try to throw a little meat in here, you may have seen the headlines that Warren Buffet or one of his portfolio managers took a position in Restoration Hardware or RH as it's now called. So, I think since we do own a position in Williams Sonoma, it'd be a great time to compare the two from the standpoint of somebody who has a lot of credibility, and then how does that compare to our dividend growth concept. So, we do own Williams Sonoma right now, and we are adding to it as the price dips. In episode 14 in August, we did go into much more detail regarding Williams Sonoma. I can't stress enough that for individual investment ideas, you have to remember, we have an entire portfolio. You never just buy one or two stocks. This podcast is really more about learning the concept and how to apply it. You have to look at your own portfolio. You always have to look at diversification but don't take this as a specific recommendation, it's part of a portfolio. So having said that, recently, Warren Berkshire Hathaway took a position in Restoration Hardware. And it's been a, you know, pretty good growth stock. But these are sort of similar situations because Williams Sonoma, most of their revenue actually comes from Pottery Barn, which is furniture. I don't know if you've ever been in an RH store, but they are an interesting concept. Personally, I'm not so sure I'm big on it, but the company has been very successful. They are, they are definitely upscale. Pottery Barn is probably, I would call it, maybe a notch below, but they're still high quality. And then of course, Williams Sonoma has the upscale cookware. Well, to look at these two, Restoration Hardware or RH, it does not pay a dividend and Williams Sonoma does. So, this is an interesting dilemma. Do you want a 100% growth stock or do you want a company that's a combination? 


It definitely has growth embedded in it, but they pay part of that growth to you in a dividend. Well, both of these stocks have come down quite a bit in the last several months. Williams Sonoma, it's been up in the mid two $200’s, and right now the stock is around $117, so it has come down quite a bit. RH has had a recent high of over $700 a share, and right now it's a $260, so it also has come down a lot, and most of it is centered around the fear of a recession. Both of these companies have been great long-term wealth creators, and if you look at Williams Sonoma, it's up 245% total return in the last 10 years while the S&P 500 is up 243%, but if you go back about a year, it's total return was well over 400%. It was way ahead of the market, but fear of recessions brought it back down to basically a market return, which is still pretty good. If you look at RH right now on a 10-year total return comparison, the S&P's up 243% while Restoration Hardware or RH is currently up 600%. So, it has still dramatically outperformed, and if you go back about a year, you know, it was almost on a different planet. It really became a growth stock in 2020. It just exploded from the whole move to working from your home. Well, ultimately, you're going to get posed with a question: “well, which one would you rather own?” 


Let's just look at revenue growth. Last 20 years, revenue growth for Williams Sonoma is up 400%, and in the last five years, it's up 62%. Restoration Hardware or RH is up 900% in the last 20 years. But in the last five years, it's up 71%, so it's up a little bit more than Williams Sonoma, but not by much. Five years ago, revenue for RH was about 2.2 billion, and Williams Sonoma had revenue of around 5 billion. So part of what's happening I think, is Restoration Hardware, they're starting to mature a little bit and a lot of the big phenomenal growth may be behind them. Well, you've got earnings per share for Williams Sonoma— it's got about $15 of earnings, so that gives you a PE ratio of less than 10. The PE for Restoration Hardware is around 11 or 12, earnings are $22, So it’s trading a little bit more expensive, but that's because the growth rate's been a little bit more. But if you go back to five years, the growth rate is not that much better for Restoration Hardware. The payout ratio for Williams Sonoma right now is around 20%, and it has a dividend yield just a little bit below 3%. So, you've got a pretty good income coming out of this thing, and you've got a very low payout ratio, which is good because they've got a lot of room to raise that over time. Even if earnings don't grow at all for restoration hardware, you don't have a payout because there's no dividend. So, you know, we're looking totally at price appreciation. Profitability of businesses: Williams Sonoma has a profit margin right now of about 13.5% and the profit margin for Restoration is 15%, it's a few points higher. Here's, here's a part that starts to get a little bit more compelling. Williams Sonoma has achieved all that growth with no debt, and you've got Restoration Hardware that's gone from 20 years ago— the debt-to-equity ratio was 0.4, so they had about twice the equity of debt then, now it's up to almost two times. So debt is almost two times the amount of equity that they have. Well, right there, that tells you that they've used leverage to finance a lot of that growth and to get some of these higher profit margins. That has risk embedded in it. And shares outstanding: Williams Sonoma 20 years ago had about 114 million shares out, they've bought back about 70% of their shares, and now they're down to 66 million. Restoration Hardware, they had 28 million shares 20 years ago, and now they have 23 million. Their share count has declined by 20%. So not only has Williams Sonoma grown the business fairly dramatically, they've done it without adding any debt, and they bought back more shares. To me, that turns the table. If you look at return on invested capital, William Sonoma, they earn 60% on their total invested capital while restoration Hardware’s is 30%, it's half. Now this gets tricky, we just don't have time, nor are we going to go through all these numbers of why that is, because it, you know, “why, why would one have a higher profit margin but have a lower return on invested capital?” Well, they got a lot of assets on the balance sheet and they've got leverage there. It gets complicated, let's just leave it at this. If you look at cash flow to market cap, just what you have to pay for the two businesses, the market cap of Williams Sonoma is a little bit under $8 billion, and with the free cash flow that you've got, it's a 17% return if you own the entire company. Looking at Restoration hardware, the market cap is $6 billion, so you've got a return, if you own the whole business based on the cashflow, of 10%. So, it is not nearly as attractively priced. So, with that, which one would you rather own? 


Sure. Restoration Hardware has grown faster, but we've got a much higher debt situation. One of the things that you start to see here is the numbers are starting to come together somewhat. Part of that's because Restoration Hardware, as the company gets bigger, the growth rates start to slow down a little bit, and it is converging somewhat with William Sonoma. You know, really the companies are not that different in profitability, You’ve got two somewhat comparable companies here, they're not that much different. But for Williams Sonoma, you've got a growth story with a lot less risk in it. And with no debt and the way these guys have managed their balance sheet over the last several decades, you've got the potential of great dividend growth over the next decade. So I'm going to go with the dividend. 


That leads us to a couple of concepts that I think, hopefully, they will tie in and you'll see the connection here. It also ties back to the whole concept of these higher dividend or higher yielding investments and what you got to be careful with. There's a great book out by Mandelbrot, and the name of the book is The Misbehavior of Markets. If you're going to spend much time managing your own money, it's probably worth getting the book, and I can even say that you really only have to read half of it because the core concept is there. You may have heard of the bell curve, and basically, it is that investments tend to accumulate towards the center and the average returns and all that, and that's what happens on these high dividend or high-yielding investments. Most of the time they're working just fine. But then there's what we call the tail risk, and that's where all the excitement is. And the problem is, that's what burns you on a lot of this stuff. Mandelbrot's theory is those tail events that are only supposed to happen every 100 years or every 50 years, statistically, when they suggest they are rare events, they happen much more frequently than what they're statistically supposed to. His concept was a hundred-year event tends to show up a lot more times than every hundred years. You can't predict them, but what you can do is build a portfolio that you can withstand. On these higher-yielding investments, they're yielding more because of leverage or lower credit quality, which usually it's one of those two things, then sometimes they can't withstand the stress. You just never get your money back, because either the companies had to liquidate or they had to sell off assets to survive some version of that. The point is, a higher quality portfolio will rebound, and then over time it'll go higher because you've got a growing income stream. You know, investors think that, well, okay, we see a recession coming, so they think it's somewhat predictable. But the problem is a lot of times these things come about, you don't know it till after it's already happened. Recessions are usually defined after we're already out of one, which really gets into if you have a high debt load and you have a surprise, you don't know when that surprise is coming, and that's why sometimes the distress in these prices becomes so dramatic. With the debt load of Restoration Hardware, not implying it's going to happen, but if you get into a fairly severe recession, that debt load can become a real burden. And the one thing that investors don't like is uncertainty and debt in a recession equals uncertainty. I think, you know, when you look at this tail risk and, and, and the fact that you can't predict it. Sooner or later something's going to happen that either you didn't predict or that was a total surprise. So with that, we will go to some food for thought, that is a great mindset to have as an investor. 

It's good to be humble as an investor, and I want to go into a little bit of what I mean by that. And you may think, well, you got to have confidence to be an investor, and that's true. But first of all, I want to explain what my definition of humble is. And first of all, if you look it up in the dictionary, it says: not proud or arrogant, modest, having a feeling of insignificance, inferiority, low and rank importance, status, quality, to be humble although successful. You know, basically, I think a lot of times, people refer to, or they think of being humble as not being confident, or just basically not being as successful because you're just considered to be back to the low level or small in size. On some level, it's a negative trait, or as an investor, investors to a point, don't like to be humble because you need the confidence to stay invested and you have to be confident in your ability to buy turnarounds or to buy, you know, when the market is down 20, 30%. Well, if you look at the derivative of where humble came from, it's actually the word humus and humus is the dark, organic material in soils produced by the decomposition of vegetables or animal matter and essential to the fertility of Earth. And the concept there and the tie-in kind of to humility or being humble, is you break things down— and it was, as we were talking about earlier, with yields and the different high yields and risk that's embedded— if you want to create wealth, you got to create the environment. And the environment is to strip away a lot of this fluff and headline stuff and just stick to the core building blocks and just give yourself the opportunity to let it grow. It's that lower dark soil, that's where all the biggest and tallest and strongest plants come. In investing, I think a great analogy is if you stick to the core, the dark organic material is that 6% line that grows over the last hundred years, 6% a year, it compounds as GDP has compounded at 6%, earnings have compounded at 6%, and dividend growth has compounded at basically 6% a year. That's sort of the core. And if you just stay humble and try and stay on that line and stay away from the seduction of these higher yields where you've got more risk, just accumulate and let compounding create wealth over the long term. Not to beat a dead horse here, but I guess I will. If you plant plants out in a desert, as soon as it stops raining, they don't live very long. And I think kind of what dovetails into this is then kind of the concept of grace. Sooner or later, something's not going to work. And even if you're in a high-quality portfolio, you're going to have selloffs, you're going to have market declines, and occasionally you're going to get one of them that may not work. GE 10, 15 years ago, it was considered a AAA company and now it's on varying levels of trying to survive and restructure, the dividend has been cut to virtually nothing. You're going to have stuff like that happen. Give yourself some grace. Give yourself the ability to make mistakes. All the great investors make mistakes, everybody does. You know, Warren Buffett's portfolio, I mean, you name it, everybody's had some things that haven't worked. Nobody has this all figured out. Just understand, and I think it's a great combination: be humble, stick to the core, but give yourself some grace. And if you don't become too overconfident and if you have a quality portfolio and it's diversified, you're going to live those mistakes. You're going to be able to recover when the market gets into these distressed situations. As you get into a riskier investment and as you go into these higher growth stocks, if something changes, the price of your investment can change extremely fast, and you just have to realize if you're going to go there, you have to be careful. So, as we conclude, and we've covered several different topics here, I think the theme that sort of underlies it all is having faith in the overall system that long term, the economy does grow. You just need to do your homework, but you're going to have to allow yourself to make mistakes because over time it's going to get you where you want to go. These things all sort of tie together and create the long-term wealth that we're looking for.


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Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks including dividend stocks are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.