What Measurements Matter?
Recently my wife made some pea soup. It was delicious. Each time we have pea soup we retell the story of the first time our son made that recipe as a boy. Before I tell you what he did, let me assure you that he is quite the chef and knows his way around the kitchen. When he came for thanksgiving, he helped make portions of the meal, including the turkey gravy. We all make mistakes, and those mistakes help us learn. Well, we should learn, but sometimes don’t.
When making pea soup, one of the ingredients is salt. The recipe my wife gave our son used abbreviations like “t” for teaspoon and “c” for cup. Our son interpreted the “t” for salt as tablespoon. One tablespoon (US) is equal to three teaspoons (US). To say the resulting soup was too salty would be an understatement. He learned the right measurement and going forward the food would not have too much salt.
So it is with investing for income growth. There are some essential measurements you cannot afford to get wrong. If you do, your investment mix will not satisfy your needs.
Four Major Stock-Based Investment Strategies
A recent AAII Journal article (November 22) said, “Broadly speaking, there are two main dividend investment strategies: high-yield and high dividend growth.” This has been my experience as well, but I think there are four I can suggest that might help you see the possibilities. The four are: 1) High-Yield Dividend stocks; 2) Dividend Growth stocks; 3) A hybrid of the first two; and 4) Growth stocks that don’t pay a dividend.
Because measurements matter for all strategies, I will share the measurements I have found that have led to my success. However, bear in mind that sometimes my recipe book doesn’t produce the results I desired. I also have sell rules to exit investments that are stale or rotten in spite of my best efforts to pick quality and avoid putrid investments.
Today I will focus only on number one. In subsequent posts I will discuss the other three.
High-Yield Dividends for Income Growth
In my previous post I said “that it is also helpful to buy high-yield dividend investments and use the dividends to buy more dividend growth investments. Not every investment has to have internal dividend growth to fuel your overall dividend growth results. For example, some of my positions don’t offer significant dividend growth or share appreciation growth. What they do offer is dividend yields from 5-10%. Some of these also pay monthly dividends, so I receive income every month to buy more investments. This dramatically increases the income over time.” But here is the problem: many high-dividend investments are recipes for disaster.
There are a few things I always look for when buying high-yield investments. I don’t care about dividend growth and can accept zero growth or minimal growth. Let me start with an example and give you the metrics I believe are most important.
Ares Capital Dividend History
Ares Capital (Ticker: ARCC) is a high-dividend investment that pays a quarterly dividend. From March 2012 to December 2022 (10 years), ARCC has paid a dividend. It also paid dividends in 2008-2009. In fact, ARCC has paid dividends every quarter since 2007. So they have a 16-year track record of paying their dividend. Bear in mind that there was a serious stock market and housing crash in 2008. The crash was the result of several things, but you can trace it to the unprecedented growth of the subprime mortgage market beginning in 1999. “U.S. government-sponsored mortgage lenders Fannie Mae and Freddie Mac made home loans accessible to borrowers who had low credit scores and a higher risk of defaulting on loans.” SOURCE: Investopedia
Don’t miss this key point: a company that doesn’t cut or suspend their dividend during times of crisis is likely to do many things right. I always look at dividend history, when possible, to determine how a company’s management behaves in crisis mode.
There have been no missed quarters, even during Covid. The following graph from Seeking Alpha illustrates this history.
This graph is from Stock Rover, another good source for investor information. In fact I just subscribed to Stock Rover because they have a “Black Friday” sale. My thanks to a Fidelity Investor Community member (handle: eniac) who pointed me to this helpful resource! See the link below if you are interested in learning more about Stock Rover.
ARCC Dividend Safety
There are many different numbers to consider, and it is possible to spend a lot of time on evaluating an investment. However, I don’t want to spend more than fifteen minutes determining if an investment fits my requirements. Often, after looking at dividend history I can stop, saving time, and move on. However, if the dividend history shows consistency in payments, I want to know just a bit more. The following image from Seeking Alpha is most helpful for that purpose.
You can see the things I look at. First of all, I am concerned about “Dividend Safety.” Any score less that “C” is suspect. Secondly, I want to be reminded that this investment is in a specific sector, and the ratings compare apples-to-apples. Thirdly, I want to know the QUANT score. While I am interested in the Seeking Alpha author opinions, and the opinions of Wall Street, I have found the QUANT rating most helpful in quickly avoiding too much salt in the soup.
The fourth measurement is the dividend payout ratio. For many investments (there are exceptions) this number should be less than 100%. In fact, I prefer investments that fall between 20-70%. “The dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends. This is calculated as the ratio of the Dividend per share to Earnings Per Share (EPS).” SOURCE: Seeking Alpha.
In other words, for every $1.00 in earnings per share, ARCC is paying $0.86 in dividends.
The most important factors are dividend history, dividend growth, dividend payout ratio, and the various ratings I can see in Seeking Alpha.
If I don’t get sidetracked today, I will create a post tomorrow covering one more of the “Four Major Stock-Based Investment Strategies” I use for income growth.
ARCC Business Description
Ares Capital Corp is a United States-based closed-ended specialty finance company. Its investment objective is to generate both current income and capital appreciation through debt and equity investments. The company focuses on investing primarily in U.S. middle-market companies with investment opportunities as well as in larger companies. Its portfolio comprises of first lien senior secured loans, second lien senior secured loans, and mezzanine debt (subordinated unsecured loan), which may include equity components that are diversified by industry and sector. The company may invest in preferred and common equity investments to a lesser proportion. Its revenue mainly consists of interest and dividend income received from the investment made.
What Might You Do?
Consider a subscription to Seeking Alpha or Stock Rover, or both. You can try both for free, but the subscription is well worth the cost, if you are serious about investing in stocks and ETFs.
Cindie and I own a combined total of 4,900 shares of ARCC. It is one of our top ten investments. Therefore, if we hold the shares until the Ex-Dividend date, we will receive $2,352 in dividends. But the news gets even better. We hold 1,800 of those shares in our ROTH IRAs. Therefore, $864 of the income will not be taxed this year or ever. That becomes a powerful engine for future dividend growth because I can reinvest those dollars into dividend growth stocks or ETFs. Furthermore, 2,000 of the shares are in my traditional IRA. As a result, another $960 will not be taxed until I withdraw the dollars or convert the shares into my ROTH IRA.
Finally, the total dividends from our ARCC investment in 2022 will be $9,408. You can buy a lot of grocery ingredients. In other words, the average monthly income from ARCC is $784. I can tell you we don’t pay that much per month for groceries, at least not yet. Inflation might bring us to that amount some day.
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