top of page
  • Writer's pictureHigh Dividend Opportunities

Dividends Aren't Magic

Good Morning, Income Investors!


We are offering a first year discount on our fullfledge service giving 30% off the first year.

 

As a young boy, I was captivated by the world of magic. Unlike most who simply enjoyed the spectacle, I was captivated by the mechanics behind the tricks. I'd record David Copperfield's performances and repeatedly watch and rewind them until the tape was nearly worn out, all in an effort to uncover the "secrets" behind the illusions. My curiosity led me to the library, where I devoured books on magic tricks, applying what I learned to understand how magicians deceive the mind. 


I discovered that many magic tricks are rooted in mathematical principles. Magicians create their illusions using their expertise in math, science, and psychology.

Today, I'm going to share a magic trick that is based on math. While it might not make me the next Criss Angel, it provides valuable insights into how we should think about our investment portfolios and manage our cash withdrawals.


Dividends "Don't Matter"?


Some have developed the theory that "dividends don't matter", and that an investor could achieve the same effect by selling off shares as they need cash. Their reasoning is that cash paid in dividends are paid from the company, and therefore the value of the company is reduced by the exact amount of the dividend.


Indeed, cash paid to the company is not available for other uses. With each payment, the book value of a company is reduced by the exact amount of the dividend.

So what is the one detail that this theory is missing out on?


The reality is that the stock market does not value companies based on book value. That's a good thing for the "Magnificent 7" as they trade at enormous premiums to book value:

Alphabet (GOOG) trades at the smallest premium of "just" 790%. It would only have to fall 87% to trade at book value. AI superstar NVIDIA (NVDA) trades at the largest premium to book value and would have to fall over 98% to reach book value.


I’ll go out on a limb and say that it is very unlikely to see such a collapse among these companies. Some might argue that certain companies should trade closer to their book value, the reality is that even those companies that are expected to align with their book value often don't. 


Annaly Capital (NLY) is a mortgage REIT that invests primarily in agency mortgage-backed securities. Agency MBS are a very liquid asset class that you can buy directly through your brokerage account. Hence, many suggest that book value should be the method to measure the valuation of NLY. Historically, NLY has traded between 80% to 160% of book value.



Since stock prices aren't directly tied to book value, $1 per share paid in dividends could be worth more or less than $1 in share price movement. Share prices move every day; the value of a dividend in your pocket doesn't.


This isn't always a meaningful distinction. If you are investing in a bull market, selling shares when prices move upwards can result in very similar cash flows as a stock with identical returns that pays a dividend. If shares are trading at large premiums, then $1/share on the balance sheet might generate far more than $1/share in share price.


However, in a bear market, everything trades at a significant discount. Receiving a dividend or selling shares can be the difference between destroying your portfolio and cruising through the bear market. This is due to the "Sequence of returns" risk, which we will review in detail.


The Magic Of Sequence Of Returns


I'm going to show you a magic trick. Here is a chart of Annaly Capital (NLY) compared to Invesco QQQ Trust (QQQ) and the S&P 500 from April 1999 through June 26, 2024:


From a $1,000,000 original investment, QQQ more than doubled in the following year before the dot-com bubble burst causing it to underperform vs NLY. QQQ caught back up and outperformed NLY from 2002 through 2024.


So if you could go back in a time machine and had to choose one of these holdings to buy and hold no matter what, QQQ would be your choice right? After all, it ends with an extra $1.3 million in value. Who doesn't want an extra $1.3 million?


Not so fast, let us now observe the magic trick. During the same time period, with the same tickers, and with one small change, you will see that the investor with $1 million in 1999 likely felt very good about retiring. $1 million is a good bit of money even today but in 1999? If you were a millionaire in 1999, people thought you were set for life. So if that investor retired, and started withdrawing an inflation-adjusted amount starting at $40,000/year (using the 4% rule),  here is what that looks like:

NLY goes from slightly underperforming, to dramatically outperforming the market indices. The QQQ investor needs to be extremely concerned. They have $129,564 left from the original $1 million, and the 4% rule prescribes withdrawing over $75,000 in 2024. That withdrawal is probably their last. Meanwhile, the NLY investor has $6.5 million in portfolio value, an income of over $765,000 in 2023, and the annual recommended withdrawals are less than 10% of the generated income.

How can such a relatively small withdrawal cause such an enormous difference? Let's go back to where the wheels came off and look at the annual returns during the early years:

Pay attention to the market value of QQQ in 2000 through 2001 without withdrawals:

Now compare the same numbers with cash being withdrawn:

The withdrawals caused the QQQ position to be worth 21.5% less by 2002, than it would have been if the funds stayed invested. In essence, the investor was forced to sell shares at terrible prices. By 2007, without withdrawals, QQQ was able to fully recover and survive the Great Financial Crisis. With withdrawals, it was only able to recover to $489K, and in 2008 it was at $234K while annual withdrawals were approaching $51K, forcing the investor to sell even more shares at low prices.


I ask again, how "selling shares is no different than dividends"?


Selling Low Destroys Capital


It's simple math. If you sell shares at low prices, you hold fewer shares to effectively participate in the recovery. It will take more upside to get you back to even. With the Income Method, where the amount of dividends you receive is greater than your withdrawals, you are in a position to buy more shares when prices are low.


The fastest way to decimate your retirement portfolio is to be forced to sell when prices are low. The Income Method is a strategy we have adopted at High Dividend Opportunities. This strategy is designed to avoid ever being forced to sell shares to withdraw income. This way, you can decide to sell on your own time, at good prices.


Dividends do not magically make your investments successful. They do not guarantee that you will get a particular dividend indefinitely. They can perform exceptionally well, or very poorly. Dividends can be cut, raised, or even suspended. Also, if you withdraw more cash than is produced by your dividends, you may be forced to sell shares at poor prices, creating the same problem faced by the QQQ investor.


A well-constructed income investment strategy accommodates and mitigates these risks through adequate diversification. This is why we recommend holding at least 42 income-producing investments, rather than placing all your investment dollars in a single ticker. We recommend a healthy allocation to fixed-income which tends to be more stable. Finally, we suggest that income investors plan towards reinvesting at least 25% of the dividend income both to provide a source of income growth and also to provide a buffer in the event that we experience a period of higher-than-average dividend cuts.

What Dividends Are Not


Dividends are not "magic money" conjured out of thin air. Nor are they “free money” that companies give away. They are payments sourced through a company’s operations in multiple ways.


  1. Cash on hand: Sometimes a company might have excess cash on their balance sheet.

  2. Operating cash flow: Many companies will pay dividends from the cash that is generated by their operations. Various non-GAAP metrics often aim to measure the amount of recurring cash flow being produced by the company's operations. These include FFO (Funds From Operations), AFFO (Adjusted Funds From Operations), FAD (Funds Available for Distribution), and CAD (Cash Available for Distribution). These metrics can often be a fantastic way to estimate the sustainability of a dividend. However, investors must be aware that with non-GAAP metrics, even if the metric carries the same name, the calculation may vary from company to company. It is essential that you look at the reconciliation to GAAP earnings so that you understand the adjustments made. If comparing two different companies, make your own adjustments so that the metrics are comparable.

  3. Investment Income: Some businesses like mortgage REITs and BDCs make money primarily through investments.

  4. Capital gains: Capital gains can be sources of cash that is eventually distributed. In many cases, large capital gains are paid out as one-time "special" dividends. However, for other investments, it might be a recurring part of their strategy. For example, CEFs (closed-end funds) are required to distribute most of their realized capital gains. So if you invest in a CEF, you can expect a significant portion of your dividends to come from from capital gains.

  5. Borrowing: A company might borrow money, usually on its line of credit or revolver, to fund a dividend payment. These are to be studied a bit more carefully, to see if the company has some money coming in the form of accounts receivable.

  6. Raising capital: Companies can raise cash by issuing common or preferred equity. This is again a cause for concern as it falls in the lines of the soliciting Peter to pay Paul technique.

When evaluating a dividend-paying investment, it is critical that we take the time to understand the company's business model and how it will sustainably support the payments. We want to avoid companies that are funding their dividends primarily through temporary or unsustainable sources like borrowing or issuing equity unless we have a very clear picture of how they will achieve sustainable coverage in the future.


There is no shortcut. Using a metric to screen investments to narrow down the number of options you want to do a deep dive on can be helpful. However, you cannot rely on headline metrics to gauge how a dividend is being paid and whether or not it is safe. There are always numerous things going on within a company. The company could be increasing its overall debt level to expand, while the dividend enjoys comfortable coverage through existing operations. Or a company might have significant capital gains that won't be recurring, making the dividend appear to have coverage just for now.


Conclusion


Dividends aren't magic, but they are capable of performing a very incredible magic trick. They can prevent you from being forced to sell shares during a market downturn. Market prices are volatile and have very little to do with the fundamentals of the underlying business. For those of us who are not forced to sell shares to produce cash flows, the volatility of share prices presents solid buying opportunities. For those who rely on selling shares for income, the volatility of market prices poses a significant risk to your financial well-being in retirement.


There is no secret to avoiding losses in the stock market. Life isn't a video game; there is no cheat code. Instead of worrying about things not in your control, focus on what the companies do, and how they generate cash to pay the dividend. Then, make your best estimate as to whether or not they will be able to continue their operating performance and keep delivering those dividends. You will go wrong sometimes, and that is ok.


Focus on building your income, and make sure you are withdrawing less than you make. Maintain a cushion of excess dividends, and if that cushion shrinks, that is a warning sign for you to make changes to your portfolio. The greatest benefit of an income strategy is that you are not faced with the decision that so many had to make in 2001/2002 on whether or not it was safe to withdraw funds. Since you aren't spending money until it is paid to you, you know the budget you have to work with, and you know if you need to do something to either increase your income or reduce your spending before it is too late. The Income Method offers this much-needed financial flexibility in retirement.

 

A Price Increase Is Coming

Soon, High Dividend Opportunities annual and monthly membership fees are going to rise. You can beat that increase by subscribing today. All current members will be grandfathered into our $549.99 annual membership price.

HDO price hike

Move quickly to lock in today's rate. Waiting would mean paying more for our valuable research when you don't have to! Pay $549.99 this year to lock in the ongoing rate forever.


We're offering a limited-time 30% discount on our annual price of $549.99 via this link only:

 

Are you ready to become an income investor?


We can't say it better than our members:

Stop wondering if you will have the income you need in retirement; start growing your income stream now. We are the largest community of income investors and retirees, with over 8,000 members. Our "Model Portfolio" targets a +8% yield, with the highest and safest dividend stocks, preferred stocks, and bonds. This service is ranked #1 in dividends, income, and retirement. If you are looking for high, sustainable income, you have come to the right place!





0 comments

Comments


Commenting has been turned off.
bottom of page