Monday, January 13, 2014

Should Dividend Investors Worry About Rising Interest Rates?

If you have followed any news stories over the past year, you might have been exposed to a lot of negative information about dividend paying stocks. I have rebutted some of them, such as the story about the end of the dividend craze. Others include the notion that rising interest rates are somehow so bad for dividend paying stocks, which it would put the end to dividend investing once and for all. The problem with those statements is that while interest rates affect the relative valuation of assets, they are just one input in valuation formulas.

I keep hearing that rising interest rates will mark the end of dividend growth investing. I am actually hoping that this talk results in lower entry prices for those investors like me who are in the accumulation age. But for other long term holders who are living off portfolios, I think that they should ignore this noise, and instead focus on enjoying the fruits of their growing income stream.

There are several reasons why I ignore this non-sense:

1) First of all, few people can predict interest rates with any accuracy. Actually, few people can actually predict anything with a reasonable success rate. I still remember how everyone was expecting hyper inflation in 2008 – 2009. I actually wrote an article about it at the time, and several readers told me how wrong I am, and how they were going to stop reading my website because of that. Before that, everyone was worried about the fall of the US dollar against other currencies, and by the fact that the World were running out of oil. So naturally, while I do agree that interest rates could start increasing over time, I cannot tell you what the timing and amount of this increase is going to be. Therefore the impact of rising interest rates might not affect companies as much as expected. Even if interest rates did increase, and cost of capital was raised for all of corporate America, it could impact the speculative companies with untested products or constant need of new capital to maintain operations. This could potentially deflate the ongoing bubble in some technology stocks today.

2) Second, as a dividend investor, I actually do not care about short term fluctuations in the value of my investment holdings or about my total return performance relative to a group of investors with other goals and objectives. As long as my total dividend payments are stable and growing above the rate of inflation, I would be a happy camper. My goal is to live off the dividend income from my portfolio when I retire, and not be at the mercy of Mr Market’s irrational fluctuations. Dividends are more stable than capital gains, which is why they are my preferred method of funding my lavish retirement. This is because they are the only direct link between a company’s underlying business performance, and investor returns.

3) Third, as I hinted above, I focus on dividend income over time. In order for me to remain retired, I require that the total amount of distributions from my retirement portfolio grow at or above the rate of inflation over time. While rising interest rates might cause some investors to prefer fixed income yields rather than the rising yields on cost of dividend paying stocks, I would not see that as a risk. Rather, I would view this as an opportunity to purchase quality merchandise at cheaper prices than available today. Investors should remember that fixed income securities might provide you them with a decent entry yield, and almost no risk in the case of US Government or Agency bonds. However, your purchasing power will erode over time due to inflation. With dividend paying stocks, especially those who have a culture of raising dividends, you have the chance to increase dividend income and maintain your standard of living.

4) Last, as a dividend investor, I focus my energies on individual stock selection and then building a diversified portfolio of income generating stocks over a long period of time. I focus on individual securities, how they earn money, check for competitive advantages. In this analysis I focus on catalysts that could provide these companies ways for earnings growth and dividend growth. After that, I focus on purchase of these securities at attractive valuations. I also balance the expected future growth in earnings and dividends, against the quality of earnings and business, and against valuation I am paying for this growth and quality. Some businesses such as Coca-Cola (KO) and Johnson & Johnson (JNJ) have strong predictability of cash flows and strong pricing and earnings powers. These are the types of businesses that manage to build a record of fifty years of consecutive dividend increases.  Because I have a long-term investment horizon, I do not care if interest rates go up or down over the next five years, as long as dividends from my portfolio are higher than today for the next 30 years.

In other words, if Realty Income yields 6% today, but grows distributions by 4% over the next 20 years, I would gladly choose it over Treasury Bonds today. That is because in 20 years, even if you spend all your dividends each year, your yield on cost will be 12%. With US Treasury Bonds, you are stuck with the yield on cost you lock in today, for better or worse. Think about that, and think probabilistically, the next time you make an investment.

In conclusion, I believe that investors should develop a method of independent thinking and ignore short-term noise that has no relevance to their positions. If you have a set of solid investment guidelines, which describe your objectives, what securities you are looking to purchase and at what price, how to evaluate them and when to sell, you should be able to perform well over time. This set of basic guidelines will provide the opportunity hold on to your investment portfolio during any set of varying economic, market and business conditions that you will experience over your investing lifetime.

Full Disclosure: Long O, KO, JNJ

Relevant Articles:

Complete List of Articles on Dividend Growth Investor Blog
Rising interest rates affect all businesses, not just dividend paying ones
Yield on Cost Matters
Lower Entry Prices Mean Locking Higher Yields Today
Dividends Offer an Instant Rebate on Your Purchase Price

3 comments:

  1. Could you please describe how rising interest rates could affect utilities?

    With higher yields, won't that force debt service to be an issue? This combined with higher rates pushing investors to less-risky investments like CDs?

    Thanks!

    ReplyDelete
  2. Hello DGI,
    A good posting as always. Dividend growth investing has been around for a long time and will continue to be, in my opinion. It's been around during many higher interest rate periods. However, as you occasionally point out, diversification into bonds is not a bad idea at all. So, I plan to add to those positions too when prices on bond funds become more attractive, which I fully expect. At present, they are too expensive for my taste. I agree that those kinds of investments provide a static, non-growing income. But they provide some stability, greater initial income and seems prudent to me. Plus, a new, and different income source in retirement, aside from dividend stocks is not a bad idea.

    Keep the faith!
    A

    ReplyDelete
  3. Thank you both for reading and commenting.

    First Anon,

    Higher yields could attract investors to fixed income, and make them require higher yields on utilities. Higher yields could make cost of capital more expensive, therefore eating into profitability. Given that utilities largely expand by selling debt and equity to investors, this could impact profits and abilities to pay higher dividends.

    Second Anon,

    I agree with you that bonds could be helpful for diversification purposes. Unfortunately, they do not seem like a good value today.


    ReplyDelete

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