Investing for Dividends

Investing for dividends is one of many strategies investors use to identify stocks for their portfolios. Among the strategies I identified in my post on what you need to know about stocks, this is not one that I have ever used.  So I reached out to one of my Twitter followers who uses it to get more information, Dividend Diplomats (aka Lanny and Bert) to get some real-life insights. With Lanny’s and Bert’s help, I will:

  • define dividends.
  • talk about the criteria that Lanny and Bert use for selecting companies and why they are important.
  • show some historical returns for dividend-issuing companies.
  • explain the tax implications of dividends on your total return.

What are Dividends?

A dividend is a cash distribution from a company to its shareholders. The amount of the dividend is stated on a per-share basis.  The amount of cash you receive is equal to the number of shares you own times the amount of the dividend. When companies announce that they are going to pay a dividend, they provide two dates.  The first is the date on which share ownership is determined (also known as the ex-dividend date).  The second is the date on which the dividend will be paid. For example, a company might declare a 15₵ dividend to people who own shares on May 1 payable on May 15. Even if you sell your stock between May 1 and May 15, you will get 15₵ for every share you owned on May 1.

When a company earns a profit, it has two choices for what to do with the profit. Under one option, the company can keep the profit and use it to support future operations. For example, the company might buy more equipment to allow it to increase the number of products is makes or might buy another company to expand its operations. Under the second option, the company distributes some or all of its profit to shareholders as dividends. My experience is that companies that are growing rapidly tend to keep their profits, whereas companies that can’t find enough opportunities to reinvest their profits to fund growth tend to issue dividends.

Dividend Diplomats – A Little Background

Lanny and Bert have been blogging for over 5.5 years and have been best friends for 7.  They both are pursuing the same goal of reaching financial freedom and retiring early to break the “9 to 5” chains.  They hope to achieve financial freedom through dividend investing, frugal living, and using as many “personal finance” hacks as possible to keep expenses low and bring in additional income. For more information about the Dividend Diplomats, check out their web site at www.dividenddiplomats.com.

Why Use the Investing for Dividends Strategy

As you’ll see in future posts, I have used several strategies for my stock investments, but have never focused on investing for dividends.

My Preconceived Notions

I have always considered investing for dividends as most appropriate for people who need the cash to pay their living expenses, such as people who are retired. I am retired, but currently have cash and some bonds that I use to cover my living expenses. As I get further into retirement, I will need to start liquidating some of my stocks or start investing for dividends.

Lanny’s & Bert’s Motivation

So, when I started reading about Lanny and Bert, I wondered why people who are still working (and a lot younger than I am) would be interested in investing for dividends.   Here’s what they said.

“There were a few different motivating factors.

Lanny had endured a very difficult childhood, where money was always limited and his family had struggled financially.   Due to this, he personally wanted to never have to worry about money, period.

Bert was not a dividend growth investor until he met Lanny.  Once he talked to Lanny, learned about dividend investing, and saw the math, he was sold and hasn’t looked back since.

Therefore, we are looking to build a growing passive income stream so we can retire early and pursue our passions.  Building a stream of growing, truly passive dividend income has always been a very attractive option to us.  We love the fact that dividend income is truly passive (outside of initial capital, we don’t have to lift a finger) and we are building equity in great, established companies that have paid dividends throughout various economic cycles.

Second, the math just makes sense.  It is crazy how quickly your income stream grows when you are anticipating a dividend growth rate of 6%+ (on average).  Lanny writes an article each quarter showing the impact of dividend increases and we have demonstrated the impact of dividend reinvesting on our site in the past. When you see the math on paper, it is insane. “

Lanny and Bert provided links to a couple of their posts that illustrate the math: Impact of Dividend Increases and Power of Dividend Reinvesting.

Lanny’s & Bert’s Strategy

Lanny and Bert developed a dividend stock screener that helps them identify undervalued dividend growth stocks in which to consider investing.  At a minimum, the companies must pass three metrics to be further considered for investment:

  • Valuation (P/E Ratio) less than the market average.
  • Payout Ratio Less than 60%. (Unless the industry has a higher benchmarked figure. i.e. oil, tobacco, utilities, REITs, etc., then they compare to the industry payout ratio.)
  • History of increasing dividends.

They don’t consider dividend yield until later in the process.  They never advocate chasing dividend yield at the risk of dividend safety. That is, they would rather a dividend that has very low risk of being reduced or eliminated (i.e., safety) than a higher dividend be unsustainable over the long term.

That’s why they don’t look at yield initially.  It allows them to focus on the important metrics that help them gain comfort over the safety of the dividend.  Here is a link to their Dividend Stock Screener.

Payout Ratio

Lanny and Bert mention that that one of their key metrics is a payout ratio. A dividend payout ratio is the annual amount of a company’s dividend divided by its earnings per share.  For more about earnings per share, check out my post on reading financial statements.

A dividend payout ratio of less than 1 means that a company is retaining some of its earnings and distributing the rest. If the ratio is more than 1, it means that the company is earning less money than it is paying out in dividends.

I worked for a company that had a payout ratio of more than 1. When I first started working there, the company had more capital than it could use. The company was returning its excess capital to its shareholders through the high dividend. After several years, the company’s capital approached the amount it needed to support its business. If it had cut its dividend to an amount lower than its earnings, the stock price might have decreased significantly. Instead, the company was sold. Had the company not been sold, its shareholders might have had both a decrease in future dividend payments and a reduction in the value of their stock at the same time.  This double whammy (dividend cut at the same time as a price decrease) is a risk of owning a stock in a dividend-issuing company especially those with high dividend payout ratios.

Performance – Lanny and Bert’s View

Lanny and Bert are not assuming they can do better than management or the market.  As noted above, they tend to focus on companies with a dividend payout ratio less than 60%.  This approach allows for all three of increasing dividends to shareholders, share repurchases, and internal growth for profit.  Also, this approach ensures the company is continuing to invest in itself as well.  You can’t pay a dividend in the future if you can’t grow, or even maintain, your current earnings stream.  Therefore, if revenues are stagnant or shrinking, the safety of the company’s dividend comes into question.  Companies “can” pay out a dividend that is larger than your earnings over the short-to-medium term.  However, it is not sustainable as was the case with the company for which I worked.

Historical Performance

I was curious about how stocks that met Lanny and Bert’s criteria performed. I have a subscription to the ValueLine Analyzer Plus. It contains current and historical financial data and stock prices about hundreds of companies. I looked at two time periods.  I first looked at the most recent year (November 2018 to November 2019).  Because I was curious about how those stocks performed in the 2008 crash, I also looked at the ten-year period from 2003 to 2013. I would have used a shorter period around the 2008 crash and the period thereafter, but didn’t save the data in the right format so had to look at time periods for which I had saved the data in an accessible manner.

How I Measured Performance

For both time periods, I identified all stocks for which the data I needed for the analysis were available at both the beginning and end of the period.  There were 1,505 companies included in the sample in the 2018-2019 period and 952 companies for the 2003 to 2013 period.

I then identified companies (a) whose dividend grew in each of the previous two fiscal years, (b) whose dividend payout ratio was less than 60% and (c) whose P/B ratio was less than the average of all of the companies in the same. That is, I attempted to identify the companies that met Lanny and Bert’s criteria. There were 332 companies in the 2018-2019 period and 109 companies in the 2003-2013 period that met these criteria.

ValueLine ranks companies based on what it calls Timeliness, with companies with Timeliness ratings of 1 having the best expected performance and those having a rating of 5 having the worst expected performance. Because I suspected that Bert and Lanny’s screen would tend to select more companies with favorable Timeliness ratings than those with poorer ones, I looked at both the overall results, as well as the results by Timeliness rating.

November 2018 – November 2019

In the most recent year, the stocks that met Lanny’s and Bert’s criteria had an average total return (dividends plus change in stock price) of 11% as compared to 8.5% for the total sample. That is, in the current market, dividend issuing companies meeting their criteria returned more than the average of all companies.

Interestingly, when I stratified the companies by Timeliness rating, it showed that for companies with good Timeliness ratings (1 and 2), the Lanny’s and Bert’s companies underperformed the group. For companies with two of the three lower Timeliness ratings (3 and 5), though, Lanny’s and Bert’s companies not only did better than the average of all companies in the group, but also did better than even the group of companies with a Timeliness rating of 1! It looks to me as if their approach might identify some gems in what otherwise appear to be poorer performing companies.

The chart below shows these comparisons.

2003 to 2013

Over the longer time period from 2003 to 2013, the companies meeting Lanny’s and Bert’s criteria didn’t do quite as well as the average of all companies. In this case, the stocks meeting their criteria had a compound annual return of 5% as compared to 7% for all stocks in the sample. Without more data, it is hard to tell whether the difference in return is the sample of dividend-issuing companies is small, because those companies didn’t fare as well during the Great Recession or something else.

I looked at the total returns by Timeliness rating and the results were inconsistent for both the “all stocks” group and the ones that met our criteria. A lot can happen in 10 years! Nonetheless, it was interesting to see that the dividend-yielding stocks that had Timeliness ratings of 5 in 2003 out performed all other subsets of the data. So, while these stocks didn’t have quite as high a total return over the 10-year period in the aggregate, there are clearly some above-average performers within the group.

Tax Ramifications of Dividends

One of the drawbacks of investing in companies with dividends, as opposed to companies that reinvest their earnings for growth, is that you might need to pay taxes on the dividend income as it gets distributed.

Types of Accounts

If you hold your dividend-yielding stocks in a tax-deferred (e.g., Traditional IRA or 401(k) in the US or RRSP in Canada) or tax-free (e.g., Roth IRA or 401(k) in the US or TFSA in Canada), it doesn’t matter whether your returns are in the form of price appreciation or dividends. Your total return in each of those types of accounts gets taxed the same. That is, if you hold the stocks in a tax-deferred account, you will pay tax on your total returns, regardless of whether it is interest, dividends or appreciation, at your ordinary income tax rate. If you hold the stocks in a tax-free account, you won’t pay taxes on any returns.

The only type of account in which it matters whether your return is in the form of price appreciation or dividends is a taxable account. In the US, most people pay 15% Federal income tax plus some additional amount for state income taxes on dividends in the year in which they are issued. They pay taxes at the same rate on capital gains, but only when the stock is sold, not as the price changes from year to year. In Canada, the difference is even greater. Dividends are taxed at your ordinary income tax rate (i.e., they are added to your wages) and capital gains are taxed at 50% of your ordinary income tax rate and only when you sell the stock.

Dividend Reinvestment

When you earn dividends from a company, you often have the option to automatically reinvest the dividends in the same company’s stock. This process is a dividend reinvestment plan. Lanny and Bert take this approach.

Dividend reinvestment plans are terrific ways to make sure you stay invested in companies that you like, as you don’t have to remember to buy more stock when the dividend is reinvested. The drawback of dividend reinvestment plans is that you will owe tax on the amount of the dividend, even if you don’t receive it in cash. If you reinvest 100% of your dividends, you’ll need to have cash from some other source to pay the taxes unless you hold the investments in a tax-free or tax-deferred account.

Illustration

Let’s assume you are a US investor subject to the 15% Federal tax rate and pay no state income tax. You have two companies you are considering. You expect each to have a total return of 8%. One company’s return will be 100% in dividends, while the other company issues no dividends. You plan to own the stock for 10 years. Your initial investment will be $1,000 and you will pay your income taxes out of your dividends, so you reinvest 85% of the dividends you earn each year.

At the end of the 10th year, you will have $1,931 if you buy the company with 8% dividends. If you buy the company with no dividends, your stock will be worth $2,159. After you pay capital gains tax of $174, you will have $1,985 or 2.8% more than if you buy stock in the company that issues 8% dividends.

If you pay Canadian taxes, the difference is even bigger because of the much lower tax rate on capital gains than dividends. Over the full ten-year period, you will end up with almost 11% more if you buy stock in the company with no dividends than if you buy stock in the dividend-issuing company.

As such, you’ll want to put as much of your portfolio of dividend-issuing stocks in a tax-deferred or tax-free account as possible to minimize the impact of taxes on your total return.

Reading Financial Statements

Reading financial statement guides many investors in their decisions to buy and sell stocks.   Investors who focus on financial fundamentals look at recent financial statements in the context of other trends to estimate how much a company’s future profit might grow.  High-dividend yield investors need to understand the company’s financial statements to evaluate the sustainability of current dividend payments into the future.

Before investing in the stock of individual companies, it is good to understand the basics of their financial statements. In this post, I’ll identify the important values in the income statement and balance sheet and discuss important ratios that investors use to evaluate financial performance.  This post provides the basics of how stocks work.  In future posts, I’ll illustrate how these values can be used to evaluate companies and their stock prices under different investment strategies.

McCormick

Every company’s financial statements will be slightly different because every business is different. For illustration, I will use excerpts from the financial statements in the McCormick 2018 Annual Report. McCormick sells spices under its own name, but also owns the French’s mustard, Club House crackers and Lawry’s seasonings brands, among others. To be clear, my selection of McCormick for illustration is not intended to be a recommendation.

In this post, I’ll explain the key line items in McCormick’s financial statements.  If you are interested in other line items, you can either ask me in the comments or by e-mail or do some research on your own.

Income Statement

An income statement presents a summary of the financial aspects of a company’s operations and other financial transactions that occur during the financial reporting period. Publicly traded companies are required to provide their income statements to financial regulators (e.g., the Security & Exchange Commission in the US) quarterly and annually in reports known as the 10-Q and 10-K, respectively.

Here is a picture of the income statement from the McCormick 2018 Annual Report.[1]   All of the numbers in the excerpts from McCormick’s financial statements are in millions.

Revenue

Revenue is the money that a company receives for the goods and services it delivered during the year.  As you can see in its income statement McCormick had $5.4 billion in total revenues (net sales) in 2018.

Expenses

Expenses represents all the money that a company spends in the year, with one exception.

Depreciation

When the company purchases something that is expected to last for a long time, it is called a capital asset. Companies don’t include the full cost of capital assets in expenses in the year in which they buy them. Rather, they spread the costs of capital assets over several years. The amount spread to each year is called depreciation. The depreciation of capital assets is included on the Income Statement, not the actual cash expense.

Operating Expenses or Cost of Goods Sold

Operating expenses, sometimes called Cost of Goods Sold for sellers of products, are those that are directly related to the manufacture of products or provision of services sold in the year. For McCormick, these expenses were $3.0 billion in 2018.

General and Administrative (G&A) Expenses

G&A expenses, sometimes called overhead expenses, represent the cost to run the company and are not directly related to specific products or services. Some companies include research and development (R&D) expenses with G&A expenses while others show them separately. For McCormick, these expenses were about $1.4 billion, an amount I had to find in its Notes to Financial Statements.

Other Income/Expenses

There are many types of income and expenses that don’t relate to products and services and aren’t G&A expenses. These items are usually small relative to the other line items on the income statement. For McCormick, there are three line items that fall in the Other Income/Expenses category

  • Transaction and integration expenses of $22 million
  • Special charges of $16 million
  • Other income, net of $13 million

These amounts combine to a net total of $25 million (=$22 million + $16 million – $13 million) in 2018. Compared to the other revenue and expense items, all of which are measured in billions of dollars, these amounts are small, as expected.

Interest Expenses

Interest expense represents interest that the company pays on its debt.  McCormick’s had $175 million of interest expense in 2018.

Income Taxes

These expenses represent income taxes that the company pays to any federal, state or local governments. McCormick had a tax benefit of $157 million in 2018. By looking at the Notes to Financial Statements included in the Annual Report, I found that McCormick owed $183 million in taxes related to 2018 operations, but the reduction in the US Federal tax rate on corporations in early 2018 caused an adjustment to McCormick’s tax liabilities. The decrease in tax rate created a benefit of $340 million. The $157 million tax benefit on the income statement is equal to the $183 million for current operations offset by the $340 million reduction in future taxes. When looking at McCormick’s profits going forward, the $183 million of taxes for current operations is the more important number because the $340 million is a one-time adjustment.

Accrual Basis vs. Cash Basis

One of the hardest things for most people to understand about income statements is the difference between the values on the income statement and the cash the company receives and pays. The income statement is said to be on an “accrual” basis. Accrual amounts relate to goods and services delivered during the year, regardless of when the cash is actually received or paid.

To clarify, revenues on the income statement represent the amount of cash the company has or will receive for goods or services delivered in the year. If the company hasn’t received some of its compensation for goods or services by the end of the year, it creates an asset on its balance sheet for accounts receivable. If it receives the cash before it delivers the goods or services, it creates a liability for goods or services due to customers.

Similarly, the expenses on the income statement relate to the products or services delivered in the year. If a company has to pay for components of its products, for example, before it delivers them, it will create an asset on its balance sheet for inventory. If it hasn’t paid all of the bills related to products delivered in the year, it creates a liability on the balance sheet for accounts payable.

As you can see, many balance sheet items (discussed further below) are really differences between amounts accrued on the income statement and actual cash received or paid.

Measures of Profit

Companies have several measures of profit. They can be measured as either dollar amounts or percentages or revenues. In this post, I’ll put “%” after the type of profit when I’m referring to the profit as a percentage of revenue.

Gross Margin

The gross margin is calculated as revenues minus operating expenses. This line is labeled as “Gross profit” in the McCormick income statement. In 2018, McCormick’s gross margin was $2.4 billion and corresponds to 44% of revenues. It represents the amount of profit the company would have had if its only expenses were those directly related to products and services.

Operating Income

Operating income is calculated as the gross margin minus G&A expenses and some components of other income and expenses. For 2018, McCormick’s operating income was $903 million or 17% of revenues. It represents the amount of profit the company would have had if it didn’t have any interest expense or taxes. It is sometimes called EBIT or earnings before interest and taxes.

Pre-tax Income

Pre-tax income is calculated as operating income minus interest expense and some components of other income and expenses. For 2018, McCormick had $741 million of pre-tax income (also known as EBIT or earnings before income taxes) or 14% of revenues.

Net Income

Net income is the bottom-line profit after taxes. It is calculated as pre-tax income minus income taxes. For 2018, McCormick had net income of $899 million. Recall, though, that McCormick had a one-time benefit from the change in tax rate of $340 million, so its net income would have been $559 million on a “normalized” basis or 10% of revenues. This adjusted net income is a better value for estimating future profits, as McCormick won’t get the benefit of a tax rate change every year.

Other Comprehensive Income

There are some values that impact the net worth of a company that don’t appear in the calculation of net income, but rather appears either at the bottom of the Income Statement or on a separate schedule in the financials. These items are referred to as Other Comprehensive Income. They can include the impact of changes in foreign exchange rates, certain transactions or changes in valuation related to investments and changes in the value of pension plans. As with other income, Other Comprehensive Income is usually small relative to other values on the income statement. If it isn’t, you’ll want to read the Notes to Financial Statements to understand the sources of Other Comprehensive Income and how it might affect profitability and growth in the future.

Balance Sheet

A balance sheet shows everything that a company owns or is owed (assets) and owes (liabilities) on a particular date.  As I mentioned earlier that many balance sheet items represent the differences between what the company has accrued on its income statement and what it has actually paid or received in cash. The balance sheet also shows the difference between assets and liabilities, which corresponds to its net worth or shareholders’ equity.

Here is a picture of McCormick’s 11/30/18 balance sheet taken from its Annual Report.[2]

Assets

Assets represent the value of things the company owns and amounts it is owed. Current assets are assets that a company can sell and turn into cash within a year. They are usually reported separately on a balance sheet.

McCormick had $10 billion in total assets on November 30, 2018. As you can see, inventory was its largest current asset at $786 million. Inventory represents the amount already spent on products that are ready to be sold or are in the process of being manufactured.

McCormick’s largest assets overall are its $4.5 billion of goodwill and $2.9 billion of intangible assets. These assets appear on some companies’ financial statements but not others. As you look at the net worth of a company, you’ll want to understand these assets.

Goodwill is created when one company buys another for a price that is higher than the net worth of the acquired company. That difference between the price and the net worth is intended to represent the present value of future profits on the acquired business. Goodwill is generally reduced as the profits emerge. In 2017, McCormick’s bought RB Foods which includes the French’s mustard, Frank’s RedHot and Cattlemen’s brands. More than three-quarters of McCormick’s goodwill was created when it bought RB Foods.

In McCormick’s case, the intangible assets represent the value of its brand names and trademarks. Although not exactly correct, the amount can be thought of as the present value of the future profits McCormick thinks it will get as the result of owning the brand names and trademarks.

Liabilities

Liabilities represent money or the value of products or services a company owes to others. McCormick had $7.1 billion in liabilities on November 30, 2018. The largest of these liabilities was Long Term Debt of $4.1 billion. McCormick issued roughly $3.4 billion in debt to finance its acquisition of RB Foods in 2017.

Equity

Shareholders’ equity represents the difference between assets and liabilities. It represents what is known as the “book value” of the company. On November 30, 2018, Boeing’s shareholders’ equity was $3.2 billion.

Key Financial Ratios

When deciding whether to buy or sell stock in a company, there are a number of ratios that many investors consider. I’ve highlighted a few important ones in this section, using the McCormick financial statement excerpts from above for illustration. I note that I have used simplified versions of the financial statements and the calculations, so you will likely see published values for McCormick that differ a bit from those calculated here.

ROE or Return on Equity

Return on equity (ROE) can be approximated as Net Income for the year divided by Shareholders’ Equity at the beginning of the year. For McCormick, it is approximated for 2018 as the $899 million of net income divided by the $2,571 million of shareholders’ equity at the end of its 2017 fiscal year or 35%. That ROE is very high. Recall, though, that McCormick had a one-time tax benefit of $340 million in 2018. If we exclude that benefit as it won’t be repeated in the future, we get an adjusted ROE of 22%.

According to CSI Market[3], the average ROE for the total market for 2018 was around 13%. ValueLine, a source for lots of qualitative and quantitative information about companies, reports that the average ROE for companies in the food processing industry (in which McCormick falls) is about 15%.[4] As such, even McCormick’s adjusted ROE is higher than these averages.

P/E Ratio or Price/Earnings Ratio

The Price/Earnings or P/E ratio is the stock price divided by the earnings per share. McCormick had roughly 130 million shares of stock outstanding in 2018. As such, its earnings per share was about $7 (=$899 million/130 million shares). McCormick’s stock price on November 30, 2018 (the date of the financial statements) was $150, which corresponds to a P/E ratio of about 22.

According to ValueLine, the average P/E of companies in the food processing industry on October 31, 2019 was 23. By comparison, the average P/E for the market has been between 16 and 18 for the past year or so. As such, McCormick’s P/E is in line with its peers. If we adjust McCormick’s earnings to exclude the one-time tax benefit, its earnings per share would have been about $4.25 per share. When we divided the $150 stock price by this smaller number, the adjusted P/E is about 35 or much higher than its peers.

P/B Ratio or Price/Book Ratio

The Price/Book or P/B ratio is the stock price divided by shareholders’ equity (book value) per share. McCormick’s equity as of November 30, 2018 was $3,182 million. When divided by the number of outstanding shares, the book value per share was $24. The stock price divided by the book value is about 0.90. ValueLine indicates that the average P/B ratio on October 31, 2019 for the food processing industry was about 3.3 or much higher than McCormicks’ P/B ratio.

P/B Ratio > 1

When the P/B ratio is greater than 1, the difference between the stock price and the book value per share is the present value of future earnings estimated by investors. The higher the P/B ratio, the higher the value investors place on future earnings.

P/B < 1

When the P/B ratio is less than 1, it means that investors either think that the future earnings are going to negative (which doesn’t appear to be the case for McCormick) or they don’t think shareholders’ equity is fairly valued. In the case of McCormick, it could be that investors think that the goodwill and intangible assets might be overvalued or they might be concerned that the future reductions to income as the goodwill and intangible assets are reduced will have a significant adverse impact on earnings. If either of those is the case, investors may be adjusting the company’s book value (equity) in their analyses for their perceived overstatement of goodwill and intangible assets.

Within the group of investors who look at financial fundamentals for decision-making, there is a subset called “value investors.” Value investors look for companies whose stock price doesn’t full reflect the value of the company which is often determined by P/B ratios of less than 1.00. A value investor who was confident that McCormick could maintain its current profitability and that the company had fairly estimated its goodwill and intangible assets might find McCormick to be an attractive stock.

Debt-to-Equity Ratio

Both debt and equity are ways in which a company can get money to finance their operations – either when it issues bonds or new shares of stock. The sum of the two is sometimes called total capital.

The Debt-to-Equity ratio is the amount of long-term debt divided by shareholders’ equity and is a measure of the mix the company has chosen to use for financing its operations, growth or acquisitions. McCormick has a total of $4.1 billion of debt ($4.05 billion recorded as long-term debt plus $84 million reported as the portion of long-term debt on its balance sheet). The debt-to-equity ratio is 1.30 (=4.1/3.2).

The higher the debt-to-equity ratio, the more leveraged a company is said to be. To clarify, when there is a lot of leverage, its ROE will be much higher than if some or all of the debt were equity instead. For example, McCormick’s ROE for 2018 was 35%. If all of its debt had been equity instead, its ROE would have been 13% (=$899 million/[$3.2 billion + $4.1 billion]).   The opposite it true when a company has a negative ROE. If McCormick’s ROE in 2018 had been -10% based on its current leverage, it would have been only -4% if it had only equity capital instead of its current mix of debt and equity.

Tangible Equity/Total Equity

I wasn’t planning to talk about tangible equity in this post, but my choice of McCormick almost forces me to. If you recall, I pointed out earlier in this post that McCormick’s two biggest assets are Goodwill and Intangible Assets. If a company encounters financial difficulties, it sometimes has to reduce or write-off the value of any goodwill or intangible assets. When these assets are reduced, its total equity will be reduced by the same amount, after adjustment for income taxes. In addition, goodwill and intangible assets are reduced as the future profits are expected to be earned. As such, goodwill and other intangible assets cause future net income to be lower than it would otherwise be, even if there are no write-offs.

Tangible equity is equal to total equity minus goodwill minus intangible assets. Because these assets can’t be quickly turned into cash and can have their value reduced, many investors look at ratio of tangible equity to total equity. The total of McCormick’s goodwill and intangible assets was $7.4 billion. This amount is more than twice its shareholders’ equity. What this means is that McCormick’s book value would become negative if it were required to write-down more than half of its goodwill and intangible assets.  As long as everything goes as expected, though, McCormick will be just fine. As such, this ratio is a measure of the riskiness of the stock price.

Earnings Growth Rate

Another important metric that investors consider is the earnings growth rate. When considering when to buy a stock, investors try to estimate future earnings growth rates. In the estimation process, they often consider historical growth rates. The historical earnings growth rate is the ratio of this year’s net income to last year’s net income minus 1.00.

For McCormick, after adjustment for the one-time tax benefit, the earnings growth rate from 2017 to 2018 was 25% (=$559 million / $444 million – 1). From 2016 to 2017, it was a much more modest 2%.

Stock prices tend to reflect estimated future earnings as well as estimated future earnings growth rates. There are many investment analysts who estimate the future earnings growth rates for publicly-traded companies. Yahoo Finance and most large brokerage firms’ web sites include information about analysts’ estimates of future earnings growth rates. Also, some investors look at recent growth rates and trends in the markets in which companies operate to estimate the future earnings growth rates.

Investing Decisions

These ratios, along with others, are often used by investors to evaluate the financial condition of the company and the reasonableness of its stock price. For example, one rule of thumb is that stocks are fairly priced when the P/E ratio is less than the expected future earnings growth rate. I’ll take about this rule of thumb and other decision criteria in future posts in my series on investing in stocks.

[1] https://ir.mccormick.com/financial-information, 2018 Annual Report, p50.

[2] https://ir.mccormick.com/financial-information, 2018 Annual Report, p. 51.

[3] https://csimarket.com/Industry/industry_ManagementEffectiveness.php?&hist=4, November 7, 2019

[4] ValueLine Investment Analyzer, October 31, 2019.

What You Need to Know About Stocks

Stocks are a common choice for many investors.  There are two types of stocks – preferred and common.  Because most investors buy common stocks, they will be the subject of this post.  I’ll talk about what you need to know about stocks before you buy them, including:

  • Stocks and how they work.
  • The price you will pay.
  • The risks of owning stocks.
  • Approaches people use for selecting stocks.
  • How stock are taxed.
  • When you might consider buying stocks.
  • How to buy a stock.

What are Stocks?

Stocks are ownership interests in companies.  They are sometimes called equities or shares.  When you buy a stock, you receive a certificate that indicates the number of shares you own.  If you buy your investments through a brokerage firm, it will hold your certificates for you.  If you buy them directly, you will usually receive the certificate (and will want to maintain it in an extremely safe place as it is your only proof that you own the stock).  Some companies track their stock’s owners electronically, so you may not always get a physical certificate.

How Do Stocks Work?

Companies sell stock as a way to raise money.  The company receives the amount paid for the shares of stock when they are issued, minus a fee paid to the investment banker that assists with the sale.  The process of issuing stock is called a public offering.  The first time a company offers its shares to the public, it is called an initial public offering (IPO).

Stockholder-Company Interactions

After the stock has been sold by the company, the stockholder has the following interactions with the company:

  • It receives any dividends paid by the company.
  • It gets to vote on matters brought before shareholders at least annually.  These issues include election of directors, advisory input on executive compensation, selection of auditors and other matters.
  • It has the option to sell the stock back to the company if the company decides to repurchase some of its stock.

In addition to these benefits of owning stock, you also can sell it at the then-current market price at any time.

Why Companies Care About Their Stock Prices

Interestingly, after the stock has been sold by the company, future sales of the stock do not impact the finances of the company other than its impact on executive compensation.  That is, if you buy stock in a company other than when it is issued, you pay for the stock and the proceeds go to the seller (who isn’t the company)!

You might wonder, then, why a company might care about its stock price.  That’s where executive compensation comes in!  Many directors and senior executives at publicly traded companies have a portion of their compensation either paid in stock or determined based on the price of the company’s stock.  When the leadership owns a lot of stock or is paid based on the stock price, it has a strong incentive to act in a way that will increase the price of the stock.  As such, with appropriate incentive compensation for directors and executives, their interests are more closely aligned with yours (i.e., you both want the price of the company’s stock to go up).

What Price Will I Pay?

The price you will pay for a stock is the amount that the person selling the stock is willing to take in payment.  Finance theory asserts that the price of a stock should be the present value of the cash flows you will receive as the owner of a stock.

In my post on bonds, I explain present values.  They apply fairly easily to the price of a bond, as the cash flows to the owner of a bond are fairly clear – the coupons or interest payments and the return of the principal on a known date.

By comparison, the cash flows to the owner of a stock are much more uncertain.  There are two types of cash flows to the owner of a stock – dividends and the money you receive when you sell the stock.

Dividends

Dividends are amounts paid by the company to stockholders.  Many companies pay dividends every quarter or every year.  In most cases, the amount of these dividends stay fairly constant or increase a little bit every year.  The company, though, is under no obligation to pay dividends and can decide at any time to stop paying them.  As such, while many people assume that dividends will continue to be paid, there is more uncertainty in whether they will be paid than there is with bond interest.

Proceeds from the Sale of the Stock

The owner of the stock will receive an amount equal to the number of shares sold times the price per share at the time of sale.  This cash flow has two components of uncertainty to it.

  1. You don’t know when you will sell it. You therefore don’t know for how long you need to discount this cash flow to calculate the present value.
  2. It is impossible to predict the price of a stock in the future.

What are the Risks?

The biggest risk of buying a stock is that its value could decrease.   At the extreme, a company could go bankrupt.  In a bankruptcy, creditors (e.g., employees and vendors) are paid first.  If there is money left after creditors have been paid, then the remaining funds are used to re-pay a portion of any bond principal.  By definition, there isn’t enough money to pay all of the creditors and bondholders when there is a bankruptcy.  As such, the bondholders will not get all of their principal re-paid and there will be no money left after payment has been made to bondholders and creditors.  When there is no money left in the company, the stock becomes worthless.

Any of the following factors (and others) can cause the price of the stock to go down.

Economic Conditions Change

Changes in economic conditions can cause the interest rate used for discounting in the present value calculation to increase. When the interest rate increases, present values (estimates of the price) will go down.

Company Changes

Something changes at the company that causes other investors to believe that the company’s profits will be less than previously expected. One simple way that some investors estimate the price of a company’s stock is to multiply the company’s earnings by a factor, called the price-to-earnings ratio or P/E ratio.  Although P/E ratios aren’t constant over time, the price of a stock goes down when its earnings either decrease or are forecast to be lower than expected in the future. For more about P/E ratios and how a company calculates and reports on its earnings, check out this post

Increased Risk

Changes either in the economy or at the company can cause investors to think that the future profits of the company are more uncertain, i.e., riskier. When a cash flow is perceived to be riskier, a higher interest rate is used in the present value calculation.  This concept is illustrated in my post on bonds in the graph that shows how interest rates on bonds increase as the credit rating of the company goes down.  Recall that lower credit ratings correspond to higher risk.  The same concept applies to stock prices.  The prices of riskier stocks are less than the prices of less risky stocks if all other things are equal.

How Do People Decide What to Buy?

There are a number of approaches investors use to decide in which companies to buy stocks and when to buy and sell them.   I will discuss several of them in future posts.

Reasonable Price Investing

Reasonable price investors look at the financial fundaments and stock prices of companies to decide whether and when to buy and sell them.

Technical Analysis

Technical analysts, sometimes called momentum investors, look at patterns in the movement of the prices of companies’ stocks.  Day traders tend to be technical analysts whose time horizon for owning a stock can be hours or days.

High-Yield Investing

Some investors focus on companies who issue dividends.

Mutual Funds and Exchange-Traded Funds (ETFs)

Rather than invest in individual companies, some investors purchase either mutual or exchange-traded funds.  Under this approach, the investor relies on the fund managers to select the companies and determine when to buy and sell each position.

How are Stocks Taxed?

There are two ways in which stocks can impact your income taxes:

  • When you receive a dividend.
  • When you sell your ownership interest in the stock.

The total amount of the dividend is subject to tax.  The difference between the proceeds of selling the stock and the amount you paid for the stock is called a realized capital gain or loss.  It is gain if the sale proceeds is more than the purchase amount and a loss if the sale proceeds are less than the purchase amount.

In the US, realized capital gains and losses on stocks you have owned for more than a year are added to dividends.  For most people, the sum of these two amounts is taxed at 15%.  For stocks owned for less than a year, the realized capital gains are taxed at your ordinary tax rate (i.e., the rate you pay on your wages).

In Canada, dividends and half of your realized capital gains are added to your wages.  The total of those amounts is subject to your ordinary income tax rate.

When Should I Buy Stocks?

Understand Stocks

The most important consideration in determining when to buy stocks is that you understand how stocks work.  One of the messages I wished I had given our children is to invest only in things you understand.  If you don’t understand stocks, you don’t want to invest in them.

Understand the Companies or Funds

You also want to make sure you understand the particular company or fund you are purchasing.  One of the biggest investing mistakes I made was when I was quite young and didn’t understand the business of the company whose stock I owned.

My parents gave me some shares of a company called Wang Laboratories.  In the 1970s and early 1980s, Wang was one of the leaders in the market for dedicated word processors.  Picture a desktop computer with a monitor that’s only software was Microsoft Word, only much harder to use.  That was Wang’s biggest product.  At one time, the stock price was $42.  Not understanding that PCs were entering the market and would be able to do so much more than a dedicated word processor, I was oblivious.  As the stock started going down, I sold a few shares in the high $30s.  When the stock dropped to $18, I told myself I would sell the rest when it got back to $21.  It never did.  A year or so later, the stock was completely worthless. Fortunately, I was young enough that I had a lot of time to recover and learn from this mistake.

Be Willing and Able to Understand the Risks

You should also not buy stocks if you can’t afford to lose some or all of your principal.  Even though only a few companies go bankrupt, such as Wang, the price of individual stocks can be quite volatile.  As discussed in my post on diversification, you can reduce the chances that your portfolio will have a decline in value by either owning a large number of stocks or owning them for a long time.  Nonetheless, you might find that the value of your portfolio is less than the amount you invested especially over short periods of time when you invest in stocks.  If you want to invest in stocks, you need to be willing to tolerate those ups and downs in value both mentally and financially.

Market Timing

There is an old investing adage, “Buy low, sell high.”  In principle, it is a great strategy.  In practice, though, it is hard to identify the peaks and valleys in either the market as a whole or an individual stock.

People who invest over very short time frames – hours or days – often use technical analysis to try to identify very short-term highs and lows to create gains.  I anticipate that most of my followers, though, will be investing for the long term and not day trading.  While you will want to select stocks that are expected to produce a return commensurate with their riskiness, it is very difficult to time the market.

That is, my suggestion for new investors with long-term investment horizons (e.g., for retirement or your young children’s college expenses) is to buy stocks or mutual funds you understand and think are likely to appreciate whenever you have the time and money available to do so.  If you happen to buy a fundamentally sound stock or index fund just before its price drops, it will be difficult to hang on but it is likely to increase in the price by the time you need to sell it.

As Chris @MoneyStir learned when he reviewed the post I wrote about whether he should pre-pay his mortgage, a fall in the stock market right after he started using his extra cash to buy stocks on a monthly basis was actually good for him!  While he lost money at first on his first few month’s investments, the ones he made over the next several months were at a lower stock price and produced a higher-than-average return over his investment horizon.  The process of buying stocks periodically, such as every month, is called dollar-cost averaging.

How and Where Do I Buy Stocks?

You can buy stocks, mutual funds and ETFs at any brokerage firm.  This article by Invested Wallet provides details on how to open an account at a brokerage firm.

Once you have an account, you need to know the name of the company or its symbol (usually 2-5 letters that can be found using Google or Yahoo Finance, for example), how many shares you want to buy and whether you want to set the price at which you purchase the stocks or buy them at the market price.

Limit Orders

If you determine you want to buy a stock at a particular price, it is called a limit order.  The advantage of a limit order is you know exactly how much you will pay.  The disadvantages of a limit order are:

  • You might pay more than you have to if the stock price is lower at the time you place your order.
  • You might not buy the stock if no one is interested in selling the stock at a price that is a low as your desired purchase price.

Market Orders

If you place a market order, you will buy the stock at whatever price sellers are willing to take for their stock at the moment you place your order.  In some cases, you may end up paying more than you want for a stock if the price jumps up right at the time you place your order.  The advantages of a market order are (1) you know you will own the stock and (2) you know you are getting the best price available at the time you buy the stock.

Transaction Fees

Many of the major brokerage firms have recently announced that they will no longer charge you each time you purchase or sell a stock.  Some firms charge you small transaction fees, such as $4.95, each time you place a buy or sell order.  Other firms have higher charges.  You’ll want to consider the fees when you select a brokerage firm.

Investing in Bonds

Bonds are a common investment for people targeting a low-risk investment portfolio. One of the pieces of advice I gave my kids (see others in this post) is to never buy anything you don’t understand. In this post, I’ll tell you what you need to know so you can decide whether investing in bonds is appropriate for you.

What is a Bond?

A bond is a loan you are giving the issuer.  The parties to the transaction are exactly opposite of you taking out a loan. You’ll see the parallels if you compare the information in this post with that provided in my post on loans!  When you buy a bond, you are the lender.  The issuer of the bond is the borrower.

How Do Bonds Work?

The issuer of a bond sells the bonds to investors (i.e., lenders).  Every bond has a face amount.  Common face amounts are $100 and $1,000.  The face value of the bond is called the par value.  It is equivalent to the principal on a loan.  When the issuer first sells the bonds, it receives the face amount for each bond.

The re-payment plan for a bond is different than for a loan.  When you take out a loan, you make payments that include interest and a portion of your principal.  Over the life of your loan, all of your payments are the same (unless the interest rate is adjustable).   By comparison, a bond issuer’s payments include only the interest until the maturity date when it pays the final interest payment and returns the principal in full.

Before selling bonds, the issuer sets the coupon rate and the maturity date of the bond.  The coupon rate is equivalent to the interest rate on a loan.  The maturity date is the date on which the issuer will pay the par value to the owner of the bond.  It can vary from something very short, like a year, all the way to 30 years.  In Europe, there are even bonds with maturity dates in 99 years.  In the meantime, the issuer will pay coupons (interest) equal to the product of the coupon rate and the par value, divided by the number of coupons issued per year. Coupons are often issued quarterly. For example, if you owned a bond with a $1,000 par value, a 4% coupon rate and quarterly payments, you would get 1% of $1,000 or $10 a quarter in addition to the return of the par value on the maturity date.

What Price Will I Pay

You can buy bonds when they are first issued from the issuer or at a later date from other people who already own them.  You can also sell bonds you own if you want the return of your initial investment before the bond matures.  If you buy and sell bonds, the sale prices will be the market price of the bonds.

Present Value

Before explaining how the market value is calculated, I need to introduce the concept of a present value. A present value is the value today of a stated amount of money you receive in the future.  It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time between the date the calculation is done and the date the payment will be received.  Specifically, the present value at an interest rate of i of $X received in t years is:

The denominator of (1+i) is raised to the power of t to adjust for the time element.

Market Price = Present Value of Cash Flows

The market price of a bond is the present value of the future coupon payments and principal repayment at the interest rate at the time of the calculation is performed.

Interest Rate = Coupon Rate When Issued

The interest rate when the bond is issued is the coupon rate!  Because the issuer sells the bonds at par value (the face amount of the bond), the par value has to equal the market value.  For the math to work, the coupon rate must equal the interest rate at the time the bond is initially sold.

Interest Rates after Issuance

If interest rates change (more on that in a minute) after a bond is issued, the market value will change and become different from the par value because the “i” in the formula above will change.  When the interest rate increases, the price of the bonds goes down and vice versa.

Also, as the bond gets closer to its maturity date, the exponent “t” in the formula will get smaller so it will have less impact on the present value, making the present value bigger. As such, all other things being equal, a bond that has a shorter time to maturity will have a higher market price than a bond that has a longer time to maturity.  Remember that the par value is all paid at the end, so the market price formula is highly influenced by the present value of the repayment of the par value.

How is the Interest Rate Determined

There are two factors specific to an individual bond that influence the interest rate that underlies its price – the bond’s time to maturity and the issuer’s credit rating. In addition, there are broad market factors that influence the interest rates for all bonds.  These factors influence the overall level of interest rates as well as the shape of the yield curve.

What is a Yield Curve

The interest rate on a bond depends on the time until it matures.  If I look at the interest rates on US government bonds today (March 7, 2019) at this site, I see the following:

The line on this graph is called a yield curve.  It represents the pattern of yields by maturity.  In this case, there is some variation in yields up to 5 years and then the line goes up.

A “normal” yield curve would go up continuously all the way from the left to the right of the graph.  Up to five years, the chart above would be considered essentially “flat” and, above five years, would be considered normal.  If the entire yield curve went down, similar to what we see in the very short segment from one year to two years in this graph, it would be considered inverted.

Time to Maturity

The yield curve along with the maturity date of a bond influencethe interest rate and therefore its market price.  Looking at US Government bonds, the interest rates for bonds with maturities between 0 and 7 years are all around 2.5%.

The price of a 30-year bond will reflect interest rate of about 3%.  If the yield curve didn’t change at all, the same 30-year bond would be priced using a 2.5% interest rate in 23 years (when it has 7 years until maturity).  With the lower interest rate, the market value of the bond will increase (in addition to the increase in market value because the maturity date is closer).

Credit Rating

The other important factor that affects the price of a bond is its credit rating.  Credit ratings work in the same manner as your credit score does.  If you have a low credit score (see my post on credit scores for more information), you pay a higher interest rate when you take out a loan.  The same thing happens to a bond issuer – it pays a higher interest rate if it has a low credit rating.

Instead of having a numeric credit score, bonds are assigned letters as credit ratings.  There are several companies that rate bonds, with Standard and Poors (S&P), Moodys and Fitch being the biggest three.    When you buy a bond (more on that later), the credit rating for the bond will be quite clearly stated.

The graph below summarizes information I found on the website of the St. Louis Federal Reserve Bank (FRED).

It shows the interest rates on corporate bonds with different credit ratings on February 28, 2019. As you can see, there is very little difference in the interest rates of bonds rated AAA, AA and A, with a slightly higher interest rate for bonds rated BBB.  Bonds with BBB ratings and higher are considered investment grade.

Bonds with ratings lower than BBB are called less-than-investment grade, high yield or junk. You can see that the interest rates on bonds with less-than-investment grade ratings increase very rapidly, with C-rated bonds having interest rates close to 12%.

What are the Risks

There are two risks – default and market – that are inherent in bonds themselves and a third – inflation – related to using them as an investment.

Defaults

Default risk is the chance that the issuer will default or not make all of its coupon payments or not return the full par value when it is due.  When an issuer defaults on a bond, it may pay the bond owner a portion of what is owed or it could pay nothing.  The percentage of the amount owed that is not repaid is called the “loss given default.”  If the loss given default is 100%, you lose the full amount of your investment in the bond, other than coupon payments you received before the default.  At the other extreme, if the loss given default is only 10%, you would receive 90% of what is owed to you.

Issuers of bonds with low credit ratings are considered riskier, meaning they are expected to have a higher chance that they will default than issuers with high credit ratings. I always find this chart from S&P helpful in understanding default risk.

It shows two things – the probability of an issuer defaulting increases as the credit rating gets lower (e.g., the B line is higher than the A line) and the probability of default increases the longer the time until maturity.

These increases in the probability of default correspond to increases in risk.  Recall from the previous section that interest rates increase as there is a longer time to maturity when the yield curve is normal and as the credit rating gets lower. The higher interest rates are compensation to the owner of the bond for the higher risk of default.

When you read the previous section and saw you could earn between just under 12% on a C-rated bond, you might have gotten interested.  However, it has almost a 50% chance of defaulting in 7 years!  The trade-off is that you’d have to be willing to take the risk that the issuer would have a 26% chance of defaulting in the first year and a 50% chance by the seventh year!  It makes the 12% coupon rate look much less attractive.

Changes in Market Value

As I mentioned above, you can buy and sell bonds in the open market as an alternative to holding them to maturity.  In either case, you will receive the coupon payments while you own the bond, as long as the issuer hasn’t defaulted on them.  If you buy a bond with the intention of selling it before it matures, you have the risk that the market value will decrease between the time you purchase it and the time you sell it.  Decreases in market values correspond to increases in interest rates. These increases can emanate from changes in the overall market for bonds or because the credit rating of the bond has deteriorated.

If you hold a bond to maturity and it doesn’t default, the amount you will get when it matures is always the principal.  So, you can eliminate market risk if you hold a bond to maturity.

Interest Doesn’t Keep Up with Inflation

The third risk – inflation risk – is the risk that inflation rates will be higher than the total return on the bond.  Let’s say you buy a bond with a $100 par value for $90, it matures in 5 years and the coupons are paid at 2%.  Using the formulas above, I can determine that your total return (the 2% coupons plus the appreciation on the bond from $90 to $100 over 5 years) is 4.3%.  You might have purchased this bond as part of your savings for a large purchase.  If inflation caused the price of your large purchase to go up at 5% per year, you wouldn’t have enough money saved because your bond returned only 4.3%.  Inflation risk exists for almost every type of invested asset you purchase if your purpose for investing is to accumulate enough money for a future purchase.

How are They Taxed

There are two components to the return you earn on a bond – the coupons and appreciation (the difference between what you paid for it and what you get when you sell it or it matures).

Tax on Coupons and Capital Gains

The coupons are considered as interest in the US tax calculation.  Interest is included with your wages and many other sources of income in determining your taxes which have tax rates currently ranging from 10% to 37% depending on your income.

The difference between your purchase price and your sale price or the par value upon maturity is considered a capital gain.  In the US, capital gains are taxed in a different manner from other income, with a lower rate applying for most people (0%, 15% or 20% depending on your total income and amount of capital gains).

States that have income taxes usually follow the same treatment with lower tax rates than the Federal government, but not always.

Some Bonds are Taxed Differently

Within this framework, though, not all bonds are treated the same.  The description above applies to corporate bonds.  Bonds issued by the US government are taxed by the Federal government but the returns are tax-free in most states.

Some bonds are issued by a state, municipality or related entity.  The interest on these bonds is not taxed by the Federal government and is usually not taxed if you pay taxes in the same state that the issuer is located.  Capital gains on these bonds are taxed in the same manner as corporate bonds.

Included in this category of bonds are revenue bonds. Revenue bonds are issued by the same types of entities, but are for a specific project.  They have higher credit risk than a bond issued by a state or municipality because they are backed by only the revenues from the project and not the issuer itself.

The manner in which a bond is taxed is important to your buying decision as it affects how much money you will keep for yourself after buying the bond.  You should consult your broker or your tax advisor if you have any questions specific to your situation.

Do They Have Other Features

If you decide to buy bonds, there are some features you’ll want to understand or, at a minimum, avoid. Some of the types of bonds with these distinctive features are:

Treasury Inflation-Protected Securities or TIPS

TIPS are similar to US Government bonds except that the par value isn’t constant.  The impact of inflation as measured by the Consumer Price Index is determined between the issue date and the maturity date.  If inflation over the life of the bond has been positive, the owner of the bond will be paid the original par value adjusted for the impact of inflation.  If it has been negative, the owner receives the original par value.  In this way, the owner’s inflation risk is reduced.  It is completely eliminated if the owner purchased the bond to buy something whose value increases exactly with the Consumer Price Index.

Savings or EE Bonds

Savings bonds are a form of US Government bond.  You can buy them with par values of as little as $25.  They can be purchased for terms up to 30 years.  Currently, savings bonds pay interest a 0.1% a year.  The interest is compounded semi-annually and paid to the owner with the par value when the bond matures.   With the currently very low interest rates, these bonds are very unattractive.

Zero-Coupon Bonds

The issuer of a zero-coupon bond does not make interest payments.  Rather, when it issues the bond, the price is less than the par value. In fact, the price is the present value of just the principal payment.  So, instead of paying the par value for a newly issued bond and getting coupon payments, the buyer pays a much lower price and gets the par value when the bond matures.

I don’t know all the details, but believe that, in the US, the owner needs to pay taxes on the appreciation in the value of the bond every year as if it were interest and not as a capital gain on sale.  As such, it is better to own a zero-coupon bond in a tax-deferred or tax-free account, such as an IRA, a 401(k) or health savings account.  I’ve owned one zero-coupon bond – it was my first investment in an IRA.  If you want to buy a zero-coupon bond, I suggest talking to your broker or tax advisor to make sure you understand the tax ramifications.

Callable Bonds

A call is a financial instrument that gives one party the option to do something.  In this case, the issuer of the bond is given the option to give you the par value earlier than the maturity date.  When the issuer decides to exercise this option, the bond is said to be “called.”  The bond contract includes information about when the bond is callable and under what terms. If you purchase a callable bond, you’ll want to understand those terms.

Issuers are more likely to call a bond when interest rates have decreased. When interest rates go down, the issuer can sell new bonds at the lower interest rate and use the proceeds to re-pay the callable bond, thereby lowering its cost of debt.

In a low-interest rate environment, such as exists today, a callable bond isn’t much different from a non-callable bond as it isn’t likely to get called.  If interest rates were higher, a non-callable bond with the same or similar credit quality and coupon rate is a better choice than a callable bond. If the callable bond gets called, you will have cash that you now need to re-invest at a time when interest rates are lower than when you initially bought the bond.  (Remember that the reason that callable bonds get called is that interest rates have gone down.)

Convertible Bonds

Convertible bonds allow the issuer to convert the bond to some form of stock.  As will be explained below, stocks are riskier investments than bonds.  If you buy a convertible bond, you’ll want to understand when and how the issuer can convert the bond and consider whether you are willing to own stock in the company instead of a bond.

How Does Investing in Bonds Differ from Other Investments

There are two other types of financial instruments that people consider buying as common alternatives to bonds – bond mutual funds and stocks.  I’ll briefly explain the differences between owning a bond and each of these alternatives.

Bond Funds

There are two significant differences between owning a bond fund and own a bond.

A Bond Fund with the Same Quality Bonds Has Less Default Risk

If you own a bond fund, you are usually buying an ownership share in a pool containing a relatively large number of bonds.  Owning more bonds increases your diversification (see this post for more on that topic).  With bonds, the biggest benefit from diversification is that it reduces the impact of a single issuer defaulting on its payments.  If you own one bond, the issuer defaults and the loss given default is 50%, you’ve lost 50% of your investment.  If you own 100 bonds and one of them defaults with a 50% loss given default, you lose 0.5% of your investment.

A Bond Fund Has Higher Market Risk than Owning a Bond to Maturity

Recall that you eliminate market risk if you hold a bond until it matures.  Almost all bond funds buy and sell bonds on a regular basis, so the value of the bond fund is always the market price of the bonds.  Because the market price of bonds can fluctuate, owners of bond funds are subject to market risk.

Stocks

When you buy stock in a company, you have an ownership interest in the company.  When you own a bond, you are a lender but have no ownership rights. To put these differences in perspective, owning a stock is like owning a share in vacation home along with other members of your extended family.  By comparison, owning a bond is like being the bank that holds the mortgage on that vacation home.

Stocks Have More Market Risk

The market risk for stocks is much greater than for bonds.  Ignoring defaults for the moment, the issuer has promised to re-pay you the par value of the bond plus the coupons, both of which are known and fixed amounts.  With a stock, you are essentially buying a share of the future profits, whose amounts are very uncertain.

Stocks Have More Default Risk

The default risk for stocks is also greater than for bonds.  When a company gets in financial difficulties, there is a fixed order in which people are paid what they are owed.  Employees and vendors get highest priority, so get paid first.  If there is money left over after paying all of the employees and vendors, then bondholders are re-paid.  After all bondholders have been re-paid, any remaining funds are distributed among stockholders.  Because stockholders take lower priority than bondholders, they are more likely to lose some or all of their investment if the company experiences severe financial difficulties or goes bankrupt.

Companies often issue bonds on a somewhat regular basis.  When a bond is issued, it is assigned a certain seniority.  This feature refers to the order in which the company will re-pay the bonds if it encounters financial difficulties.  If you decide to invest in bonds of individual companies, especially less-than-investment grades bonds, you’ll want to understand the seniority of the particular bond you are buying because it will affect the level of default risk.  Lower seniority bonds have lower credit ratings, so the credit rating will give you some insight regarding the seniority.

When is Investing in Bonds Right for Me

There isn’t a right or a wrong time to buy a bond, just as is the case with any other financial instrument.  The most important thing about buying a bond is making sure you understand exactly what you are buying, how it fits in your investment strategy and its risks.

Low-Risk Investment Portfolio

If you are interested in a low risk investment portfolio, US Government and high-quality corporate bonds might be a good investment for you.  As you think about this type of purchase, you’ll also want to think about the following considerations.

How Long until You Need the Money

If you are saving for a specific purchase, you could consider buying small positions in bonds of several different companies or US government bonds with maturities corresponding to when you need the money.  If you’ll need the money in less than a year or two, you might be better off buying a certificate of deposit or putting the money in a money market or high yield savings account.  If it is a long time until you’ll need the money and you think interest rates might go up, you’ll want to consider whether you can buy something with a maturity sooner than your target date without sacrificing too much yield so you can buy another bond in the future at a higher interest rate.

How Much Default Risk are You Willing to Take

If you aren’t willing to take any default risk, you’ll want to invest in US government bonds.  If you are willing to take a little default risk, you can buy high-quality (e.g., AAA or AA) corporate bonds.  You’ll want to buy small positions is a fairly large number of companies, though, to make sure you are diversified.

How Much Market Risk are You Willing to Take

If you are willing to take some market risk, you can more easily attain a diversified portfolio by investing in a bond mutual fund.  As mentioned above, you’ll want to consider whether you think interest rates will go up or down during your investment horizon.  If you think that are going to go up, there is a higher risk of market values going down than if you think they will be flat.  In this situation, a bond fund becomes somewhat riskier than buying bonds to hold them to maturity.  If you think interest rates are going to go down, there is more possible appreciation than if you think they will be flat.

High-Risk Investment Portfolio

If you want to make higher return and are willing to take more default risk, you can consider buying bonds of lower quality.  As shown in the chart above, non-investment grade bonds pay coupons at very high interest rates.  However, you need to recognize that you are taking on significantly more default risk. One approach for dabbling in high-yield bonds is to invest in a mutual fund that specializes in those securities. In that way, you are relying on the fund manager to decide which high-yield bonds have less default risk. You’ll also get much more diversification than you can get on your own unless you have a lot of time and money to invest in the bonds of a large number of companies.

Where Do I Buy Bonds and Bond Funds

You can buy individual bonds and bond mutual funds at any brokerage firm.  Many banks, particularly large ones, have brokerage divisions, so you can often buy bonds at a bank.  This article by Invested Wallet provides details on how to open an account at a brokerage firm.

All US Government bonds, including Savings Bonds and TIPS can be purchased at Treasury Direct, a service of the US Treasury department.  You’ll need to enter your or, if the bond is a gift, the recipient’s social security number and both you and, if applicable, the recipient need to have accounts with Treasury Direct.  US Savings Bonds can be bought only through Treasury Direct.  You can buy all other types of government bonds at any brokerage firm, as well.

As discussed in this post, it is best to buy bonds in a tax-advantaged account, such as an IRA, 401(k), Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP) than a taxable account. You pay tax on the coupons every year when bonds are held in a taxable account, but you get the benefit of compounding without paying taxes along the way in a tax-advantaged account.

Investment Diversification Reduces Risk

Diversification-2

Investment diversification is an important tool that many investors used to reduce risk. Last week, I explained diversification and how it is related to correlation.   In this post, I’ll illustrate different ways you can use investment diversification and provide illustrations of its benefits.

Investment Diversification: Key Take-Aways

Here are some key take-aways about investment diversification.

  • Diversification reduces risk, but does not change the average return of a portfolio. The average return will always be the weighted average of the returns on the financial instruments in the portfolio, where the weights are the relative amounts of each instrument owned.
  • The smaller the correlation among financial instruments (all the way down to -100%), the greater the benefit of diversification. Check out last week’s post for more about this point.
  • Diversification can be accomplished by investing in more than one asset class, more than one company within an asset class or for long periods of time. One of the easiest ways to become diversified across companies is to purchase a mutual fund or exchange traded fund.  Funds that focus on one industry will be less diversified than funds that includes companies from more than one industry.
  • Diversification reduces risk, but doesn’t prevent losses. If all of the financial instruments in a portfolio go down in value, the total portfolio value will decrease.  Also, if one financial instrument loses a lot of value, the loss may more than offset any gains in other instruments in the portfolio.
  • A diversification strategy can be very risky if you purchase something without the necessary expertise to select it or without understanding all of the costs of ownership.

I’ll explain these points in more detail in the rest of the post.

Diversification and Returns

The purpose of diversification is to reduce riskIt has no impact on return.  The total return of any combination of financial instruments will always be the weighted average of the returns on the individual financial instruments, where the weights are the amounts of each instrument you own.  For example, if you own $3,000 of a financial instrument with a return of 5% and $7,000 of a different financial instrument with a return of 15%, your total return will be 12% (={$3,000 x 5% + $7,000 x 15%}/{$3,000+$7,000} = {$150 + $1,050}/$10,000 = $1,200/$10,000).  Similarly, two instruments that both return 10% will have a combined return of 10% regardless of how correlated they are, even -100% correlation.

Investment Diversification among Asset Classes

When investing, many people diversify their portfolios by investing in different asset classes. The most common of these approaches is to allocate part of their portfolio to stocks or equity mutual funds and part to bonds or bond mutual funds.

Correlation between Stocks and Bonds

Two very common asset classes for personal investment are bonds and stocks. Click here to learn more about bonds, including a comparison between stocks and bonds.  Click here to learn more about stocks.

 

The Theory

The prices of stocks and bonds sometimes move in the same direction and sometimes move in opposite directions.  In good economies, companies make a lot of money and interest rates are often low.  When companies make money, their stock prices tend to increase.  When interest rates are low, bond prices are high.[1]  So, in good economies, we often see stock and bond prices move in the same direction.

However, from 1977 through 1981, bond prices went down while stocks went up.  At the time, the economy was coming out of a recession (which means stock prices started out low and then rose), but inflation increased. When inflation increases, interest rates tend to also increase and bond prices go down. [2]

Correlation of S&P 500 and Interest Rates

Over the past 40 years, interest rates have generally decreased (meaning bond prices went up) and stock markets increased in more years than not, as shown in the graph below.

The blue line shows the amount of money you would have each year if you invested $100 in the S&P 500 in 1980.  The green line shows the interest rate on the 10-year US treasury note, with the scale being on the right side of the graph.  Because bond prices go up when interest rates go down, we anticipate that there will be positive correlation between stock and bond prices over this period. If we looked at a longer time period, the correlation would still be positive, but not quite as high because, as mentioned above, there were periods when bond prices went down and stock prices increased.

Historical Correlation of Stocks and Bonds

I will use annual returns on the S&P 500 and the Fidelity Investment Grade Bond Fund to illustrate the correlation between stocks and bonds.  The graph below is a scatter plot of the annual returns on these two financial instruments from 1980 through 2018.  The returns on the bond fund are shown on the x axis; the returns on the S&P 500, the y axis.  Over this time period, the correlation between the returns on these two financial instruments is 43%.  This correlation is close to the +50% correlation illustrated in one of the scatter plots in last week’s post.  Not surprisingly, this graph looks somewhat similar to the +50% correlation graph in that post.

Stock and Bond Returns and Volatility

Recall that diversification is the reduction of risk, in this case, by owning both stocks and bonds.  The table below sets the baseline from which I will measure the diversification benefit.  It summarizes the average returns and standard deviations of the annual returns on the S&P 500 (a measure of stock returns) and a bond fund (an approximation of bond returns) from 1980 to 2018.  The bond fund has a lower return and less volatility, as shown by the lower average and standard deviation, than the S&P 500.

Bond Fund S&P 500
Average 0.6% 0.8%
Standard Deviation 1.6% 4.3%

 

Diversification Benefit from Stocks and Bonds

The graph below is a box & whisker plot showing the volatility of each of these financial instruments separately (the boxes on the far left and far right) and portfolios containing different combinations of them.  (See my post on risk for an explanation of how to read this chart.)

In this graph, the boxes represent the 25th to the 75th percentiles.  The whiskers correspond to the 5th to 95th percentiles.  As the portfolios have increasing amounts of stocks, the total return and volatility increase.

Diversification Benefit from Stocks and Bonds – A Different Perspective

These results can also be shown on a scatter plot, as shown in the graph below.  In this case, the x or horizontal axis shows the average return for each portfolio.  The y or vertical axis shows the percentage of the time that the return was negative. (See my post on making financial decisions for an explanation of optimal choices.)

There are three pairs of portfolios that have the same percentage of years with a negative return, but the one with more stocks in each pair has a higher return.  For example, about 24% of the time the portfolios with 30% and 50% invested in bonds had negative returns.  The 30% bond portfolio returned 8.9% on average, whereas the 50% bond portfolio returned 8.5% on average.   Therefore, the portfolio with 30% bonds is preferred over the one with 50% bonds using these metrics because it has the same probability of a negative return but a higher average return.

How to Pick your Mix Between Stocks and Bonds

The choice of mix between stocks and bonds depends on how much return you need to earn to meet your financial goals and how much volatility you are willing to tolerate.  A goal of maximizing return without regard to risk is consistent with one of the portfolios with no bonds or only a very small percentage of them.  At the other extreme, a portfolio with a high percentage (possibly as much as 100%) of bonds is consistent with a goal of minimizing the chance of losing money in any one year.  The options in the middle are consistent with objectives that combine attaining a higher return and reducing risk.

Other Asset Classes

There are many other asset classes that can be used for investment diversification.  Some people prefer tangible assets, such as gold, real estate, mineral rights (including oil and gas) or fine art, while others use a wider variety of financial instruments, such as options or futures.  When considering tangible assets, it is important to consider not only the possible appreciation in value but also the costs of owning them which can significantly reduce your total return.  Examples of costs of ownership include storage for gold and maintenance, insurance and property taxes for real estate.  All of the alternate investments I’ve mentioned, other than gold, also require expertise to increase the likelihood of getting appreciation from your investment.  Not everyone can identify the next Picasso!

Investment Diversification across Companies within an Asset Class

One of the most common applications of diversification is to invest in more than one company’s stock. It is even better if the companies are spread across different industries.  The greatest benefit from diversification is gained by investing in companies with low or negative correlation.  Common factors often drive the stock price changes for companies within a single industry, so they tend to show fairly high positive correlation.

Diversification across industries is so important that Jim Cramer has a segment on his show, Mad Money, called “Am I Diversified?”  In it, callers tell him the five companies in which they own the most stock and he tells them whether they are diversified based on the industries in which the companies fall.

To illustrate the benefits of diversification across companies, I have chosen five companies that are part of the Dow Jones Industrial Average (an index commonly used to measure stock market performance composed of 30 very large companies). These companies and their industries are:

American Express (AXP) Financial Services
Apple (AAPL) Technology
Boeing (BA) Industrial
Disney (DIS) Consumer Discretionary
Home Depot (HD) Consumer Staples

 

Correlation Between Companies

The graph below shows the correlations in the annual prices changes across these companies.

The highest correlations are between American Express and each of Boeing and Disney (both between 50% and 55%).  The lowest correlation is between Apple and Boeing (about 10%).

The graph below shows a box & whisker plot of the annual returns of these companies’ stocks.

All of the companies have about a 25% chance (the bottom of the box) of having a negative return in one year.  That is, if you owned any one of these stocks for one calendar year between 1983 and 2018, you had a 25% chance that you would have lost money on your investment.

Adding Companies Reduces Risk

The graph below shows a box & whisker chart showing how your volatility and risk would have been reduced if you had owned just Apple and then added equal amounts of the other stocks successively until, in the far-right box, you owned all five stocks.

The distance between the tops and bottoms of the whiskers get smaller as each stock is added to the mix. If you had owned equal amounts of all five stocks for any one calendar year in this time period, you would have lost money in 19% of the years instead of 25%.  The 25th percentile (bottom of the box) increases from between -5% and 0% for each stock individually to +14% if you owned all five stocks.  That is, 75% of the time, your return would have been greater than +14% if you had owned all 5 stocks.

As always, I remind you that past returns are not necessarily indicative of future returns. I used these five companies’ stocks for illustration and do not intend to imply that I recommend buying them (or not).

Investment Diversification Doesn’t Prevent Losses

The above illustration makes investing look great!  Wouldn’t it be nice if 75% of the time you could earn a return of at least 14% just by purchasing five stocks in different industries?  That result was lucky on my part.  I looked at the list of companies in the Dow Jones Industrial Average and picked the first five in alphabetical order that I thought were well known and in different industries.  It turns out that, over the time period from 1983 through 2018, all of those stocks did very well.  Their average annual returns ranged from 19% (Disney) to 40% (Apple).  The Dow Jones Industrial Average, by comparison, had an average return of 10%.  That means that most of the other stocks in the Average had a much lower return.

Being diversified won’t prevent losses, but it reduces them when one company experiences significant financial trouble or goes bankrupt.  Here’s a recent example.

Pacific Gas and Electric

Pacific Gas and Electric (PG&E) is a California utility that conservative investors have bought for many, many years.  I’ve added it to the box & whisker plot of the companies above in the graph below.

PG&E’s average return (10%) is lower than the other five stocks and about equal to the Dow Jones Industrial Average.  Its volatility is similar to Boeing and Disney as shown by the height of its box and spread of it whiskers being similar to those of the other two stocks.

However, on the day I am writing this post, PG&E declared bankruptcy.  PG&E has been accused of starting a number of large wildfires in California as the result of allegedly poor maintenance of its power lines and insufficient trimming of trees near them.  Here is a plot of its daily stock price over the past 12 months.

In the year ending January 26, 2019, PG&E’s stock price decreased by 72%.  From its high in early November 2018 to its low in January 2019, it dropped by 87%.

How to Reduce the Impact of Another PG&E

Although diversification can’t completely protect you from such large losses, it can reduce their impact especially if you are invested in companies in different industries.   If the only company in which you owned stock was PG&E, you would have lost 72% of your savings in one year.  If, on the other hand, you had owned an equal amount of a  second stock that performed the same as the Dow Jones Industrial Average over the same time period (-6%), you would have lost 39%.  The graph below shows how much you would have lost for different numbers of other companies in your portfolio.

This graph shows how quickly the adverse impact of one stock can be offset by including other companies in a portfolio.  In a portfolio of five stocks (PG&E and four others that performed the same as the Dow), the 72% loss is reduced to about a 20% loss.  With 20 stocks, the loss is reduced to 10% (not much worse than the -6% for the Dow Jones Industrial Average).

Investment Diversification Over Time

Another way to benefit from diversification is to own financial instruments for a long time. In all of the examples above, I illustrated the risk of holding financial instruments for one year at a time. Many financial instruments have ups and downs, but tend to generally follow an upward trend.  The volatility and risk of the average annual return of these instruments will decrease the longer they are held.

20-Year Illustration

For illustration of the diversification benefit of time, I have used returns on the S&P 500. The graph below shows the volatility of the average annual return on the S&P 500 for various time periods ranging from one to twenty years.

To create the “20 Years” box and whiskers in this graph, I started by identifying all 20-year periods starting from 1950 through the one starting in 1997.  I calculated the average annual return for each 20-year period.  I then determined the percentiles needed to create this graph.  The values for the shorter time periods were calculated in the same manner.

The average return over all years is about 8.8%.  Because we are using data from 1950 to 2018 for all of these calculations, the average doesn’t change.

The benefits of long-term investing are clear from this graph.  There were no 20-year periods that had a negative return, whereas the one-year return was negative 25% of the time.

More Complicated Example

My post about whether Chris should pay off his mortgage provides a bit more complicated application of the same concepts. In that case, Chris puts money into the account for five years and then withdraws it for either the next five years or the next 21 years. The longer he invests, the more likely he is to be better off investing instead of paying off his mortgage.

A Caution about Individual Stocks

As a reminder, it is important to remember that this concept applies well to financial measures such as mutual funds, exchange-traded funds and indexes.  It also applies to the financial instruments of many companies, but not all.  If a company starts a downward trend, especially if it is on the way to bankruptcy, it will show a negative return no matter how long you own it.  If you choose to own stocks of individual companies, you will want to monitor their underlying financial performance (a topic for a future post) and news about them to minimize the chance that you continue to own them through a permanent downward trend.


[1]The price of a bond is the present value of the future interest and principal payments using the interest rate on the date the calculation is performed.  That is, each payment is divided by (1+today’s interest rate)(time until payment is made). Because the denominator gets bigger as the interest rate goes up, the present value of each payment goes down.    I’ll talk more about this in a future post on bonds.

[2]An explanation of the link between inflation and interest rates is quite complicated.  I’ll write about it at some point in the future.  For now, I’ll just observe that they tend to increase at the same time.