Quest for yield (It’s Not As Easy As It Seems)

Some thoughts which I has crossed my mind recently.. (other than the hot weather)

Dividend investing

A few days ago, I was talking to one of my colleague, and found out that he is an investor, or more specifically a dividend investor. I am glad he is an investor.

There are different variations of investors: Growth investors (GARP), Value Investors / Deep value investors (Net-Net), Dividend investors, etc (then there are those that just copy what other great investors do …:p just kidding). This is in contrast to traders. Although the values of the different forms of investors are not the same, however, they basically originate from the value investing ideas of Benjamin Graham. The core principles are the same, to view an investment from its fundamentals, and not from its stock prices / volumes / trend movements.

“The moment you make passive income and portfolio income a part of your life, your life will change. Those words will become flesh.” – Robert Kiyosaki

So my colleague started telling me that he invests in REITs, or other high yield stocks like bank stocks, Telcom stocks, Utility stocks etc..  He said that most people like REITs because they are easy to understand etc.

Ok, before we continue further, please note that I don’t study much into REITs or bank stocks, Telcom stocks, Utility stocks etc, So I am basically taking a macro view.

I think dividend investing is a smart way of investing (and of generating passive cash flow), and many financial bloggers have done that (and excel in it). However, just purely looking at dividend yield is dangerous.

I told him that although dividend is important, but I felt that most of these companies / stocks have high debt structure and in an increasing interest rate environment it might be too late to go in. Also I don’t particularly like the rights issues (or private placements) by many of the REITs, whereby I need to purchase more to avoid dilution of my holdings. In typical companies, I rather they repurchase their stocks at low prices.

Exposed! 3 Things Investors Should Know About Keppel REIT (read here)

Well, to this he says that since REITs pay out most of their profits (90%) as dividends, they need money for upgrading of existing properties or to purchase more properties.

Frankly, I do not find REITs investing easy.. there are many variables. Likewise, property developers, banks, financial institutions are often big complex entities, and one really need to understand the multi structures & the proper use of financial leverage before investing. I need to first convince myself before pressing the buy button. Come to think of it, investing in general is simple in concept but never easy.

REITs operating in different sectors with different lease periods: Healthcare, Residential, Commerical, Industrial etc.. and then there is the Forex risks. However, please note, that I don’t completely write off REITs, they do have their merits.

a) Net Asset Value

For instance my colleague talked about how he evaluate using NAV (Net Asset Value). To this I asked him – who came up with the NAV then? Eg. Realty companies? I reckon it would be the same way a real estate agent quote any property.

Think about it, when a real estate agent appraise a property, how does he do it, and if you are to appraise a property which you wish to buy for investment, how would you do it? A property agent would probably quote the price of a similar property nearby and says that your property is worth somewhere around that price (and prices of property will always go up in the future). On the other hand, if you are looking at it as an investment, you would probably be thinking in terms of the possible cash flow yield you are getting eg. Total rent minus Cost of purchase, taxes, interest on loans, maintenance, management fee, utility fee, etc. If the yield is negative, it is technically not an asset.

The NAV is a moving / fluctuating figure. It fluctuates as per market conditions. Even if we only consider properties and cash, and exclude other assets which are less valuable and stable (eg. uncompleted properties or those for sale), the value is still not completely accurate. For example,  CNAV (Conservative Net Asset Value) strategy – investing in stocks below current valuation and not future valuation.

Then there is the notion of Historical Cost (minus depreciation cost) – which tends to be more accurate. It is basically the original purchase price of the property minus the yearly depreciation value of the property. Typically for leasehold properties (esp. those with short leases like 10 or 30 years), the value of the properties will be reduced as the years progresses. For longer lease properties, value may appreciate due to inflation and improving economy but near the end of the lease, the value will drop. But then again, the original historical cost may not be reflective of the true cash flow yield of a property.

The way Value investors or GARP investors value a company is to use its historical earnings (or other metrics) and calculate the intrinsic value, much like how investors value a property base on its projected cash flow.

Buy or Rent? Learn the Rule of 15 (read here)

b) High Debt & Low growth

I don’t particularly like companies with high debt. I can understand why banks /financial institutions or property developers/REITs require high debt. However, for the sake of illustration, to simplify, let’s think of typical companies. Companies that pay out high dividends typically are big mature companies with very little growth prospects (ok, I may be generalizing here but bear with me).

Think of telecommunication companies, the Singapore market (for telecommunication services)  is saturated, growth is capped. The best way to reward investors is to issue out the profits as tax free dividends. Investors typically do not invest in these companies for growth prospects. For the telecommunication companies themselves, debt financing is the preferred choice of financing for them.

Four Things to Dislike about the Telecommunication Industry (read here)

Although the instant gratifications of dividends is great (a bird in the hand is worth two in the bush) – you get significant cash yearly, but in the long term, a zombie like company with no growth is not going to out-perform. For instant, the moment a new change occur (in the business structure or innovations in other products), this could very well threaten the rigid models of these companies. The recent announcement of a 4th telecommunication company in Singapore is affecting the stock prices of the listed telecommunication companies here. Future profit margins / dividend could also be adversely affected.

Commodity-like pricing: Simply said, the pricing power of the companies is still rather weak.

IDA wants fourth telco, auction slated for Q3 this year and new player could go online by April 2017 (read here)

Telco Price Wars In Singapore – At What Cost Though? (read here)

Then of course, at the core, dividends are derived from profits. With diminishing profits, eventually the high dividend payout will cease. Ultimately it is the business fundamentals that is important. And at the end of the day, a business moat is important.

Rickmers Maritime: A Strong Dividend Yield Play Or Trap? (read here)

3 Stocks That Are Nothing but Dividend Yield Traps (read here)

And coming back to REITs, this is why rights issues or private placements are needed for many of them, since they need to upkeep and increase their inventory of properties to maintain or achieve better yield.

For typical companies, if you think along the line of a business owner (rather than a dividend receiving investor), would you rather get the cash (from profits) every quarter or year, or rather have the cash reinvested back into the company if it generates returns on equity (ROE) or return on invested capital (ROIC) well in excess of 15% to 25%?

Frankly, I find it hard to find that kind of yield in Singapore (be it bonds, savings, stocks etc). Perhaps P2P loans maybe (but the risk is higher). I would much rather the company do the work for me eg. reinvest back in the company and generate better yield. Of course, growth is never constant… but then, there are companies with consistent historical high growth and low debt (to this my colleague says: “Got meh?”).

The cash flow is still there, just that it is not with you. It is cash flow within the company. As a business owner, I can choose to draw the cash out and spend it / reinvest elsewhere or throw it back in the company to create more growth (most young high growth companies founders do the latter).

However, having said that, if the company is not able to have high ROE or ROIC in the future, it would be better to just issue out the profits as dividends. The worst is if the company has negative growth, high debt and still continue to issue most of its profits as dividends (instead of paying off the debt or reinvesting to achieve better growth).

 

In gist, I think it is great that we think in terms of cash flow when investing… but that is just the beginning. The “how to do it” part is a bit more tricky.

Like I said before, some time back, I started to think in terms of companies fundamentals first… dividend yield is important but it is not at the top of my list (still somewhere up there though).

Nowadays when I think of yield, I think of P2P loans.

“Be the bank… not the banker” – Robert Kiyosaki

 

Shall leave you with this cute little song. We are always learning and moving forward in our investing journey…. we will trip and fall, what is important to learn from our mistakes and move on.