In addition to the cash dividends that the Board of Directors chooses to send out to the owners of the business every three months, there are two other things that will be responsible for driving your total return: the growth rate of your investments, and the valuation of those investments.
It is those last two things “growth rate of investments” and “valuation of those investments” that lead me to shy away from bonds, utility stocks, and REITs at this point in time. Right now, the ten-year treasury is only yielding 3%. Not only do rates like that not help you build wealth, but they actually make you poorer. You sit there collecting your 3%, pay your taxes on it, and then see your purchasing power decrease over time due to a long-term inflation rate in the 3-4% range. The point of investing is that you are setting aside capital so that you grow richer; with ten-year treasury bonds, you are currently on pace to grow modestly poorer over the passage of time.
In the case of utilities and REITs, they are trading at valuations that are not particularly conducive to building wealth right now. With utilities, growth is capped at 6-8% annually in most cases because utility companies carry large amounts of debt and need to rely on rate increases from regulators to secure growth. This comes with a consequence; overpaying for utilities is much more problematic than overpaying for something like Coca-Cola or Colgate-Palmolive because you don’t get a high 9-12% earnings per share growth rate that allows the companies to “grow” into their valuations.
The other sector which is typically part of income portfolios are REITs, and a lot of valuations in that sector make little sense to me. Federal Realty Trust is an excellent real estate company that has been raising its payout for about four decades, but it is not a company I would want to buy today. Before extraordinarily low interest rates came along, Federal Realty traded at 12-16x its funds from operations. In other words, its current “profit” of $4.50 per share would be valued between $54 and $72 per share. The current price is over $100. You’re not stacking the odds in your favor when you are going to be sitting on a decline of at least 30% in share price when interest rates inevitably rise. That’s not shrewd asset planning.
If you are interested in high current income, then you should be looking at things like BP and Royal Dutch Shell. They are both slightly to moderately undervalued, and have $100 billion or more in energy reserves backing the company up. It’s one of the few ways to secure a dividend of around 5% without overpaying for a stock.
If you are looking for a safe, reliable, sturdy dividend, and are looking to pay fair value, then you should be looking at a company like Coca-Cola. There it is, sitting right in front of us, trading at 20x earnings. In Coca-Cola’s trading history, investors that got their hands on shares have always done quite well (usually around 11% or better) if they paid 20x earnings or less for their Coca-Cola shares and held on for a very long time. My guess is that Coca-Cola at $40 in 2013 is going to be one of those things that people will look back upon ten, twenty, thirty years from now and think, “I can’t believe I could have gotten shares of Coca-Cola stock at that price and got distracted by something else.” Buying a company that has profits for 76 of the last 80 years, and has raised dividends for 50 years running, is a beautiful thing. No one is sitting on his deathbed thinking, “I wish I didn’t buy a block of Coca-Cola stock to take care of me during my retirement years.”
In a nutshell, those are my thoughts as we fine tune our portfolios heading into 2014. Bonds, REITs, and utilities generally do not present good deals right now. That is the result of the prevailing low interest rates, and when they increase, you will be able to get better deals on all three. If you want higher current income without overpaying, look to the big ‘ole international oil giants. And if you want to do something sturdy and make an investment that will give you more and more money for the next few decades, then it probably makes sense to take a good, hard look at Coca-Cola.