Income Investing: 3 Rules for Capital Preservation
The ultimate goal of every investor is to build wealth. But it’s also important to have a long-range plan. As an investor, you should assess your personal situation and understand your level of risk tolerance.
Sure, you want to generate income. But at the same time, you also need to preserve capital.
If you make a lot of risky investments, your return will be volatile. You will have some big winners, but you will also have some big losers. The frequent ups and downs of aggressive investing aren’t for everybody. Importantly, you should not risk money you can’t afford to lose.
Other investors prefer a conservative strategy. Usually these are older folks who already have a substantial nest egg and just want to preserve that capital and generate a steady return from their investments. They don’t need to swing for the fences every time; they just want some consistent base hits and avoid frequent strikeouts.
A common strategy for conservative investors is income investing. This is a strategy that concentrates on steady generation of income — typically, bond coupon payments or stock dividends. In recent years, low fixed-income yields have made income stocks an attractive choice.
An income stock, of course, pays regular and in some cases growing dividends. You need to pick the right income stock, without losing principal. Here are three rules to follow.
1) Beware of “Yield Traps”
When picking income stocks, it’s important to look at more than just the stock’s dividend yield. For example, a $10 stock that pays $1 in dividend per share per year will have an indicated yield of 10% ($1/$10).
The 10% yield looks tempting on the surface, but you must dig deeper. Sometimes, a high-yielding stock is a “yield trap” that can snap shut on you. These stocks boast unsustainable yields that can get cut or eliminated.
Important factors to consider:
Is the company generating enough operating cash flow to pay for the dividend? If yes, how well does the cash flow cover the dividend? If not, how is the company coming up with the cash to pay for the dividend?
You should find out if the dividend is sustainable, and better yet, if there’s a good chance for future dividend growth.
2) Avoid Risky Yield Growth
Stocks with abnormally high dividend yields are usually risky. To understand why, consider the following.
If a company increases its dividend and the stock price does not change, the yield will rise. But if a company increases its dividend because it’s doing well, it will for sure attract buyers, and the stock price will go up. Therefore, the yield will actually not change much. In fact, it could even go down, depending on how much demand there is for the stock.
On the other hand, if investors don’t believe a company will do well and they don’t believe the dividend is sustainable, they will demand a higher yield. Translation: Investors won’t buy unless the stock price were lower. When the dividend stays the same, but the stock price falls, yield rises.
3) Look for Steady Businesses
For conservative income investors, it’s crucial to invest in companies with stable businesses and high floors. These companies have the types of businesses that enjoy steady demand and hold up well during rough economic times.
If a company’s revenue and profit don’t fall significantly during recessions, its dividend is likely safe. This is why companies in the utility, telecom, and consumer staples sectors have traditionally been popular choices for income investors even though they usually aren’t growing very fast, if at all.
At the same time, because they don’t have much growth, these companies’ share prices usually don’t rise very much, especially during periods when overall market sentiment is high. During these periods, investors tend to prefer growth stocks. For conservative investors whose top priority is to receive a dependable stream of dividend payments, though, that is an acceptable trade off.
Again, it’s important to understand your investment goals to strike a proper balance among growth, income and risk. Above all, you must preserve capital.
In this article, I’ve talked about income stocks. But they are just one way to generate income. My colleague Jim Fink, chief investment strategist of Options for Income, has developed a system for generating high income under any market conditions. His method works during bull or bear markets, economic booms or busts.
Jim’s technique is based on a decades-old, tried-and-true practice that was common among pit traders on the exchange floor of the Chicago Board of Trade.
As Jim puts it: “It is, quite simply, the most sensible way I’ve ever found to generate large amounts of investment income, practically on demand.”