Nearly all my conversations are around income investments. It makes sense since I write about dividend investing, but equally perplexing is that many of my conversations are focused on high yielding investments to the point that it defies corporate finance.
I get it, once you are retired, you want income, and you want as much as you can. Unfortunately, your income needs to keep up with inflation, and company profits aren’t magical.
Management has to decide on how to deploy the profits which either leads to a dividend increase, or not. We often come to expect it based on historical precendent but it is reviewed every quarter.
Why is this topic important for retirees? In two words; INFLATION PROTECTION.
3 Ways To Spend Corporate Profits
It’s important you understand this concept to capture how your investment will perform.
Companies have board of directors that help the executives put plans together on how to be profitable and grow the business. Nearly all their time is spent on the first point below, as the other two points tend to be conclusions to the first topic.
However, it’s rare in the early business cycles to pay dividends and do share buyback. You should try to be familiar with the business cycle of your holdings.
- Start-up: A new launching new products or services. Rarely do they trade on the stock market. Still proving themselves ahead of an IPO.
- Growth: Successful launch and growing. Usually with rapid sales growth. Looking at an IPO and turning a profit.
- Established: Sales are slowing down from competition or saturation.
- Maturity: Sales are normalizing, and profit margins are getting thinner.
- Expension/Decline: This is an adapt, or fail turning point. Larger companies will have products go through the cycle internally at faster rate.
Profit Is Re-Invested In The Company
This is what most businesses do when they start in business. The money re-invested usually leads to more growth and it’s usually fast and compounded if the company is successful.
The money spent can cover many aspects of a business such as modernization of software/machines, mergers & acquisitions, or even employee retention strategies
This management style usually has investors solely focused on total returns.
Company Share Buybacks
At some point, when the company’s business matures, the extra cash doesn’t compound faster, and the company will from time to time decide to buy back shares.
This management style reduces the number of shares in the market with the goal of increasing the value of the remaining shares. This method also favors total returns.
Dividends Paid To Shareholders
In this case, the above two spend strategies have reached a point where it has less impact on the stock price, and the management team is looking to give money back to investors.
When a company reaches this stage, it has usually matured in its business goals. Note that I do not mean that it is a blue-chip stock, or that it is the largest company, but that the company’s management has established itself as “coasting” for lack of better words. Rogers Sugar
If you want to see dividend growth, you cannot have a business “coasting”. A business “coasting” will not give you dividend increases to keep up with inflation.
If the yield is high, it usually means less is re-invested in the business, and dividend growth will be lower. It can still keep up with inflation though, just be clear about what you need for dividend growth.
If the company does share buyback & pays dividends, it usually has a lot of extra cash to reward investors with.
The extra cash will usually lead to dividend growth, but not if it cannot re-invest some of it to stay competitive. Often times, these companies will have a lower yield.
Your dividend growth is usually the inverse of the yield. What I have come to observe is that if you take 10% and you take the yield out, the dividend growth will be the remaining percentage.
If you have a 4% yield from a common stock, you should expect 6% dividend growth (10% – 4% = 6%) if the business is not “coasting”.
Here is what my portfolio looks like. I love this chart, as it shows the proportion of my portfolio in the various space.
|wdt_ID||Dividend||None||Low Growth (< 6%)||Medium Growth (> 6%)||High Growth (> 10%)||Total|
|3||Low Yield (< 2%)||0.00||3.01||0.00||41.89||44.90|
|4||Medium Yield (> 2%)||0.00||0.00||19.72||12.20||31.92|
|5||High Yield (> 4%)||0.00||0.00||15.50||0.00||15.50|
|7||Aggressive Yield (> 6%)||0.00||3.58||0.00||0.00||3.58|
What About Distributions?
It is very critical you understand the difference between a dividend and a distribution.
Income trusts are not the same share type as common stocks. By nature of the share type, those business have to grow the profit to increase the distribution.
Most of the high yield investments you find pay a distribution, and not a dividend. Tax implications are different.
DRIP Shares Is For Compound Growth, Not For Inflation
Even if you DRIP your high yield investments, what it does is compound your portfolio growth as a total return measurement. The best total return measurement metric is the annual rate of return.
Here is what compounding does, regardless of how you do it based on your annual rate of return. Here is the growth of a TFSA account.