Stock Buybacks

Apple just announced it would use $100 Billion of its cash hoard to buy back its own stock.  This Article says that S&P 500 companies spent $158 Billion during 1Q 2018 on stock buybacks – this is before the Apple announcement.  The same article (from the WSJ) argues that these stock buybacks have been effective as companies seek ways to use their cash to boost their stock prices.

Method

When a company buys back its stock, it is acting like any other investor.  It uses cash that it presumably has generated from its business operations to buy stock in the stock market, thereby taking that stock out of circulation from other investors and thereby paying cash to the investor who sold it to the company.  The laws of supply and demand work in this case:  The company acts to reduce the supply of the stock by buying some of it back, and thereby boost the price if demand stays the same or goes up.

Alternatives

How should a company deploy the positive cash flow it generates from its operations, presumably from the sale of its products or services?  Here are some (but not all) alternatives:

  1. The company could redeploy the cash back into the company in order to generate even more positive cash flow.  The decision process that follows this options is whether or not the project that they are thinking of redeploying cash into is accretive to earnings.  If the new project generates a greater profit than their already-existing operations, then the new project is accretive and the decision would be to go ahead with the new project.  If not, then not.
  2. The company could pay more to its employees – either pay the existing employees more, or hire more employees, or both.  Some companies are paying their employees more, either through higher wages or through one-time bonuses.  However, despite low unemployment (3.9% at the latest report), there is not strong upward pressure on wages in a macro sense, meaning companies don’t yet have to increase wages significantly in order to retain or hire new employees.
  3. The company could keep the cash.  It is nice for a company to have a rainy day fund.  The problem is that they don’t earn much money on undeployed cash because they mostly invest it in safe bonds or other investments which don’t offer strong returns.  It is bad for the Return on Assets ratio to keep a lot of cash.
  4. Dividends could be increased.  This is similar to stock buybacks in that it puts money into the pockets of existing shareholders.  The dividend path retains all existing stock and shareholders, whereas the buyback path seeks to pay off some existing shareholders and decrease the supply of stock.

IMO

Until wages start to grow, the buyback strategy is the best alternative for companies because it is an effective way to boost the stock price.  We may be getting to the point that wages will rocket upward, but not yet.  More likely, wages will move up slowly.  Companies are not being evil by not paying higher wages – Apple, for instance, already pays its employees very well.  Management’s first (but not only) responsibility is to its shareholders.  Lastly, tax cuts and/or a change in the tax code as it relates to cash that companies (such as Apple) keep in foreign banks are not the source of the cash used to buy back stock.  Rather, the companies’ operations are the source of the cash.  The change in the tax code merely results in more of the cash ultimately going back into the hands of the shareholders and less cash into the hands of government.

Confirmation Bias

Do you agree only with facts that support your viewpoint?  Do you make a decision about something and then go back and find evidence to support your decision and ignore facts that don’t support your decision?  If so, you may be a victim of Confirmation Bias.

Investing Problem

Confirmation bias is one of a number of logic mistakes people are guilty of when making investment decisions.  It is very difficult not to favor information or facts that back up your choices.  Confirmation bias in investing starts with a pre-conceived opinion about a stock.  The investor develops an opinion prior to looking at any of the data.  Let’s use Apple as an example.  You (as an investor) walk past an Apple store in the mall and see that it is packed with customers, and you interpolate from this that Apple’s future prospects are good.  You then go online to look up analyst reports and find that 28 of the 29 analysts that cover Apple have either a Strong Buy or Hold rating on the stock.  You conclude this is positive news that supports your positive outlook, and so you go ahead and buy the stock.  You may think you have done your own research by going to the Apple store and seeing the big crowd, but the analysts’ thoughts are not yours – they are the analysts’.  Just because they all on balance think Apple’s prospects are good doesn’t mean that Apple stock will go up.  For instance, the crowded store you saw:  Is it more or less crowded than it was 3, 6 or 12 months ago?  Or will it be more or less crowded 3 months from now?  The store evidence you saw was purely random and anecdotal.  The analyst reports you read fed your preconceived notion or bias that Apple’s prospects were good and that you would buy Apple stock.  Apple might go up, but your thought process was flawed in making the buy decision.

Herbalife

A good example of how Confirmation Bias played out in real life was Bill Ackman and Pershing Square’s shorting of Herbalife stock.  Ackman developed an opinion that Herbalife was a pyramid scheme and developed an argument based only on “evidence” that supported his position.  Ackman then went about taking a short position in Herbalife stock and then taking to the airwaves to badmouth Herbalife and thereby drive down the stock and increase the profitability of his short position.  The problem was that there was an equal amount of evidence that Herbalife’s multi-level marketing structure was legitimate and that the company’s sales were in fact growing and properly reported.  Ackman’s Confirmation Bias about Herbalife cost him dearly – as I wrote in “Short Selling” on March 13, 2018, Ackman lost at least $1 Billion on the failed Herbalife short and he has had to cut 25% of his staff as he covered the trade.

The Correct Mindset

Instead of developing an opinion and then going out and finding data that proves your opinion, you need to do it the other way around.  You need to approach it like Officer Joe Friday on Dragnet:  “Just the facts, Ma’am.”  Analyze all of the facts and then make a call based your analysis.  Don’t jump to conclusions – one of my father’s favorite sayings.  The crowded Apple store is good news, but you have to understand the context of that crowd, and determine what drives the crowd and whether it is likely to get more or less crowded in the future.

IMO

Confirmation Bias makes you feel more comfortable.  The proper method of analysis can make you uncomfortable.  Confirmation Bias is based on emotion and preconceived notions, but proper analysis is based on proper logic.  Don’t ignore data that doesn’t support your theory – at least address that data and determine whether or not it is valid.  Be more like Joe Friday, or like Missouri, the Show-Me State.  It is your money and you should not make logical mistakes with what you do with it.  Another way to minimize Confirmation Bias:  Stay diversified among asset classes, and look at mutual funds or ETF’s if you don’t have a lot of money to invest.

401K Millionaire

We Financial Planners are instructed that we should get our clients to set specific and measurable financial goals.  One goal that you should think about for yourself is to become a 401k Millionaire.  You read that phrase and you know exactly what it means:  You set a goal to have $1 Million in your 401k.  While it is not easy and it requires discipline over a number of years, such a goal is certainly attainable for those who can contribute to a 401k and who stay in their job (or at least stay in a job where they can contribute to a 401k) for many years.  If you are a public-sector employee, a 403b account has the same contribution limit so you can reach the same goal that way as well.

I enjoyed Slumdog Millionaire a few years back so here is a shot from that Academy Award-winning film from Danny Boyle:

Time Value of Money

Calculating how long it will take to become a 401k Millionaire is a simple Time Value of Money calculation on a financial calculator.  Say you start with nothing – you are young and have started a new job with a large employer.  You know you can contribute a maximum of $18,500 per year into your 401k, and you know you want to become a millionaire.  You figure, conservatively, that you can earn 5% per year on your account.  I have been using an HP 12c financial calculator for over 30 years, and I bought a new one last year.  They are much faster and less expensive than they were when I started, so I encourage you to get one or get a new one if yours is old.

To calculate how long it will take, use the following steps:

  • -$18,500 PMT (Your contribution/payment is an outflow from your standpoint, hence the negative sign)
  • $1,000,000 FV (Your Future Value goal is $1 Million)
  • 5 i (You think you can make 5%)
  • Solve for n

It turns out that n = 27, which means that you can become a 401k Millionaire if you contribute the current maximum to your account every year for 27 years.  If you are young, perhaps that 27-year-old who is just starting their first job, saving for 27 years may sound like forever.  However, if you think again about it, it really isn’t.  If you are 27 now, in another 27 years you will be 54, and you can have a 401k worth $1,000,000 if you just follow the rules.  Not easy, requires a lot of discipline, but very doable.

What if you think you can make 7% per year on average?  A little more difficult, but that’s in line with the return on the S&P 500 Index during the past 30 years.  At 7%, the time it takes to reach $1 million is reduced to 24 years.  You can have that $1 million by around Age 50 if you start early enough in your career.

A number of employers have an incentive program whereby they will match employee contributions up to a certain amount.  Employers do this to entice lower-compensated employees to save and contribute to a 401k.  Let’s assume the employer contributes $2,000 per year, which means the total of employee plus employer contribution is $20,500.  If that’s the case, and you earn the same 5% on your account, it takes only 26 years to reach $1 Million, thereby shaving 1 year off the time.  Better than a kick in the pants!

What if – there are a lot of what-ifs.  If you are intrigued by this notion of setting a tangible, measurable goal for your 401k and you are curious about how to factor in various changes to the base case of contributions, please contact me.  If you are older, or if you already have a 401k and want to know how you too can reach that goal, contact me and I can help set you in the right direction.

Two/Ten Spread

The 2/10 spread is the difference between the current yield on 10-Year US Treasury Notes and the current yield on 2-Year Treasury Notes.  The 2/10 spread in Treasuries is different than the 2/10 Split in bowling, which looks like this:

As I write this (on May Day), the 2/10 Treasury spread stands at 0.46% or 46 basis points, and it has been getting narrower.  Here is a (somewhat cut-off) chart from Investors Business Daily that shows that the 2/10 spread has been narrowing during the past few months:

Sorry that chart didn’t copy correctly but, trust me, the spread has narrowed from about 120 basis points at 1/1/17 to 46 basis points now.

Invert

The concern on Wall Street is that the 2/10 spread will invert, meaning that 2-year rates will be higher than 10-year rates.  This inverted spread has happened in the past but not for several years.  The inversion is a leading indicator of an upcoming recession.  Wall Street does not want the 2/10 spread to invert because that means the party is over or at least is most likely to end relatively soon.  It makes sense if you think about it:  If short-term rates are higher than long-term rates, that means there is greater uncertainty about the short-term than about the long-term.

The Fed

The 2/10 spread has been narrowing and is threatening to invert mostly because short-term rates have risen more than have long-term rates.  Short-term rates have risen substantially because the Fed has pushed rates higher during the past 2 years.  The Fed doesn’t set 2-year Treasury rates – market forces do – but market forces react directly to Fed moves and statements.  10-year rates are not as correlated to the Fed, so although 10-year rates have risen (about 50 basis points this year), they haven’t risen commensurate with 2-year rates.

Last week I wrote about the 10-year rate reaching 3%.  I also wrote about technical resistance levels.  Since reaching 3%, the 10-year rate has fallen back a bit and closed today at 2.96%.  I wrote that the 10-year has touched but not exceeded 3% several times in the recent past.  You could say that 3% is a Resistance level for the 10-year.  We will see if the 10-year yield is able to muscle through the resistance and stay higher than 3%.

IMO

I believe that inflation may be slightly higher than in the previous recent past but not significantly so.  I also believe this current Jerome Taylor-led Fed is not a hawkish, inflation-fighting Volker-type Fed.  The Fed has stated they intend to raise rates 3 times during 2018 and are contemplating a 4th rate raise.  I believe that the Fed will not continue to raise rates such that it will force the 2/10 spread to invert and thereby portend a recession.  As time goes on, if the 10-year doesn’t break above the 3% resistance level, I believe the Fed will re-think the 4-raise policy for 2018, and may even back down on 3 raises.  While I have also written that there is No Script for the Fed to rely on this time because we have not faced a backdrop of Quantitative Tightening, I think the threat of an inverted 2/10 spread is a more immediate factor that the Fed will consider and that they will come down on the side of letting the good times roll in the stock market.

 

Technical Witchcraft

In Finance classes that I have taken, two different instructors used the exact same phrase:  “Our next topic will be Technical Analysis, also known as “Witchcraft”.  Apparently, Finance instructors huddle together and decide what they like or don’t like, or the Chairman of the All-College Finance Department sends out a memo that tells instructors how to describe certain topics.

Instead of the Chairman of the Finance Department, I give you the Chairman of the Board, with one of his biggest hits:

Technical Analysis

Technical Analysis is everything related to looking at a chart of the past price performance of a stock and trying to derive some meaning out of the chart, or trying to predict how the stock will perform in the future based on what it has done in the past.  Disciples of Technical Analysis believe there are elements of human psychology that underlay the charts.  The increasingly prevalent world of quantitative trading has its roots in technical analysis.  Quant traders believe there are anomalies that can be found in sophisticated technical analysis that they can exploit for profit.

Resistance and Support

Two of the most well-known terms in Technical Analysis are Resistance and Support.  Resistance is a high point in the stock that was recently reached, perhaps even an all-time high.  When a stock reaches a high and then sells off, it is perhaps said that the stock is “consolidating” prior to trying to reach new highs.  The previous high point is the “resistance”, above which it will take a concerted effort by investors to achieve.  The following is an example of a Resistance line involving a stock that eventually broke above that line and made new highs:

To clarify, this is different than the “Resistance” movement that is working to thwart President Trump.

Support is the opposite of Resistance.  Support is a level which it is deemed difficult for the stock to drop below.  Here is an example of a Support line:

Moving Average

Another significant concept in Technical Analysis is Moving Average.  The most common Moving Average periods are the 50 Day and 200 Day Moving Average.  A Moving Average adds up the closing prices for each trading day and divides by the number of days.  As each day elapses, the farthest back day drops off of the average.  That’s why it is called a Moving Average.  The 200 Day Moving Average is, as its name implies, a longer-term indicator of the direction of a stock’s trading.  I use the 200 Day MA as a Sell indicator – if a stock (or an index) falls below its 200 Day MA, it is perhaps a time to sell, or at least not to buy.  Anything shorter-term, including the 50 Day MA, is not as meaningful as a trend indicator because even a 50 Day MA can be heavily influenced by short-term trading.

Efficient Market Theory

All Efficient Market Theorists, which may include you, believe Technical Analysis is worthless as a predictive tool.  Must be the Chairman of the Finance Department who sends out the memo is an Efficient Market Theorist.  If, as the Efficient Market Theory hypothesizes, stock prices are random, then there is no value to using charts of how the stock performed in the past to predict how it will do in the future.

IMO

I believe Technical Analysis can be useful as to the timing of when to buy or sell a stock.  Technical Analysis is tactics, not strategy.  I also believe Technical Analysis is more useful on a market index than it is on an individual stock.  During the “volatility spike” that commenced around February 1, 2018, the 200 Day Moving Average of the S&P 500 Index was put forward as an important line of defense for the index.  As it turned out, the 200 Day MA was touched on the downside but never really pushed through.  The S&P 500 Index has remained above its 200 Day MA, and that it has done so has provided solace to investors and traders who have been concerned that we are headed for a larger correction.  Regarding individual stocks, I believe it is more important to look at the context within which you are deciding to buy or sell.  Because most stocks trade with the broader market, and because most price movements by individual stocks can be explained by movements by the broader market, rather than to look at a stock’s technicals, it is more important to look at where the broader market is before deciding to buy or sell that stock.

3%

The 10-Year US Treasury is now yielding 3% (maybe just a bit under), which is up almost 100 basis points (1%) since late September 2017.  That is a relatively big move in a relatively short period of time, but not unprecedented.  The chart below from Bloomberg shows that the 10-Year rate moved from under 1.5% to over 2.5% during a 5 month period in the second half of 2016.  From late 2012 through all of 2013, the 10-Year moved from the 1.4%-range to 3.05%.  The point:  The 10-Year rate fluctuates more than do shorter-term rates because shorter-term rates are more pegged to Fed rate decisions.

Different This Time

What is different this time is that we are likely entering a period of Quantitative Tightening, reversing the Quantitative Easing period we had been in since the Great Recession.  This backdrop is why equity markets are not happy with the rise in rates.  Interest rate concerns are what sparked the initial correction in early February 2018.  The stock market seemed to steady itself as the 10-Year rate failed to hit the 3% marker, but the stock market now is correcting again as the 3% marker has been touched.

Bloomberg

This article from Bloomberg.com on April 20 offers a basic description of what the 10-Year at 3% means.  The main take from it, in my opinion, is that the 10-Year is set by market forces, while shorter-term rates (particularly rates under 1 year) are more tied to the Fed Funds rate.  The Bloomberg article states that the consensus of projections is that the 10-Year will end 2018 at the 3% level, meaning that rates should remain about stable for the rest of this year.  I doubt this – all markets have become more volatile this year and more volatility would mean that the end of the year will not look like it does today.

Ceiling to Floor

Another point the Bloomberg article makes is a technical one:  The 3% level on the 10-Year (Bloomberg actually uses 3.05%) could become a floor, after having been a ceiling for the past 7 years.  This means that if the 10-Year yield moves above 3.05%, it will be difficult to move it back below that yield.

IMO

Higher interest rates are a sign of a stronger economy, so you could look at the higher interest rates as good news.  I believe the stronger economy can be sustained even with the 10-year at 3%.  4% may be a different story.  Corporate earnings remain strong.  The debt-to-equity ratios of companies on a macro basis have been getting smaller, meaning that the effect of higher rates on corporate profits will not be as great as it was when the corporations had higher levels of debt.  Corporate tax rates are going down and that should more than compensate for higher interest rates.  If the consensus is right and the 10-Year rate remains around 3%, then this stock market correction will have been a buying opportunity.  Stay in the market, stay focused on the long term, and keep a diverse portfolio that can help you absorb this struggle that is playing out between those who are more concerned about higher rates and those who are not as concerned about higher rates.

Sucked Out

We are all horrified and saddened by the ordeal of Jennifer Riordan, the Southwest Airlines passenger who was nearly sucked out of the airplane and later passed away after the plane blew an engine, spewing parts that struck open the window next to Ms. Riordan.  Kudos to the brave passengers and crew that tried to help her and to the pilot who somehow landed the plane without additional deaths.  It is the worst nightmare of any of us who fly.

Metaphor

If you fly, I’m sure that you think about something like this happening to you.  Do you also think about the same thing happening to you and your investment portfolio, your life savings, in a metaphorical sense?  That something bad will happen completely out of your control which causes rapid decompression in the financial markets and your life savings get sucked out the window?  Your savings are gone, poof!  Sucked out of the fuselage of your life journey.

Safeguards

Fortunately, unless you make some really poor choices, like putting all of your life savings into something very risky, your investment portfolio will not suffer the same fate.  Markets can drop quickly – the 1,000+ point drop in the DJIA on February 5 was a case in point – but even that was only 4%, and markets have somewhat stabilized since then.  The poor choice that would have resulted in your portfolio being sucked out the window then was being extremely short the VIX Volatility Index.  No able financial advisor would have recommended going all-in on the short-the-VIX strategy.  Old enough to remember the 22% drop on October 19, 1987?  If your seatbelt was strapped on, you were able to ride that short-term turbulence and recover your losses from that day in short order.

My point is that the stock (or bond) market doesn’t experience rapid decompression to zero.  It does take some time, and you can take steps while it happens to make sure you can land your aircraft and live to fight another day.

Further

Carrying the metaphor even further, what else can you learn from the SWA Flight 1380 ordeal?

  • Don’t Sit in the Window Seat:  This is not at all a criticism of poor Ms. Riordan.  She did not do anything wrong.  However, the window passenger is the first to get sucked out if the window blows out.  Metaphorically, don’t position your portfolio to get sucked out if something really bad happens.  For instance, don’t put all of your savings into the stock of one company.  What if you wake up one day and you find out that company was a fraud, or did something illegal?  I guess Enron comes to mind, as does Madoff.  Don’t be 100% leveraged to one company.  Diversify among asset classes and among brokerage and bank accounts.
  • Keep your Seat Buckled:  Ms. Riordan was buckled in but she got sucked out anyhow.  If you and your portfolio are “buckled in”, along for the ride and on the journey for the long haul, you will be better able to ride out turbulence, even turbulence that claims some victims.
  • Fly with an Experienced Pilot:  An experienced financial advisor that has been through turbulence and knows what to do when you hit a few bumps can help guide you to land safely.  If for no reason other than to get a second opinion as to your potential vulnerability in the event of rapid decompression in the markets, do yourself and your portfolio a favor and contact me or your trusted advisor.  It will help you with your peace of mind.

Paying Down Debt = Buying Bonds

Financial planners like to put clients into investment portfolios that are neatly boxed in, such as 60% stocks and 40% bonds, or 70%/30%.  In my opinion, such a portfolio split is ok only after all of the client’s debt is paid off.  At least, all non-mortgage debt should be paid off prior to investing in any bonds, and even then it is debatable as to whether it makes sense to invest in bonds.

Spread

Mortgages now are in the 4%-range, as are perhaps car loans.  Student debt is now in the 8% range.  Credit card debt is in the high-teens.  Why would you invest in say a bond fund that pays 5% while at the same time you have a mortgage, student loan debt, a car loan, and maybe even unpaid credit card balances?  It doesn’t make economic sense.  Banks make money on their “spread”, which is the difference between what they earn on loans and what they have to pay to depositors.  If you have unpaid loan balances, you probably have a negative spread, meaning that you are borrowing money at a higher rate than what you are earning by lending it out.  Investing in bonds is equivalent to lending money to the party from whom you are buying the bonds, including the US Government if you are buying US Treasury Securities.  No bank would stay in business if it lent at a higher rate than that at which it borrowed.  You shouldn’t, either.

Mortgages

Mortgages are somewhat different because individuals can deduct the mortgage interest on their taxes.  However, the new 2018 tax law will increase the Standard Deduction to $24,000 for Married Filing Jointly, which means that, unless your itemized deductions (including mortgage and all other itemized deductions) exceed $24,000, then it is unlikely you will opt to deduct your mortgage interest.  The new tax law also reduces the amount of mortgage that can be deducted from $1 Million to $750,000.  The point is that the tax favorability of mortgage interest is reduced starting in 2018.  So, in my opinion, it is a push as to whether it makes sense to buy a bond fund or pay off or pay down your mortgage.  The money in and the money out will be about the same even after taxes.

Less Current Income Needed

In addition to portfolio balance and risk mitigation, another important reason why investors buy bonds or other debt instruments is for current income.  They need the incoming interest payments to live on.  If you pay down debt, you reduce your burn rate, meaning that you will need less income from the bonds that you are buying.  By reducing your monthly outflow, you will accomplish the same goal of balancing your income and expenses at the end of each month as you would have had you kept your outflow the same and increased the amount of your inflow.  It is easier and makes more sense just to reduce your outflow by paying down your debt burden.

IMO

It is a different story in your retirement account because you can’t use retirement account money to pay off debt.  Do the 70%/30% allocation split in your 401k.  However, if you are sitting there with a mortgage, car loan, student loan, or especially credit card outstanding balances, do yourself a favor that makes complete financial sense and use any excess investment money that you were thinking about allocating to a bond fund and instead allocate it toward paying down those loan balances.  Also:  Pay down the loan balance with the highest interest rate first.  This may be the subject of another blog post.

Copy The Pros

My father thought he could improve his golf game by watching closely other good golfers at his club and copying swing tendencies he thought were good.  For instance, one golfer had a slight hesitation at the top of his backswing before starting his downswing, so my father copied that move.  Did it work for my father?  Sometimes, but that’s not the point.  The point is, my father tried to emulate those that were better than him.  There is a lesson there for your financial planning.

This article shows that, the wealthier you become, the more you tend to pay down debt rather than accumulate more assets.  Maybe it is time for you to start doing the same!  If you aren’t already doing so, use any extra money you come into to pay down debt rather than to buy something else.  Save more, spend less.

The Millionaire Next Door

Twenty-two years ago in 1996 Thomas Stanley and William Danko published “The Millionaire Next Door“.  In it, they describe habits and tendencies of wealthy people from all walks of life, and who mostly live in blue-collar neighborhoods.  Some of the common traits among wealthy people (which they call Prodigious Accumulators of Wealth) were as follows:

  • Spend less than you earn
  • Don’t buy too expensive of a house.
  • Don’t go into debt
  • Buy a used car, and buy it by the pound:  Don’t buy an expensive small sports car
  • Don’t try to Keep Up with the Joneses
  • Take a financial or investment risk only if the odds are in your favor
  • Don’t bail out your own deadbeat children

Stanley and Danko’s point was the same:  If you emulate those that are already wealthy, you are more likely to become wealthy yourself.

Find Someone to Copy

If you are not where you want to be financially or in life, or if you just want to improve your current position, instead of inward soul searching, just go out and find someone who is successful at what you want to do and copy what that person is doing.  Your role model can be someone famous or they can be someone in your own family or neighborhood.  They can be world-renowned for what they do or just good in your own opinion.  You can talk to your role model before setting about to change your life, or you can just wake up one morning and set to the task.   You don’t need to copy everything the role model does, just those things that make your role model successful.  Tweak it so that it works for you.

A Good Financial Planner

If you are still struggling to find a role model, especially in your financial life, I would be glad to provide assistance.  Though I am not holding myself out there as a role model, I can help you come up with a plan that will help you get you to where you want to be, and I can provide examples of people who are successful in getting their financial lives in order.  For some people, working with another person, a qualified, caring financial planner, is the only way they are able to understand their financial goals and get the help they need to get there.

 

Duration for Stocks

As I wrote in my previous post, Duration risk is the price risk sensitivity of a bond due to changes in market interest rates.  What about dividend-paying stocks?  Do they also have Duration risk?  There have been many academic studies about this, and the conclusion is that dividend stocks do exhibit price risk similar to Duration risk in bonds.

Higher Dividend = Higher Duration Risk

This study by a couple of doctoral students concludes that stocks that pay a higher dividend exhibit traits that are consistent with a higher Duration risk.  I use Finviz.com, a free stock charting site that also has a Screener function.  With Finviz.com, you can screen for stocks that pay a dividend of 4% or over, for instance.  (The dividend percentage is the last dividend paid per share divided by the current stock price).  You can input other parameters as well, such as sector or market capitalization.  In doing this, you can find stocks that pay 7%, 8% or even more.

There are stocks wherein dividends amount to the bulk of the total return you expect from investing in that stock, and there are other stocks wherein you invest hoping for price appreciation, and, oh, by the way, the company also pays dividends.  Utility companies are examples of the former – stocks that pay relatively large dividends – and Microsoft is an example of the latter – growth stocks that also pay dividends.  If interest rates go up or are expected to go up, you would expect that utility stocks would get hurt more than would Microsoft, because the dividend is so important to the total return to the utility stock investor.  Thus, you could say that stocks that pay a higher dividend, or for which the dividend is more important, have more Duration risk than does a Microsoft, even though Microsoft’s current dividend rate is no small change at 1.86%.

Back to my Finviz.com example, when I do my screen for higher dividend stocks, and then sort by dividend yield, I would expect that the highest dividend-paying companies (in terms of dividend yield) would have more Duration risk than do the companies lower on the list.

Again, Why Should I Care?

This is important to you if you are seeking a higher yield and investing in dividend stocks as an alternative to traditional bonds or other fixed-income.  Just because you are investing in stocks instead of bonds doesn’t mean that you are avoiding Duration risk.  Dividend-paying stock prices are at risk if interest rates are seen to be on the uptrend, as they are now.  Indeed, the Dow Jones Utility Index declined about 15% from early December 2017 through early February 2018, as interest rates ticked up.  This is a real-life example of Duration risk in stocks.

Oil Stocks

Many of the large oil companies – the Exxons, Chevrons, Shells and the like – pay strong dividends, sometimes in the 4% to 5%-range.  I don’t think these companies contain as much Duration risk as do other pure-dividend plays such as utilities and real estate investment trusts.  The reason is that the companies themselves have opportunities for growth over and above what is offered through the dividend.  Put another way, investors invest in Big Oil possibly for dividends but more so for the potential growth in the oil business.  This is just my observation, not through the aforementioned study by the doctoral students.

IMO

My point is to give you another way of looking at dividend stocks and the inherent risks therein.  If you are “reaching” for a dividend by investing in a company that pays a very high dividend, you must be aware that your investment is subject to Duration risk through a decline in price as interest rates rise.  Lastly, I am not forecasting a rise in interest rates, but others are and the market narrative is that rates will rise.  Let’s see how it plays out.  Again, contact me if you want to explore this futher.