Q&A About 'The Income Method': Dividends Matter

Co-authored by Beyond Saving.

The Income Method is an investing strategy that we follow at High Dividend Opportunities. It is a strategy that is designed to maximize cash flow in your portfolio. From the very first investment I made, it simply "made sense" to me that I should be paid for my capital. Why would I want to buy ownership in a company that wasn't willing to share its profits with me? So I started buying stocks that paid dividends.

Over the decades, I've seen many people do quite well in the market without ever collecting a dividend. So often, I see folks arguing on the Internet about the "best" way to invest; there is no "best" way to invest. The U.S. stock market is one of the greatest generators of wealth in history, and there is more than one way to harness that power.

The Income Method is the best strategy for me. It is a strategy that:

1. Makes sense to me. When investing, you will go through difficult times. It is crucial that you have the confidence to follow your chosen strategy.
2. I can successfully follow and consistently execute. It doesn't matter how great your strategy is if you don't have the time, skills, and knowledge to implement it!
3. Fits my goals. I love having a high level of cash flow.

The primary goal of the Income Method is to provide a high immediate income. Our goal is to find investments that will start paying right now. I'm not interested in IOUs and promises of future returns; I want to start realizing those returns right now. As a result, the HDO Model Portfolio typically has an average current yield in the 8-10% range.

Today, I want to discuss a few of the common questions I often encounter about the Income Method.

Doesn't High Yield = High Risk?

As someone who is talking about stocks with yields that are typically over 8%, I frequently get comments from people who can't believe that I would invest in something so "risky." When asked why they think it is risky, they point to the yield as if the yield alone is evidence of risk.

A common bit of investing wisdom is that "high yield means high risk."

The real damage of this assertion is not to the security that has a high yield. All investments have risks, and investors should always do their research and try to understand the risks and rewards of any investment. The real danger is the implication of the opposite – that low yield implies low risk. It doesn't.

In 2023, we've seen several companies start slashing their dividends. Former dividend aristocrat V.F. Corporation (VFC) cut its dividend by 40%, Paramount Global (PARA) slashed its dividend by nearly 80%, Intel Corporation (INTC) broke its 20-year dividend hiking track record with a 65% cut, and Advance Auto Parts (AAP) cut its dividend by nearly 85%. Just one year ago, all four of these had dividend yields of 3% or lower.

Over the past three years, investors in iShares 20+ Year Treasury Bond ETF (TLT) have seen losses of 36%.

It was the price declines of "safe" investments like U.S Treasuries and agency MBS that caused the bank failures this year. Don't assume that just because the yield is low or that there is no credit risk that an investment is "safe." All investing carries an element of risk.

With thousands of potential stocks to choose from, investors love to use "screeners" to try to identify investment opportunities. They will try to find tools that estimate "dividend safety." These tools might be useful for narrowing down from thousands of stocks to a few dozen to look at further. However, they are not a replacement for your own due diligence.

Dividend safety always has to be assessed at the company level. There is no magic website or magic formula that is going to tell you whether a dividend is safe or not.

How Do Companies Maintain 8%+ Yields?

It is interesting that many investors will readily accept the assumption that stock prices should experience an 8-10% CAGR over the long run, but find it hard to believe that companies can distribute 8-10%/year in profits. They have been conditioned by investment advisors and brokerages to put their focus on the big number and focus on unrealized capital gains.

In a higher-yielding portfolio, you will often find that many of the investments are "RICs" or Regulated Investment Companies. RICs include ETFs, CEFs, REITs, and BDCs. Companies that elect to be RICs have various requirements, including the requirement to distribute most of their taxable income or face an excise tax. As a result, these companies tend to payout much higher dividends than average. You will also see MLPs, yieldcos, and partnerships, all of which are corporate structures that favor paying dividends.

Where a growth company might retain profits and reinvest them in the hopes of growing future cash flows, these dividend investments tend to be in more mature industries that require large amounts of upfront capital but produce predictable recurring cash flow.

Whether they are investing in real estate, loans, bonds, or pipelines, these companies are making large cash investments into assets that are expected to produce cash flow. The capital is raised by issuing common equity, and the shareholders, in turn, are rewarded with dividends as cash comes in.

With these investments, investors can expect that most of their long-term returns will come from dividends – expecting an 8-10% return is just average for the stock market.

Isn't Buying High Yield Sacrificing Dividend Growth?

Many investors draw a distinction between "high yield" and "dividend growth" investing. We do see periods of dividend growth even among high-yielders. For example, we've seen numerous dividend hikes from the BDCs in our portfolio. Plus, we have several holdings that have been hiking their dividends annually for decades, such as Enterprise Products Partners (EPD). So don't be in a hurry to assume that a higher yield means giving up dividend growth. However, it is fair to say that most dividend growth picks will have lower yields.

The problem with dividend growth is that you have to predict decades into the future. Consider INTC compared to PIMCO Corporate and Income Opportunity Fund (PTY) from 2003 through 2022. During that period, INTC experienced a dividend growth rate of 15.6% CAGR. That's about as good a 20-year growth rate as any investors could hope for. Source.

It took 20 years for INTCs dividend to approach PTY's dividend, and PTY even helped out a bit with a dividend cut. With INTC's dividend cut this year, it will take even longer to catch up. And note that this illustration assumes that the investor is taking out all of the cash and spending it. The PTY investor has been living a more extravagant lifestyle!

How Do You Grow Your Income?

Over the decades, on a $10,000 investment, PTY paid from $919 to $2265/year, with the main variance being whether a special dividend was paid. An investor shouldn't be sad at receiving a yield on their capital ranging from 9 to 22%! Still, the dividend isn't growing.

But what if you didn't have to rely on PIMCO management for your raises? What if there was a way to grow your income without their help? There is. One of the main tenets of the Income Method is to reinvest at least 25% of your dividend income.

Here is a look at your income if you withdrew $750 in year one, then indexed your withdrawals to inflation and reinvested the excess: Source.

Note that with this little bit of reinvestment, what was flat or declining income from PTY before is now growing income. It is also worth noting that in this scenario, INTC fails to maintain income growth as the need to sell shares to meet the cash requirements decimates the portfolio.

Trying to predict which companies will continue hiking their dividends 20+ years from now is risky business. There are only 66 Dividend Aristocrats, such a consistent history of dividend raises is not easy to achieve!

At HDO, we love to find stocks that have a high current yield and can also provide the occasional dividend raise. However, we are not going to depend on a company to keep hiking indefinitely. We take dividend growth into our own control by reinvesting a portion of our dividend income. When your portfolio has an average dividend yield of 8-10%, there is plenty of excess to reinvest! But when your portfolio is yielding 3%, there isn't.

Conclusion

The retirement industry is focused on encouraging investors to keep capital invested. This makes sense since most of the industry makes money from assets under management.

While there is a risk of retirees selling off too many of their stocks and irreparably harming their retirement portfolio, there is a more insidious risk that most never realize: Millions of retirees are living in fear of enjoying their retirement because they are afraid their portfolio won't be enough.

Retirees who could be generating a very livable income, with a reasonable amount reinvested to ensure it keeps growing, are instead pinching pennies. They are afraid to spend their money because they don't know what the stock market will do next year. They don't want to sell today because prices are so far down.

Money in the stock market is a tool. Use it. Use it to generate an income, which you can then spend freely as if you were generating an income with your own hands. Don't cheat yourself out of your golden years. Be responsible, generate an income, and live within that income – but don't settle for living off a fraction of your portfolio's potential.

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