Tag Archives: Investing

Fear of Higher Interest Rates Ending Technology Stocks Growth

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Technology stocks have been the driving force behind the longest-running bull market in history.

The technology sector is vast, comprising gadget makers, software developers, wireless providers, streaming services, semiconductor companies, and cloud computing providers, to name just a few, according to Motley Fool. Any company that sells a product or service heavily infused with technology likely belongs to the tech sector.

And, the pandemic has been mostly positive for the tech industry. Companies like Amazon have thrived as consumers shifted hard toward e-commerce. Additionally, companies like Microsoft have also done well, buoyed by demand for collaboration software, devices, gaming, and cloud computing services as people spend more time at home.

Many of the most valuable companies in the world are technology companies.

Growth stocks have outperformed for 12 years and counting. Since the end of the Great Recession in 2009, growth stocks have been a driving force on Wall Street. Many of the most valuable companies in the world, like Apple and Microsoft, are technology companies.

Historically low lending interest rates and the Federal Reserve’s ongoing quantitative easing measures have created a pool of abundant cheap capital that fast-paced businesses have used to expand operations and investors have used to fuel the longest running bull market.

Technology stocks have been a key component of the market’s rising trend. Since the financial markets collapsed, demand for consumer electronics and related products and services has caused the tech sector to far outperform every other segment. 

However, revenue growth is starting to slow, although the delta variant surge may drive consumers away from stores once again. The economic dynamics favoring technology’s 12 year growth are changing.

Inflation is running rampant, and the Federal Reserve has indicated it’s become more hawkish on fighting it, indicating as many as three interest rate hikes may be in the cards calendar year 2022, effectively ending its loose money policy. Higher interest rates hurt growth stocks because growth stocks intrinsic value is based on the value of their future earnings. And, those future earnings are not worth as much if interest rates go up.

To best analyze tech stocks, first determine if the company is profitable or not.

For mature tech companies that produce profits, the price-to-earnings ratio is a useful metric. Divide stock price by per-share earnings and you get a multiple that tells you how highly the market values the company’s current earnings. The higher the multiple, the more value the market is placing on future earnings growth.

Many tech companies aren’t profitable, so the price-to-earnings ratio can’t be used evaluate them.

Revenue growth matters more for these younger companies.

If you’re investing in something unproven, you want to make sure it has solid revenue growth.

For unprofitable tech companies, it’s important that the bottom line be moving from losses toward profits.

As a company grows, it should become more efficient, especially when it comes to the sales and managing expenses. If it’s not, or if spending is growing as a percentage of revenue, that could indicate something is wrong.

Ultimately, a good tech stock is one that trades at a reasonable valuation given its growth prospects.

Accurately figuring out those growth prospects is the hard part. If you expect earnings to skyrocket in the coming years, paying a premium for the stock can make sense. But if you’re wrong about those growth prospects, your investment may not work out.

Thus, investing in technology stocks can be risky, but you can reduce your risk by investing only when you feel confident their growth prospects justify their often lofty price to earnings valuations.

References:

  1. https://www.fool.com/investing/2022/01/20/2-top-tech-stocks-ready-for-a-bull-run/
  2. https://www.fool.com/auth/authenticate/
  3. https://www.fool.com/investing/stock-market/market-sectors/information-technology/

Financial Freedom

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“It’s the ability to live and maintain the lifestyle which you desire without having to work or rely on anyone for money.” T Harv Eker

Financial Peace guru Dave Ramsey proclaims that “Financial freedom means that you get to make life decisions without being overly stressed about the financial impact because you are prepared. You control your finances instead of being controlled by them.”

It’s about having complete control over your finances which is the fruit of hard work, sacrifice and time. And, as a result, all of that effort and planning was well worth it!

Nevertheless, reaching financial freedom may be challenging but not impossible. It also may seem complicated, but in just a straightforward calculation, you can easily estimate of how much money you’ll need to be financially free.

What is financial freedom? Financial freedom is the ability to live the remainder of your life without outside help, working if you choose, but doing so only if you desire. It’s the ability to have the things you want and need, despite any occurrence other than the most catastrophic of outside circumstance.

To calculate your Financial Freedom Number, the total amount of money required to give you a sufficient income to cover your living expenses for the rest of your life

Step 1: Calculate Your Spending

Know how much you are spending each year. If you’ve done a financial analysis (net worth and cash flow), created a budget, and monitored your cash flow, then you’re ahead.

Take your monthly budget and multiply that amount by 12. Make sure you include periodic expenses such as annual premiums and dues or quarterly bills. Also include continued monthly contributions into accounts like your emergency fund, vacation clubs, car maintenance, etc.

Add all these together to get your Yearly Spending Total.

Keep in mind the lower the spending total, the lower the amount of money you’ll need to become financially independent. Learn how to lower your monthly household expenses and determine the difference between needs and wants.

Step 2: Choose Your Safe Withdrawal Rate

The safe withdrawal rate (also referred to as SWR) is a conservative method that retirees use to determine how much money can be withdrawn from accounts each year without running out of money for the rest of their lives.

The safe withdrawal rate method instructs financially independent people to take out a small percentage between 3-4% of their investment portfolios to mitigate worst-case scenarios. This withdrawal percentage is from the Trinity Study.

The Trinity Study found the 4% rule applies through all market ups and downs. By making sure you do not withdraw more than 4% of your initial investments each year, your assets should last for the rest of your life.

Step 3: Calculate Your Financial Independence (FI) Number

Your FI number is your Yearly Spending Total divided by your Safe Withdrawal Rate.

To find the amount of money you’ll need to be financially independent, take your Yearly Spending Total and divide it by your SWR.

For example:

  • Yearly Spending: $40,000
  • Safe Withdrawal Rate: 4%

Financial Independence Number = Yearly Spending / SWR

  • $40,000 / 0.04 = $1,000,000

Who becomes financially free? According to most financial advisors, compulsive savers and discipline investors tend to become financially free since:

  • They live on and spend less they earn.
  • They organize their time, energy and money efficiently in ways conducive to building wealth.
  • They have a strong belief that gaining financial freedom and independence is far more important than displaying high social status and financial symbols.
  • Their parents did not keep on helping them financially.
  • They have a keen insight to recognize financial and wealth building opportunities.

Net worth is the most important number in personal finance and represents your financial scorecard. Your net worth includes your investments, but it also includes other assets that might not generate income for you. Net Worth can be defined to mean:

  • Income (earned or passive)
  • Savings
  • Investing to grow and to put your money to work for you)
  • Simple and more frugal lifestyle

Financial freedom means different things to different people, and different people need vastly different amounts of wealth to feel financially free.

Maybe financial freedom means being debt-free, or having more time to spend with your family, or being able to quit corporate America, or having $5,000 a month in passive income, or making enough money to work from your laptop anywhere in the world, or having enough money so you never have to work another day in your life.

Ultimately, the amount you need comes down to the life you want to live, where you want to live it, what you value, and what brings you joy. Joy is defined as a feeling of great pleasure and happiness caused by something exceptionally good, satisfying, or delightful—aka “The Good Life.”

It is worth clearly articulating what the different levels of financial freedom mean. Grant Sabatier’s book, Financial Freedom: A Proven Path to All the Money You’ll Ever Need, the levels of financial freedom are:

Seven Levels of Financial Freedom

  1. Clarity, when you figure out where you are financially (net worth and cash flow) and where you want to go
  2. Self-sufficiency, when you earn enough money to cover your expenses
  3. Breathing room, when you escape living paycheck to paycheck
  4. Stability, when you have six months of living expenses saved and bad debt, like credit card debt, repaid
  5. Flexibility, when you have at least two years of living expenses invested
  6. Financial independence, when you can live off the income generated by your investments and work becomes optional
  7. Abundant wealth, when you have more money than you’ll ever need

The difference between income and wealth: Wealth is accumulated assets, cash, stocks, bonds, real estate investments, and they have passive income. Simply, they don’t have to work if they don’t want to.

Accumulating wealth and becoming wealthy requires knowing what you want, discipline, taking responsibility and have a plan.

Hundreds of thousands of Americans have great incomes, but you wouldn’t call them wealthy because of debt and lack of accumulated assets, instead:

  • They owe for their homes
  • They owe for their cars and boats.
  • They have little savings and investments
  • They have few “paid for” assets
  • They have negative net worth

Essentially, if you make a great income and spend it all, you will not become wealthy. Often, high income earners’ true net worth is far less than they think it is.

Here are several factors and steps to improve your financial life:

  • Establishing financial goals
  • Paying yourself first and automate the process
  • Creating and sticking to a budget. Know where you money goes.
  • Paying down and/or eliminating credit card and other bad debt. Debt which is taking from your future to pay for your past.
  • Saving for the future and investing for the long term consistently
  • Investing the maximum in your employer’s 401(k)
  • Living on and spending less than you earn
  • Simplify – separating your needs from your wants. You don’t need to keep buying stuff.

Financial freedom can look something like this:

  • Freedom to choose a career you love without worrying about money
  • Freedom to take a luxury vacation every year without it straining your budget
  • Freedom to pay cash for a new boat
  • Freedom to respond to the needs of others with outrageous generosity
  • Freedom to retire a whole decade early

When you have financial freedom, you have options.

“Your worth consists in what you are and not in what you have. What you are will show in what you do.” Thomas Edison

References:

  1. https://www.phroogal.com/calculate-financial-independence-number/
  2. https://www.ramseysolutions.com/retirement/what-is-financial-freedom
  3. https://thefinanciallyindependentmillennial.com/steps-to-financial-freedom/

Discounted Cash Flow

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Investments are the discounted present value of all future free cash flow.

Discounted cash flow (DCF) is a method of investment valuation in which future cash flows are discounted back to a present value using the time-value of money.

Present value (PV) is a financial calculation that measures the worth of a future amount of money or an investment’s future cash flow in today’s dollars adjusted for interest and inflation. In other words, it compares the buying power of one future dollar to purchasing power of one today.

PV is an indication of whether the money an investor receives today can earn a return in the future. Investors calculate the present value of a firm’s expected cash flows to decide if the stock is worth investing in today.

An investment’s worth is equal to the present value of all projected discounted future cash flows.

Discounted cash flow is a way of evaluating a potential investment by estimating future income streams and determining the present worth of all of those cash flows in order to compare the cost of the investment to its return.

When an investor is trying to determine how to spend capital, it is important to determine whether or not investments will result in a positive return. The DCF method allows an investor to determine the value of the future projected cash flow in today’s dollars. An investor can subtract the amount spent on the investment from the present value of future cash flows to calculate the net present value of the investment.

In other words, they can calculate how much money the investment will make in today’s dollars and compare it with the cost of the investment. NPV and Internal Rate of Return are the methods used in Discounted Cash Flow.

The Net Present Value (NPV) represents the present value of cash flow. The NPV can also be called as the difference between the present values of cash inflow and cash outflow. To calculate the net present value of an investment using the discounted cash flows method:

Example – an investor is considering investing in property that would cost his LLC $1,000,000 and he hold it for 5 years. What is the net present value of this investment using the discounted cash flows method?

The investor determined the discount rate to be 10%. With this information, he calculated the following future discounted cash flows:

  • Year 1 = $130,000
  • Year 2 = $150,000
  • Year 3 = $200,000
  • Year 4 = $210,000
  • Year 5 = $200,000

The total projected cash flows is $890,000.

The net present value of this investment is $890,000-$1,000,000 which is equal to -$110,000.

In this example, an investor should not make this investment because the original cost (cost basis) is greater than the value of the future discounted cash flow creating a negative return over the time period.

As in this example, the DCF is compared with the initial investment. If the DCF is greater than the original cost, the investment is profitable. The higher the DCF, the greater return the investment generates. If the DCF is lower than the present cost, investors should rather hold the cash.

An investor’s expected cash flows are at a discount rate that is actually the expected return. The discount rate is inversely correlated to the future cash flows. The higher the discount rate, the lower the present value of the expected cash flows.

The NPV represents the present value of cash flow and is generally used for comparing both the internal and the external investments of a company. DCF is a method to calculate the value of an investment based on the present value of its future cash flow.

References:

  1. https://www.myaccountingcourse.com/accounting-dictionary/discounted-cash-flow
  2. https://corporatefinanceinstitute.com/resources/knowledge/valuation/discounted-cash-flow-dcf/
  3. https://www.myaccountingcourse.com/accounting-dictionary/present-value

Margin of Safety

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“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger the margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.” Warren Buffett

Billionaire investor Warren Buffett, Chairman and CEO, Berkshire Hathaway, said, “The three most important words in investing are margin of safety.” Margin of Safety is a measure of how “on sale” a company’s stock price is compared to the true value of the company. You need to be able to determine the value of a company and from that value determine a “buy price”. The difference between the two is the margin of safety.

Effectively, margin of safety means you pay less for an asset than what it’s intrinsically worth. It means to buy $10 dollar bills for $5 dollars. That’s the secret to great and successful investing. The margin of safety is the difference between the intrinsic value of a stock and the current market price of the stock. The intrinsic value of an asset is its actual value, that is, the present value of the asset found by calculating the total discounted future income it’s expected to generate.

The intrinsic value is calculated based on the 10 year discounted free cash flow (DFCF).

In other words, if the stock price of a company is below the actual value of the free cash flow (income) and assets of a company, the percentage difference is the Margin of Safety.  This is the discounted price at which you are buying a share in the company.

A higher margin of safety will reduce your investment risk. If an investor can buy a stock below its intrinsic value, the potential for a bad outcome, risk, is usually lower.

Warren Buffett likes a margin of safety of over 30%, meaning the stock price could drop by 30%, and he would still not lose money. Margin of safety is only an estimate of a stock’s risk and profit potential.

Buffett determines margin of safety by estimating the current and predicted earnings from a company from today and for the next ten years.  He then discounts the cash flow against inflation to get the current value of that cash.  This is the Intrinsic Value of the company. He bases intrinsic value on the discounted future free cash flows. He believes cash is a company’s most valuable asset, so he tries to project how much future cash a business will generate.

Margin of Safety is a value investing principle strategy. If the total value of all shares of a company is 30% less than the intrinsic value of that company, then the margin of safety would be 30%. In other words, if the stock price of a company is below the actual value of the cash flow and assets of a company, the percentage difference is the Margin of Safety.  This is the discounted price at which you are buying a share in the company. Most value investors believe that the higher the margin of safety, the better.  In reality, a margin of safety between 30% and 50% is reasonable.

The Margin of Safety is the percentage difference between a company’s Fair Value per share and its actual stock price. If a company has profits and assets that outweigh a company’s stock market valuation, this represents a Margin of Safety for the investor. The higher the margin of safety, the better.

Margin of safety is only an estimate of a stock’s risk and profit potential. Most value investors believe that the higher the margin of safety, the better.  And, the larger the margin of safety, the more irrational the market has become. 

One of the keys to getting a great margin of safety is to understand that price and value is not the same thing. Price is what you pay for something, but the value is what you get.

The stock market rises about four out of every five years or about 80% of the time, according to Nick Murray. Said another way, the market only falls 20% of the time. You can fear that 20% or cheer for it.

No one ever got wealthy paying full price or top dollar for financial assets, according to Buffett. Most successful investors got that way buying assets that were distressed, out of favor, and therefore on sale. Unfortunately, few people see it that way. You need to take advantage of the sale during market selloffs and corrections when it occurs. Your money literally goes further because you can buy more share at lower prices that lead to market-beating returns later on.

If you want to make good long-term investment returns, you need to minimize your risk by purchasing companies selling at a significant discount to their intrinsic value due to market volatility. 

References:

  1. https://novelinvestor.com/10-lessons-learned-nick-murray/
  2. https://www.ruleoneinvesting.com/blog/how-to-invest/how-to-invest-margin-of-safety-the-growth-rate/
  3. https://www.liberatedstocktrader.com/margin-of-safety/

Inflation and the Bond Market

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The bond market—Treasuries, high-grade corporate bonds, and municipal bonds—are experiencing depressed yields in the 1% to 3% range and near-record negative real rates with inflation running at 6%. Barron’s

Real interest rates can be effectively negative if the rate of inflation exceeds the nominal interest rate, according to Investopedia. Real interest rate refers to interest paid to borrowers minus the rate of inflation. There are instances, especially during periods of high inflation, where lenders are effectively paying borrowers when they, the borrowers, take out a loan. This is called a negative interest rate environment.

The real interest rate is the nominal interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to a bond investor. The real interest rate is calculated as the difference between the nominal interest rate and the inflation rate:

Real Interest Rate = Nominal Interest Rate – Inflation (Expected or Actual)

While the nominal interest rate is the interest rate actually paid on a loan or bond, the real interest rate is a reflection of the change in purchasing power derived from a bond or given up by the borrower. Real interest rates can be effectively negative if inflation exceeds the nominal interest rate of the bond.

There is risk for bond returns in 2022, when the Federal Reserve is widely expected to start lifting short-term interest rates to manage inflation.

And things could get worst for bonds if inflation persists. That could force the Fed to tighten more aggressively. It wouldn’t take a big rise in rates to generate negative returns on most bonds. The 30-year Treasury, now yielding just 1.9%, and most municipals yield 2% or less and junk bonds yield an average of 5%. Bonds would drop significantly in price if rates rise a percentage point.

The real interest rate adjusts the observed market interest rate for the effects of inflation.

“Cash has been trash for a long time but there are now new contenders for the investment garbage can. Intermediate to long-term bond funds are in that trash receptacle for sure.” Bill Gross, “Bond King”

References:

  1. https://www.barrons.com/articles/best-income-investments-for-2022-51640802442
  2. https://www.investopedia.com/terms/n/negative-interest-rate.asp

Tips for New Investors

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Getting started can be the biggest hurdle for new investors.

To get started, it’s important for new investors to set clear investment objectives, open a brokerage account, create a plan, and start investing with a long-term view. You’ll gain knowledge over time. While your investment strategy may change, getting started sooner rather than later is a good first step.

Additionally, every new investor should first make an honest assessment of where they are in life and their financial priorities. And they should leave emotion out of it. And, begin investing early in life so your money will have plenty of time to grow. A 10-year difference can have a significant effect on compounding returns.

https://fb.watch/9iNk-bRTiD/

Putting together a successful investment portfolio takes a combination of research, an investing plan, patience, and a little bit of risk.

For instance, there is plenty of research showing that frequently buying and selling stocks often leads to significantly lower long term returns than buying and holding. According to the investment research, investors who try to time the market more often get lower returns, but they also introduce more volatility into their portfolio.

By paying a lower price for an investment relative to its earnings or intrinsic value, one would expect a higher income yield in the near term, as well as the greater appreciation over the long term to the extent that free cash flow, earnings and net income increases in the future (of course, all investments involve risk and there can be no guarantees of any returns).

References:

  1. https://www.thebalance.com/the-6-dumbest-things-new-stock-investors-do-357191
  2. https://www.thebalance.com/things-investors-should-know-357631

Inflation: The Elephant in the Room

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November’s CPI report showed consumer prices rising at rates last seen four decades ago.

Inflation is the biggest risk facing the equity market and is likely to end the record long bull-market. Inflation has a long history of eroding the value of financial assets and brings with it higher interest rates as central bankers try to tamp it down.

The annual inflation rate accelerated significantly in 2021, from about 0.5% at the start of the year to over 3% by September. This was driven by increased demand as the economy reopened and by a sharp rise in energy prices, among other factors.

In October, inflation measured by the consumer price index was up 6.2% from a year earlier, the highest annual rate since November 1990. It marked the sixth straight month above 5%. Kiplinger expects inflation to hit 6.6% by year-end 2021 before falling back to 2.8% by the end of 2022 – above the 2% average rate of the past decade.

“Inflation is in the air, and it risks becoming a market issue, an economic issue and a political issue,” says Katie Nixon, chief investment officer at Northern Trust Wealth Management.

As we enter 2022, inflation is expected to remain a risk amid higher food and gas prices, rising pressures from non-energy industrial sectors such as steel and chemicals, higher food and consumer goods prices, and increases in the energy prices.

Economists expect headline CPI to peak between 4.5% and 5% in the first half of 2022 and approach 2.5% year over year by the end of 2022.

References;

  1. https://www.kiplinger.com/investing/stocks/stocks-to-buy/603814/where-to-invest-in-2022
  2. https://investor.vanguard.com/investor-resources-education/article/simple-strategies-for-reducing-inflation-risk

Valuing a Company | Motley Fool

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The most common way to value a stock is to compute the company’s price-to-earnings (P/E) ratio. The P/E ratio equals the company’s stock price divided by its most recently reported earnings per share (EPS).

You can calculate it two different ways, by:

  • Taking the company’s market cap and dividing it by net income – or,
  • Dividing a company’s current stock price by earnings per share

You’ll wind up with the same number either way because in the share price approach, both numbers have already been divided by the total number of shares the company has outstanding. So it’s two different ways to the same place.

A low P/E ratio implies that an investor buying the stock is receiving an attractive amount of value.

You’ll usually see the P/E ratio quoted two different ways:

  • Trailing twelve month (TTM) – which looks at the company’s actual income over the past twelve months.
  • Forward – This approach takes analyst estimates of earnings expectations for the upcoming year and using that as the earnings figure.

If a company is growing, its forward P/E ratio will always be smaller than its trailing twelve month P/E ratio, because more income is expected and the denominator will be larger. If you see a P/E ratio out in the wild and it isn’t specified which kind it is, you can probably assume it’s based on the company’s trailing twelve month earnings.

The P/E ratio only works if there’s an E – or earnings. So it’s a helpful tool for companies that have income, but it’s totally useless if a company isn’t currently profitable. That’s why investors also use another tool for unprofitable companies, the P/E ratio would return a negative number, which really wouldn’t be very helpful, so instead investors use the price to sales ratio.

Price-to-sales is a company’s market cap divided by its total sales over the past twelve months. Because the P/S ratio is based on revenue instead of earnings, this metric is widely used to evaluate public companies that do not have earnings because they are not yet profitable.

High growth software companies can have price-to-sales ratios of over 10, while more established businesses are usually in the mid to low single digits. The P/E and P/S ratios are great because they allow you to normalize companies of different sizes and immediately get a sense of what investors are willing to pay for a piece of that company’s earnings or revenue.

You can use these ratios to compare how a company stacks up to the overall stock market, peers in their industry, or itself relative to the past. Generally, businesses that are posting high growth rates are going to have higher price-to-earnings and price-to-sales ratios. That’s because investors expect that company to be considerably bigger in the future, and they have bid up shares to reflect that. That doesn’t mean that they’re bad stocks to own, it just means that people are expecting big growth to continue and if it doesn’t, shares could fall dramatically.

Conversely, stodgy old businesses in crawling industries tend to have lower p/e ratios because they aren’t growing very quickly – for them this year’s earnings will probably look a lot like last year’s earnings. The market isn’t expecting much from stocks with low valuations, so if the outlook gets worse, they’re less likely to take a huge hit, but they’re also less likely to give investors huge returns.

All you’re trying to do with valuation is to get a sense of how much you have to pay for a dollar of earnings or revenue from a company, and what the market expects of that company.

You can look at to see how a company’s valuation compares to the growth the company is posting. The PEG ratio accounts for the rate at which a company’s earnings are growing. It is calculated by dividing the company’s P/E ratio by its expected rate of earnings growth.

Most investors use a company’s projected rate of growth over the upcoming five years, you can use a projected growth rate for any duration of time. Using growth rate projections for shorter periods of time increases the reliability of the resulting PEG ratio.

The generally accepted rule is that a PEG ratio of 1 represents a “fair value” while anything under 1 is cheap and anything over 1 is expensive compared to the growth the company is posted.

For all these ratios there aren’t absolutes, just guidelines.

As investors we’re looking for quality companies with good business models and exciting growth prospects — it’s worth paying a premium for companies like that, these metrics help us understand what the premium looks like and how it fits into the company’s growth story.

References:

  1. https://www.fool.com/investing/how-to-invest/stocks/how-to-value-stock/

Beat Inflation with Dividend Stocks | Fidelity Viewpoints

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“Stocks that can boost dividends during periods of high inflation may outperform.” Fidelity Viewpoints

Key takeaways according to Fidelity Viewpoints

  • Dividends aren’t just nice to have, they’re essential to the stock market’s return—accounting for approximately 40% of overall stock market returns since 1930.
  • During periods of high inflation, stocks that increased their dividends the most considerably outperformed the broad market, on average, according to Fidelity’s sector strategist, Denise Chisholm.
  • Dividend-paying stocks’ regular, scheduled payments also may help to reduce the volatility of a stock’s total return.

The economy is gradually recovering from its pandemic-related slowdown and shutdowns, and inflation has hit its highest rate in 39 years. People are emerging from the pandemic and are spending money they saved or money they’re getting from the government. Thus, a combination of soaring pent-up consumer demand and persistent supply chain disruptions has tarnished an otherwise robust economic recovery.

The Bureau of Labor Statistics said the Consumer Price Index of food, energy, goods and services rose by 0.8 percent in November, pushing annual inflation above 6.8 percent. The level is the highest since 1982 and it also marked the sixth consecutive month in which annual inflation rates have exceeded 5 percent.

Currently, approximately 70 percent of Americans rate the economy negatively, with nearly half of Americans blaming Biden for inflation, according to a recent Washington Post-ABC poll.

This combination of economic challenges and consumer worries may make this an especially good time to consider investing in stocks that pay consistent dividends.

A few important things for investors to know about dividend stocks:

  • Dividend payouts typically happen quarterly, although there are a few companies that payout monthly.
  • Many high-quality companies routinely raise their dividend payouts, helping hedge against inflation.
  • A stock’s dividend yield moves in the opposite direction of its stock price, all else being equal, so a high yielding stock may be reason for caution.

Fidelity research finds that dividend payments have accounted for approximately 40% of the overall stock market’s return since 1930. What’s more, dividends have propped up returns when stock prices struggle.

Dividends account for about 40% of total stock market return over time

US stock returns by decade (1930–2020). Over various decades, dividends have remained a fairly steady component of stocks’ total returns amid more highly volatile stock prices. Past performance is no guarantee of future results. Source: Fidelity Investments and Morningstar, as of 12/31/2020.

To invest successfully in dividend stocks, one of the keys is finding companies with strong balance sheets and with secure payouts that can grow consistently over the long haul. Moreover, it’s important to understand the concept of dividend yield, which investors use to gauge how much dividend income their investment will produce.

Investing in dividend stocks

When selecting dividend stocks, it’s important to keep dividend quality in mind. A quality dividend payout can grow over time and potentially be sustained during economic downturns. It’s the primary reason investors must not focus solely on yield.

Steve Goddard, founder and chief investment officer of Barclay, prefers companies with high returns on capital and strong balance sheets. “High return-on-capital companies usually by definition will generate a lot more free cash flow than the average company would,” he says. And cash flow is what pays the dividend.

Although overall dividend health has improved markedly since 2020 and looks good heading into 2022, it’s equally important to check a company’s dividend policy statement so you know how much to expect in payment and when to expect it. Dividend yield is a stock’s annual dividend expressed as a percentage of its price.

It’s crucial to recognize that a stock’s price and its dividend yield move in opposite directions, as long as the dollar amount of the dividend doesn’t change. Investing in the highest-yielding shares can lead to trouble, notably dividend cuts or suspensions and big capital losses

This means a high dividend yield may be a red flag of a problem with the underlying company. For example, a stock’s yield may be high because business problems are weighing down the company’s share price. In that case, the company’s challenges may even cause it to stop or reduce its dividend payments. And before that happens, investors are likely to sell off the stock.

Fidelity Investments’ research has found that stocks that reduce or eliminate their dividends historically have underperformed the market by 20% to 25% during the year leading up to the cut.

Also consider the company’s payout ratio—the percent of its net income or free cash flow it pays in dividends. Low is usually good: A low ratio suggests the company may be able to sustain and possibly boost its payments in the future.

“As a rule of thumb, no matter what the payout ratio is, it is always important to stress test a company’s payout ratio at all points in the business cycle in order to carefully judge whether it will be able to maintain or increase its dividend,” says Adam Kramer, portfolio manager for the Fidelity Multi-Asset Income Fund.

“It all depends on the stability of the cash flows of a company, so it’s more about that than the level of payout. You want to test the company’s ability to pay and increase the dividend under different scenarios. In general, when the payout ratio is more than 50%, it’s a good reminder to always stress test that ratio,” Kramer explains.

Be sure to diversify as you build a portfolio of dividend-paying stocks. To help manage risk, invest across sectors rather than concentrating on those with relatively high dividends, such as consumer staples and energy.

References:

  1. https://www.fidelity.com/learning-center/trading-investing/inflation-and-dividend-stocks
  2. https://www.barrons.com/articles/quality-dividend-stocks-51639134001
  3. https://news.yahoo.com/inflation-pinch-challenges-biden-agenda-200620196.html

Past performance and dividend rates are historical and do not guarantee future results. Diversification and asset allocation do not ensure a profit or guarantee against loss. Investing in stock involves risks, including the loss of principal.

Investors Need to be Patient and Rational

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“It’s a textbook example of why panic is not a[n investment] strategy, unless you’re deliberately trying to lose money.” Jim Cramer, CNBC Mad Money Host

CNBC Mad Money Host Jim Cramer made his comments after the stock market indexes moved higher after a previous major market downturn due to COVID-19 Omicron variant concerns and fear. Wall Street experienced a strong melt-up session led by the technology heavy Nasdaq Index’s 3% jump.

Markets had sold off sharply on November 26, with the Dow, S&P 500 and Nasdaq all losing more than 2% in market cap value as investors knee-jerked reacted to the discovery of the Omicron variant.

“I want you to use it as a reminder that, most of the time, it pays to wait for cooler heads to prevail rather than freaking out in a situation where everyone else is freaking out and lost their heads without complete information,” Cramer said.

“Look, it would’ve been great if you bought stocks something near the lows—that’s what I urged you to do, actually, even if you had to hold your nose because we were simply too oversold. I was relying on technicals,” Cramer said. “But the cardinal sin here was selling stocks out of fear, rather than sitting tight out of rationality.”

The obvious takeaway for investors is that fear and panic are not sound investment strategies, “…unless you’re deliberately trying to lose money.” Never make permanent investment decisions based on temporary market circumstances.

References:

  1. https://www.cnbc.com/2021/12/07/cramer-stocks-recent-rally-shows-need-for-investor-patience-not-fear-.html