Making money by speculating on stock prices can work really well, as it did throughout 2020.
Until it doesn’t.
The end of a speculative boom is inevitable. Eventually, stocks can’t go any higher.
Investors start looking for excuses to sell.
That’s known as a “top.”
I believe we hit a top on April 19 this year, at least as far as faddish technology stocks are concerned. The Nasdaq has tested the 14,000 level twice, and retreated each time. See for yourself:
(Click here to view larger image.)
That’s not to say that stock market indexes won’t reach higher levels in the future. They’re just going to do so more slowly, based on earnings growth rather than multiple expansion.
In other words, investors will be willing to pay for cash flow, but won’t push price-to-earnings ratios higher.
The obvious question is, what should investors do now?
There’s an obvious answer, and it’s hiding in plain sight.
Cash, the Once and Future King
My colleague Charles Mizrahi loves to say that he doesn’t buy squiggly lines on a chart. He buys companies.
That’s true for all investors in a technical sense.
But realistically, in the last year or so, a lot of investors have been buying squiggly lines on charts. They’ve been speculating on popular tickers, not investing in companies.
Now, if your investing focus is buying companies, you’re really doing it for one reason: because they produce cash.
Companies that produce a lot of free cash flow — i.e., money that they can use as they see fit — can do a lot of things with it.
Ideally, your companies plow that money back into investment. But in times of economic uncertainty — like today, with inflation fears and doubts about an infrastructure bill — they don’t do that.
Instead, they give that money to shareholders. And that’s exactly what’s happening right now.
U.S. companies are sitting on a nearly $2 trillion pile of cash:
They’re not planning to invest that in job-creating production capacity.
Rather, according to an analysis cited in The Wall Street Journal of first-quarter earnings transcripts for nearly 300 companies, executives emphasized buybacks and dividends three times more than capital investments.
Buybacks are back to pre-pandemic highs.
But U.S. companies also ramped up dividend spending in the first quarter, increasing their annualized payments by more than $20 billion.
That marks the largest quarterly increase in dividend payouts in nearly a decade.
And given the way the stock market is behaving at the moment, that may be one of the best sources of stable gains this year and next.
There Are Dividends … and Then There Are REITs
As subscribers to my Bauman Letter know well, I’m a big fan of real estate investment trusts, or REITs.
REITs are essentially large partnerships that own real estate or associated assets. That makes a big difference to their dividend payouts.
Unlike corporations, which have shareholders, when you buy shares of an REIT, you become a partner in that company. Under tax law, partnerships pay no corporate tax themselves. Instead, earnings “pass through” to the partners, who pay tax on them at the ordinary income tax rate.
In exchange for this favorable tax treatment, REITs are required to pay out 90% of the income that would be taxable if they were corporations, as dividends to their partners/shareholders.
Because of that, REITs often pay dividends that are two or three times bigger than comparable corporations. In my Bauman Letter Endless Income model portfolio, for example, we have REITs that pay as much as 7.4% annual dividends — monthly.
But it gets even better.
Under the 2017 tax law, 20% of income received by partners in companies such as REITs is exempt from income tax. You only pay tax at the ordinary income rate on the other 80% of your dividend income.
REITs Beat the Market
Of course, if you hold REITs in your retirement portfolio — especially in a Roth IRA — those dividends can compound to an almighty gain.
You see, over the long term, on a total return basis — that is, combining share price appreciation with dividend yield — REITs blow the stock market away:
(Click here to view larger image.)
One reason for this is that REITs tend to do well whether inflation and interest rates are up or down.
When inflation and interest rates are high, REITs can pass on those costs to their tenants to maintain their operating margins and their dividend yields. When inflation and interest rates are low, REITs become an attractive source of yield compared to bonds.
Learn to Love Cash Again
It’s been great to make gains on speculative investments over the last year. But those gains are becoming much harder to find now that we’ve hit a top.
In a situation like that, my advice is to go back to the roots of investing and buy cash flows rather than squiggly lines on a chart.
And the single best place to do that is with REITs, like those in The Bauman Letter … and the latest company we’ve added to our model portfolio. You can learn more here.
Kind regards,
Ted Bauman
Editor, The Bauman Letter
