Saturday, December 25, 2010

Equity or Income?

Should you buy stocks that increase in value (equity) or ones that pay dividends (income)?

I take a piss on the Motley Fool a lot here, and for good reason.  Their entertainment model of investments was so symbolic of the excess era of the 1990s.  Going on television in a Jester's Suit and then telling everyone to buy, buy, buy stocks was something that they probably look back at and shiver.

But the graph above is from one of their postings which actually makes some sense.  Yes, even a stopped clock is right, twice a day.  Sorry, couldn't help myself, I had to get another dig in.

But many amateur investors (which means most of us working stiffs forced to invest in 401(k) plans for our retirement) don't have even a clue what the difference between equity stocks and income stocks, or know what "retained earnings" means.  Regardless of whether you are a stock picker or investing in a mutual fund, you have to understand what it is you are investing in.

The initial idea behind stocks was that you would buy "shares" in a venture, which would then use your capital to buy equipment or build a factory, or whatever, and then sell products or otherwise seek to make a profit.  The company would then use part of that profit to buy new equipment, expand, or whatever, and the rest might be paid out as dividends - income - to the shareholders.

Seems like a simple enough scheme, right?  But like anything that looks deceptively simple, it can be devastatingly complicated (like ratio between crank swing and connecting rod length in an internal combustion engine - there is calculus involved there, although it appears to be a "simple" mechanical system).

For example, the company could use its profits to buy back shares.  This is an interesting concept, as it is a bit like a snake trying to swallow its own tail. The value of the company increases dramatically to the remaining shareholders, and thus their share price goes up (which is not a realization event, and thus not taxable until you sell your shares).

And if you did sell those shares (which have increased in value) you would pay taxes at the capital gains rate (15%) as opposed to the ordinary income rate (38% for some folks).

So you see, there are a lot of keen games a company can play to delay taxes for shareholders, or avoid them entirely.

Another variation is the "retained earnings" strategy.  The company can simply keep its profits and invest them in other stocks, mutual funds, or just put them in the bank.  The value of the company thus increases, as the liquidation value of the company is higher.  Thus, even though you have not been paid a dividend, your stock is worth more, and again, you can "cash out" at a later date, delay paying income taxes until that time, and pay the lower capital gains rate.

Of course, as you may have guessed, the IRS has some "retained earning" rules that prevent companies from keeping too much money around, without paying more taxes on it.

And occasionally, some clever investor figures out that a company that has a lot of cash on hand might be bought out for cheap - and so they try to do a "takeover" of the company to get at that cash and also spin off divisions and portions to cash out on what are in effect retained earnings of the company.  While many decry these tactics, oftentimes they are a means of clearing up a logjam in a corporation which has become too complacent and corpulent.

And this is why you see, sometimes, when a company is being stalked by a takeover outfit, that they will do things like buy back their own stock (to make it harder to take over by increasing the price per share as well as decreasing the number of available shares).  Or they may pay out more in dividends, which gets rid of that extra cash on hand and raises the share price.  Or they may go out and buy another company - which reduces the amount of cash on hand, raises the share price, and makes it harder for the takeover artist to buy out the company.  There are a number of these games, including the so-called "poison pill" provisions that can kick in, once a single investor owns a certain percentage of the company.

But aside to takeovers and various tax dodges, the difference between equity and income stocks is somewhat more profound.  Traditional businesses tend to be more income-type stocks.  For example, as I recently wrote about Altria, (which owns the Phillip Morris cigarette brands) that stock regularly pays dividends of 6% or more, which is a pretty decent rate of return in an age when banks are offering fractional interest rates.    Utility stocks are another good example.  Since they are regulated to generate a fairly standard profit, they are not an exciting stock, and they churn out dividend checks fairly regularly but increase in value very slowly.

Old manufacturing industries tend to be income stocks.  Stanley Black and Decker, one of my favorites, sends out checks like clockwork.   Until recently, auto companies (GM, Ford, and formerly Chrysler) were fairly staid dividend payers.

But in other industries, paying dividends is an anathema.  High-tech stocks, for example, rarely pay dividends.  And others that did, such as Apple, have stopped (UPDATE: they have started again). The theory is, these types of companies have to plow so much money into research and development to stay current, that they cannot afford to pay dividends.  If they have extra money laying around (like Google) they go out and buy up other companies.  Pay a dividend to the shareholder?  Never, ever, ever, EVER!

So why do people buy stocks that don't pay dividends?  I mean, if there is no profit to be had, why would the stock be worth anything?  That is a good question, and I am not sure I have the answer, either.

Because I am not very bright, I tend not to follow convoluted arguments well.  Basically, if someone can't explain a simple concept to me in 10 words or less, I just assume they are lying through their teeth and trying to deceive me to steal my money - and I move on.  And funny thing, too, in 9 out of 10 times, I'm usually right.

The arguments about equity stocks that pay no dividends are a bit convoluted.  Why buy Apple stock, for example, if they are not paying dividends - and it does not appear they ever will?  The stock has a number if inherent values, of course.  If the company was liquidated, and all the equipment sold off, the proceeds would go to the shareholders.  But for a high-tech company like Apple, there really isn't a lot of stuff to sell off - leases on office buildings, some computer equipment, and the like.  Many "high tech" companies don't even own the factories they make things in.   And as we saw from the GM example, factories are rarely worth much, anyway.

Of course, there are other inherent values in the company, such as the rights to the products, intellectual property, and the like.  But the problem with high tech products, as we all know, is that they are obsolete within a year or two.  So having the right to sell the iPhone might be lucrative - for a year or two.

And of course, owning stock represents control of a company.  If someone wants to take over Apple, they might want to buy your stock, so there is value there, as well.

But to someone as stupid as I am, the idea of a stock that pays no dividends and keeps increasing in value in equity seems somewhat odd.  I sat through an entire class in Corporations where our professor explained this all to us, and from him, it made sense.  Once I left the class, the explanation seemed to vaporize, however.

So it still puzzles me a bit and it still makes me a bit nervous that these equity-only stocks are little more than a flim-flam for us average investors.  But on the other hand, income stocks, like the old General Motors, can go belly-up in short order and leave you with nothing.

So, should you invest in stocks that pay no dividends but increase in value in terms of equity?  Or should you buy stocks that pay regular dividends?  The answer is, probably a little of both, and the mix should change as you get older.

Of course, if you are invested in a mutual fund, chances are, you have no idea what stocks you own.  You went with Fidelity, or American Funds, or Vanguard, or whatever based on the brand name of the company (and they try to use solid sounding names.  No one invests in "Joe's Mutual Fund" do they?).

Each fund prospectus should tell you what it is the fund is trying to accomplish and what the goals are.  And sometimes the name of the fund itself is a summary of its investment type - Fidelity Equity Income, for example.

As you get older, too, you might want to think about more staid, income-producing stocks as well.  Owning a stock that pays you a regular dividend can be a nice, regular source of income for your retirement, as opposed to the uneven returns on equity, which are more volatile and dependent on market pricing.

And it is an odd thing, too, as most folks buy stocks based on the equity aspect - and most financial news programs talk about stocks in that manner as well.  Share price is king!  Dividends mean nothing!  So we watch the "Dow Jones Industrial Average" - which is an indicia of price, while ignoring dividends.  News programs talk about stock price mostly.  If then mention dividends, it is only as it is related to the stock price.

Like bonds, dividends are not sexy, like stock prices are.  You can make millions overnight (or lose them) based on share price and strategic buying (gambling, basically).  But dividends?  They will never result in a huge payout for an investor, so you never hear about them.

But as I noted in my posting about Altria, getting a 6% return on your investment, annually, is not such a bad deal in this day and age.  And if the stock goes up in value - well, that is a bonus, too.

One more thing to consider about equity and income.  In a way, they are like the two aspects of Real Estate, and with the recent bubble, illustrate how people who focus on equity can lose their shirts.

When I got into Real Estate, it was for the income.  I bought  properties that would show a positive cash flow - income - through rents.   If a property cost me money to carry, I would not buy it.  In short order, I owned well over a million dollars worth of Real Estate in the Alexandria, Virginia area.  But other than my private home, it all generated rents that more than covered the costs of ownership.  Any increase in equity was pure "gravy" for me.  And there was a lot of gravy back then.

But many of my peers were buying million dollar HOMES instead, which generated no income, and even if rented out, had a negative cash-flow.  They felt that the increase in equity would more than compensate them for the cost of carrying these properties.  And we all know how that worked out.

They assumed that a bigger fool than them would buy the home for a lot more than they paid for it - and they would then "cash out" and be rich.  The same was true, by the way, for the "dot com" stocks - everyone assumed there was a bigger fool (not necessarily Motley) that would buy these pigs-in-a-poke and everyone would profit.  But we ran out of fools - a fool shortage, if you will - and the dot com and the Real Estate market collapsed.

Those of us who had positive-cash-flow income-producing property, of course, kept chugging along, generating small, regular profits, but not, necessarily, "the big kill".

And therein lies the problem with these equity stocks.  Apple stock price is through the roof.  But they are only as good as their next product, and if a product fails in the marketplace, spectacularly, the share price could plummet.  Buying these stocks is great and all, but only so long as there are bigger fools out there to buy the stock for more money than you paid for it.

The Motley fool link mentioned above illustrates that income-producing stocks tend to increase in value over time as well, particularly if you reinvest the dividends in the company over time.  Reinvesting dividends, is, of course, just another roundabout way of retaining earnings, if you think about it (and boosting stock prices, which is why most dividend-paying companies HAVE a shareholder reinvestment plan).  The drawback being, of course, that you have to pay taxes on those dividends at the ordinary income rate.

Still, it is a nice fantasy, to be able to retire and just go down to the bank and cash those dividend checks every quarter.  Of course, if you had a stock that paid an annual dividend equal to 5% of its share price (such as Altria) you'd have to own a million dollars worth of shares in order to make $50,000 a year in dividends.  Aye, there's the rub!  You make more money from the equity, which is why people invest in these equity stocks.

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