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Volume 12, Edition 20 | July 17 – July 21, 2023

The Ugly Side of Investing for Income

Doug Walters, CFA
It is tempting to be lured in by stocks paying high dividends, but income is only part of the equation. More important to long-term investors is total return.

Contributed by Doug Walters, Max Berkovich, David Lemire, Eh Ka Paw

The dichotomy of two stocks this week provides an excellent opportunity to talk about the difference between portfolio income and total return.

We often are challenged by investors to “find them more income.” Their statements might show that their portfolio is yielding 2.5%. With two-year Treasuries yielding nearly double that, the requests for more income have increased. Our response comes down to understanding the difference between income and total return, and the stories of AT&T (T) and Microsoft (MSFT) provide a timely illustration.

It is comforting to see your portfolio produce income, and some investor situations have specific income requirements. But for most long-term investors saving for retirement, the goal should be to maximize your “total return.” What is total return? It is your portfolio performance after considering both price gains and income (primarily dividends). If the security prices in your portfolio go up by 5% and they pay a 2% dividend on average, your total return would be roughly 7%. The long-term investor should be just as happy with a 6% price return and a 1% dividend.

AT&T reported results this week and is the poster child for high dividend yields. Trailing yields for AT&T have a 10-year average of over 6%, with recent yields much higher. On the face, those yields look very attractive. But over that same time period, the shares have fallen 46%. The 10-year total return? Minus 2%. So sure, you had income, but the value of your shares fell such that absolutely no portfolio value was created.

Microsoft was in the news this week with progress on its attempt to acquire Activision. Rather than return cash to investors in the form of attractive dividends, the tech giant sees opportunities to use that cash to create more value through complementary business acquisitions. Microsoft’s dividend yield has averaged only 1.7% over the past decade, but its shares are up 1003%. That is a total return of 1222%. A bit better than AT&T’s -2%!

The moral… total return is what matters more for long-term investors.

6.2%

Average 10 Year Dividend

AT&T’s dividend has averaged 6.2% over the past 10 years, but the total return over the same period has been negative. In the end, total return is what matters.

Headline of the Week

Landing Softly in the House

The recent moderation in headline inflation inflated the soft-landing thesis, whereby the Fed slows down economic activity just enough to bring down inflation without triggering a recession. The latest news out of the housing sector also pumped more air into the story.

Housing’s strength has been one of many surprising aspects of the Fed rate-raising campaign. While affordability remains challenged due to homeowners previously locking in ultra-low mortgage rates leading to a reluctance to trade up or down for fear of losing those low rates. This reluctance has curtailed supply and generally kept prices high. The good news is that home builders seem to be responding. Hopefully, increased construction activity can support GDP growth and help stave off this highly anticipated recession.

The Week Ahead

A very big week for the markets next week. If a GDP print, inflation report, and a rate decision from The Federal Reserve, Bank of Japan, and the European Central Bank were not enough, a third of the members of the S&P 500 Index are on deck to report earnings during the week.

Banking On It!

On Wednesday, Chairman Powell will reveal the Federal Reserve’s rate decision. However, the main event will be the press conference afterward. The following morning Europe steps in, and Friday, Japan bats clean up.

  • Expectations are that The Federal Reserve will press play and hike 0.25% this time after a pause last month.
  • During the press conference, reporters will try to put the chairman in a corner and force him to signal if the rate hikes are done, and he, as he has done before, will dance around those questions.
  • The Federal Reserve will take an August break, so we will have until September 20th to determine if this was the last hike.
  • The European Central Bank’s (ECB) picture is much murkier, with markets pricing in two more hikes this year and three cuts in 2024.
  • A 0.25% hike is all but certain at this point.
  • The Bank of Japan is meeting this week as well and currently seems to be comfortable where it is and will avoid altering the curve control regime it has been on.
  • Governor Ueda may have to keep a closer eye on inflation, but right now, the problem is not at home but coming in from imports, giving him more runway.

Consumer Driven

The US’s 2nd quarter Gross Domestic Product (GDP) is expected to remain resilient despite the sharp hikes in interest rates.

  • In June of 2022, inflation was at 9.1%, but after a year, it has cooled to 3%.
  • The strong labor market helped reassure consumers to keep consuming in the first quarter, and hopes are that momentum will continue in the 2nd.
  • The current consensus is that the economy grew between 1.6% and 1.9%, with manufacturing being the notable drag.

Better Late Than Never

On Friday, the Personal Consumption Expenditures Index (PCE) will come after the Federal Reserve’s meeting, but the central bank’s preferred inflation gauge will kick off the September rate discussion.

  • Core-PCE, which excludes food and energy, is expected to still hover above 4%, but a three-handle will certainly be a welcome development.

A-Eye On Earnings

With 168 companies from the S&P 500 reporting next week, it will be hard to stand out. However, the tech giants will do their best.

  • Microsoft (MSFT), Alphabet (GOOG, GOOGL), Meta (META), and Amazon (AMZN) will attract all the headlines.
  • Look for AI to dominate the conversation for the technology names.
  • Lost in the noise will be bellwethers like Visa (V), Coca-Cola (KO), Boeing (BA), Mastercard (MA), McDonald’s (MCD), Procter & Gamble (PG), and oil giants Exxon (XOM) and Chevron (CVX).

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