Financial Independence through Dividends: Yield Targeting-Risky Stocks

 

This is part 2 so I'll jump straight in. This is point number 5 from Kyith's post:

Too Much Yield Targeting Leading to More Risky Stocks 

Kyith says that one reason why a Dividend Mindset is bad is because there are some investors that will blindly buy stocks because of the dividend. In other words:

[T]hey are not respecting first principles and the first principle here is that you are picking stocks from a basket that may have more problems.

This is a totally valid point and completely fundamental. If you want to buy stocks, there are some basic investing principles you should learn, understand, and follow. If you pick stocks without following basic investing principles, the risk that you will lose money is much higher. Even if you follow basic investing principles, there is still risk, but at least you don't end up buying Eagle Hospitality Trust or Hyflux Perps.

However, I wonder how 'unprincipled investing' is a dividend investing problem. For example, you can have investors who buy any type of stock without following any principles. The classic example (or stereotype) is the investor who buys Tesla after watching a youtuber saying that Tesla is going to the moon. He may well make money and Tesla could go to the moon (depends on his entry price), but its unprincipled (because 'follow what youtubers say' is not a recognised investing principle) and higher risk compared to an investor who does his own analysis of Tesla and determines his own entry and exit prices.

I would add that taking more risk in itself is not inherently bad. Each investor has his own risk profile and his investments should mirror this risk profile. Furthermore, as I have mentioned in Part I, risk can be managed through diversification. If Kyith is trying to say that investors shouldn't engage in concentrated bets, I've mentioned in Part I that its a valid point and investors should harness the power of diversification.

The problem of demanding a certain yield or 'curve fitting'

Let's turn now to Kyith's example:

Suppose you need $60,000 a year in income, but your capital is only $1 million.

So you will end up trying to create a portfolio whose stocks pay a minimum of 6% dividend yield.

Again, another valid point. Taken to the extreme, if your capital is $1m and you need $150,000 a year in income, you are looking for something that  yields 15%, so you go out and fill your portfolio with AT1 bonds. Not a good idea. Again, someone who does not apply basic investing principles is first and foremost a bad investor, and bad investors can be found everywhere. A non-dividend equivalent could be an investor who is told that a safe withdrawal rate is 4% but says he wants a 6% withdrawal rate because Tesla will grow by more than 6% every year anyway. 

 

source: bloomberg.com

How do dividend investors deal with the 'curve fitting' issue?

I will now talk about how dividend investors can deal with the curve fitting issue. The answer is dividend growth, which refers to stocks increasing their dividend per share year-on-year.

When a principled dividend investor picks stocks, he or she is concerned about the future and whether the company can maintain and/or grow its earnings.  Fortunately, many dividend stocks are from traditional industries (there are even traditional tech stocks like CISCO which I have tiny holding in) which are relatively easy to study and analyse.

If you assemble a reasonable portfolio of quality stocks, you should expect that the average dividend to grow year-on-year (at least on a simple moving average basis).

Take for example UOB at $10, it may have been paying only $0.40 of dividends which is equivalent to 4% yield. However, in 2022, UOB paid $1.20 dividend, so your $10 initial investment is giving you $1.2 annual passive income.

Of course, as Kyith as pointed out, for every UOB, there is an SPH. I had a relatively small position in SPH and as I had posted previously, my SPH holding still gave me a CAGR of about 4% because in the end, time in market (holding SPH till the bitter end) still gave me a decent return. More importantly, the idea of diversification suggests that you will get good performers and not so good performers in your portfolio, so what is important is that the bad performers do not 'blow up' your portfolio and that the average performance is decent.

BuyafterCrash: May 2022 cash refunds from Frasers and SPH

Finally, there is some overlap between this response and Kyith's point no.8 where he talks about stocks that lose 50% of their share price. I am of course going to ask whether losing 50% of share price is more common amongst stocks that regularly pay dividend with strong free cash flow versus stocks with poor cash flow and high debt. Stay tuned.