Seeing the Forest for the Trees

During challenging market conditions, it is easy to get caught up in headlines and daily noise. Sometimes it is helpful to take a step back and visualize your portfolio for what it is: a basket of cash generating – and often cash distributing – securities (stocks, bonds, REITs, MLPs, etc.).

At Coastwise we focus on not one profit center but three: 1) dividends, 2) income from option sales, and 3) capital appreciation (the thing that makes daily headlines – price movements).

Each position held can be thought of as a money tree, with a portfolio of 30 – 40 positions being your own cash generating forest. At any one time, at least 2 of the 3 sources of profit are typically working for you. If you buy the right companies, then your forest sprouts cash dividends on almost a weekly basis, like clockwork. Cash, cash, cash, dropping to the ground for you to pick up and spend, or put back into the money tree to help it grow and generate even more cash in the future (from reinvested dividends). All of this is happening regardless of where short-term prices are headed.

If you use covered call options to hedge your portfolio and generate immediate cash credits, you have another highly reliable source of income independent of overall market conditions.

While in about three out of four years the sun is out and the trees also grow (price appreciation), from time to time there are storms. Heavy winds bend the trees and they shrink in size temporarily until the storm passes at which point they continue their rise towards the heavens. (A quick point on this, you will often hear the phrase, “trees don’t grow to the sky” when financial commentators insist a bear market is inevitable. The analogy is a false if not dangerous one. Look at a chart covering stock prices over the last 200+ years. With the occasional almost imperceptible dip along the way, the chart keeps heading higher and higher. The same goes for world human population. During our lifetimes, and those of our children and grandchildren, stock prices broadly speaking – e.g. the S&P 500 – as well as human population – will certainly be higher). That said, to be sure the periodic hurricane (i.e. broad bear market) affects your entire money forest, on other occasions a local tornado challenges an individual (single company) or group (e.g. industry) of trees while others continue to thrive.

What is important to note is that while these storms occur, the other forms of cash profits (dividends if you own dividend paying stocks, options premium if you/your advisor employs options strategies) continue without interruption. In fact, as the storms cause profit center #3 to wane, cash generators #1 and #2 actually tend to cause your money trees to generate even more cash. How? Because as dividends are reinvested at lower prices, more shares are purchased, which leads to higher future income. On the options front, as markets decline, options tend to become more expensive overall which is to the benefit of sellers.

Most investors fixate on short-term price movements but the real ‘action’ is the compounding of dividends. For the broad S&P 500, dividends have represented over 40% of total returns over time. Hold mostly dividend paying stocks rather than the broad S&P 500 which contains many non-dividend payers? Dividends as a percentage of total returns goes even higher. And when you factor in the compounding effect of dividends, they can make up 70% or more of total returns over time. Just check out this math as to the power of how dividends can compound over time leading to ever increasing income.

If you start with a $1M portfolio that has a combination of stocks paying on average 3%, in year 1 your income will be around $30,340 (not $30K since you will have received 4 payments and each payment buys more shares which in turn pays out higher dividends). Assuming that dividends grow at an annual rate of 8% per year (companies like BA have been growing their dividends at a much faster pace the last decade or so), then after 10 years the income generated is already double digits (over $100K per year). Due to the power of compounding, income exceeds 40% of original invested capital (over $400K of annual dividend payments) by year 20 when dividends are reinvested. This shows the incredible power – and importance – of dividends as a source of income and profits in a portfolio.

Since the last tsunami of 2008/2009, to mix climatic metaphors, we have seen the occasional storm (and of course plenty of individual trees have been taken out to the wood shed) with rapid forest regrowth thereafter. At some point we will again experience a real, sustained bear market. Even then, other sources of profit will invariably continue unabated, and remember the average bear market comes and goes in under 18 months. So next time your forest of money trees is taking a hit, sleep well at night knowing that beneath that storm dividends are being paid out consistently, calmly, like clockwork, and that for some of you, your hedges are…hedged. If that is not the case, contact us at 858-454-6670 to review your specific circumstances.

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