The recent sell-off took investors by surprise … and the future is uncertain.
So let’s take stock, and come up with a strategy to play the stock market for the next while:
- FACT: COVID-19 has trashed the economy. Millions are unemployed. Companies big and small are shutting down left and right. Others are hanging on only through government bailouts. But Washington seems to have pulled the plug on further bailouts for ordinary folks.
- FACT: Despite this, the stock market is near all-time highs. Stock prices relative to corporate earnings are where they were just before the Great Depression. There are some hot prospects, but it’s hard to see how most stock prices can go higher. The market knows this … hence the recent volatility.
- FACT: Investors with money in their brokerage accounts can’t just let it sit there. They must decide what to do next … quickly.
In this context, a popular strategy is to look for companies whose valuations have taken a hit from the pandemic.
If they have strong balance sheets, can survive until a vaccine is available … and if they provide goods and services that people will always buy … we can expect their stock prices to take off.
But that’s only half the story … and a lot of investors forget about the other half.
You see, there’s an easy trick to dramatically increase your gains when you go hunting for value investments … one that we’ve employed with great success in The Bauman Letter.
The Open Secret to Huge Gains
In a hyper-speculative growth market, it’s easy to forget about dividends and the income they provide.
But that’s a grave mistake.
Whether you take dividends as cash or reinvest them, income-producing companies are the smart investor’s best friend.
The facts speak for themselves.
The chart below shows the relative return of the S&P 500 Index since 1990. The bottom line shows the increase in overall stock prices. The top line shows the return if you received and reinvested dividends:
Yep, that’s right. Reinvesting dividends would have more than doubled your return.
But that’s for all 500 stocks in the S&P 500 Index. For the last 20 years or so, their combined yield has averaged a paltry 1.75%.
Here’s what happens if you had invested in a company that pays a decent 5% annual dividend 30 years ago, and reinvested the dividends:
Now let’s look at what happens with the same investment over the same time period … only this time, you swooped in to buy an undervalued company in the middle of a market bottom.
Let’s say the normal dividend yield was 5%, but the stock price temporarily fell by 50%, raising it to 10%. Here’s what happens:
For a final example, let’s assume the same company increases its dividend by 5% every year:
Your $1,000 investment is now worth over $200,000.
The Only Yield That Matters
Note one important thing about all these examples: They assume no change in the company’s stock price over time.
That’s not the way things work in the real world, of course. A company’s stock price can go up and down for all sorts of reasons. But holding the stock price constant illustrates the powerful effects of reinvesting dividends … and most of all, the concept of yield on cost (YOC).
YOC is the dividend payments you receive every year divided by the price you originally paid for the stock. As the company increases its dividend year after year, your YOC rises correspondingly.
In my final example above, your YOC in the year you bought it was 10%. By year 10, your YOC was 16%. In year 20, it’s 25%. And by year 30, it’s nearly 40%.
We use YOC to great advantage in The Bauman Letter’s Endless Income portfolio. The cumulative YOC for the portfolio is already 23% higher than the current quoted yields on the same investments.
In one case, the YOC is 67% higher than the current quoted yield … and we’ve only held that position for a little more than a year and a half!
Your Strategy for What’s Coming
YOC is the only yield that matters to an investor. That’s because it’s the yield you actually get, not a statistic on a website.
And the way to achieve great YOC is to buy solid companies with a history of consistent dividend increases — especially when they’re cheap.
That’s exactly where we are right now. We know that the stock market is overvalued. The big gains in stock price appreciation alone have come and gone.
But there are plenty of companies trading at steep discounts that have a history of paying strong dividends and raising them regularly. Some of them have temporarily reduced or suspended their dividends, hitting their stock prices hard. But given the role they play in the economy, they will definitely resume strong dividends soon.
One example is the financial sector. The Federal Reserve asked the nation’s big banks to hold off on dividend payments to strengthen their balance sheets amid the crisis.
But as sure as the sun shines, those dividends will go back up again.
To play the financial sector and tap into those dividends when they resume, you could buy an exchange-traded fund (ETF), the Invesco KBW High Dividend Yield Financial ETF (Nasdaq: KBWD). Based on historical yields for its constituent holdings, buying it at current prices sets you up for a YOC of as much as 13%.
And as the examples I’ve shown you today prove, that’s just the beginning!
Editor, The Bauman Letter