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June 18, 2012

Growing Importance of Dividend Yield Amid Low Growth Environment

There are a slew of variables that will likely extend the period of depressed economic activity and uncertainty going forward including but not limited to the likely exit by Greece from the euro, worsening unemployment and hiring figures here in…

Growing Importance of Dividend Yield Amid Low Growth Environment

There are a slew of variables that will likely extend the period of depressed economic activity and uncertainty going forward including but not limited to the likely exit by Greece from the euro, worsening unemployment and hiring figures here in the US, uncertainty about future tax rates, and an upcoming replay of the debt-ceiling drama that we went through last summer.

In light of all of these issues, investors should be mentally preparing themselves for what has become a markedly different but probably more “normal” investment environment characterized by lower returns and greater volatility.

Interest rates are already low, and valuations and corporate margins are above average. With everyone’s favorite buzzword, “Austerity”, being pedaled by central bankers across the globe, growth will be extremely hard to come by.

In fact, few people truly understand the magnitude by which debt expansion has played into economic expansion and therefore the wonderful investment growth that we’ve experienced over the past decades. In today’s world where credit contraction and deleveraging are on the minds of most everyone from governments to corporations to individual consumers, debt is now shrinking, making continued growth a highly unlikely proposition.

What’s more, volatility is likely to be higher due to the variable pace of deleveraging along with the sporadic state intervention. Politicians generally plan for the short term, and policy initiatives therefore are more likely to address the symptoms rather than the cause of our indebtedness.

All this will create distortions and uncertainty, and will encourage speculative capital flows — and is likely to extend the period of depressed economic activity. In a low-growth world, dividend yield will be crucial for generating equity returns.

Equity Yields

During the past 40 years, dividend yield and dividend growth combined have contributed about 78% of total returns from U.S. equities and nearly 100% in Europe. Lower economic growth will lead to lower growth in earnings and dividends.

Heightened macroeconomic uncertainty tends to have a dampening impact. Dividend yield therefore appears to be the most likely candidate to drive future total returns.

In a more volatile world, investment strategies should seek to produce a return with lower volatility, particularly on the downside. An asymmetric investment strategy, making money at times of rising asset prices but losing less when prices fall, is appropriate.

A focus on income has proved traditionally to be less volatile than a growth-oriented approach to equity investment and has had a “protective” quality during market downturns. Dividend yield and dividend growth tend to display significantly lower volatility than earnings growth and multiple changes. Once a dividend is established, companies tend to try to keep paying it to avoid sending a negative signal to the market. As a result, earnings growth tends to be three times as volatile as dividend growth.

Higher-yielding stocks also tend to go down less during market downturns. One possible explanation is that during market downturns, investors are drawn to the relatively stable earnings and dividends from defensive high-yielding equities.

Yield from Other Sources

Along with catering your equity portfolio toward companies that tend to be less volatile because of their enticing dividend structure, there are numerous non-equity related structures that are tremendous complements to a solid income oriented investment strategy. South Coast has written a number of pieces over the years about driving consistent portfolio returns by segmenting capital into buckets that vary by duration, liquidity and sector exposure.

Now is the time to review your portfolio and determine if there are alternative sources of income that may be viable replacement options for some of your more speculative and subsequently more volatile equity positions.

High Yield fixed income, investment real estate, oil and natural gas, structured notes, and Business Development Companies (BDCs) all present potentially compelling opportunities to balance out a portfolio where long term growth goals can be partially achieved by taking risk off the table every month or quarter when the income check arrives.

For investors attempting to match the performance that many investment historians quote for long term returns of equities (8-11% per annum), looking to investments that can achieve current returns through cash flow of 5-7% seems like a very sound place to start.

One thing to always keep in mind, especially in the low interest rate environment that we have today, is that there are tradeoffs between liquid versus non-liquid investment structures. Dividend paying equities are a solid cornerstone for a balanced portfolio today but the liquidity of their shares allows investors to “bid-up” those prices and compress those sought after yields.

In order to generate a higher percentage of your target return from current cash flow, in today’s environment it may be opportune to look beyond liquid alternatives and into longer-term, non-liquid vehicles for their higher current yield characteristics.

Triple Net Leases

If slow to no growth is the prognosis, one might find a good source of long-term stable yield from real estate leased on a triple net basis – meaning that the tenants are responsible for a fixed payment to the landlord along with also paying for most or all of the typical operating expenses that are normally born by the landlord.

By acquiring real estate leased to strong, credit worthy tenants over long terms with nominal rental growth, you can “lock in” what could be a large portion of your total return goal through current income – today yields in the net lease space can be found in the 5-7% range.

To be fair, long-term leases may provide stability but they may not fare as well as other sectors during inflationary periods. Being locked into a long term lease will restrict the landlord’s ability to raise rent in order to keep up with inflation.

While it is not appearing likely that we will be plagued by much inflation in the near term, it must always be considered during the planning process. This is why we at South Coast look to complement stable income strategies like investments in triple net leased real estate with other strategies that can help bolster purchasing power during inflationary periods.

The other main risk of owning a property with a single tenant on a long-term lease is the potential for the credit worthiness of the tenant to deteriorate over time. You should look for tenants with strong balance sheets, low debt structures, sound business fundamentals and, for the belt and suspenders safety net, acquire properties that could be easily released to a new tenant should your original tenant fold or decide to buy their lease out early. Reusability is a key characteristic that we look for in the single tenant, net lease sector.

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