Investing For Income
When a real estate investor builds an office building on Park Avenue in New York and then leases it out over 20 years to a corporate tenant, they don’t spend time checking what its resale value is every day or every week. They collect their income and either live on it, or more likely, re-invest it in additional projects that continue to grow their income every month. This is true of other investors, including business owners and industrial companies.
Ford Motor Company, for example, may build a new plant to make cars and trucks. Once the investment is made and the factory is up and running, nobody at Ford cares much about what the re-sale value of the plant is from time to time, since Ford is not in the business of selling factories. What they care about is the number of vehicles it produces on a regular basis, and how to increase that number going forward.
That’s the approach I take to my investing. I think of my portfolio as an Income Factory® whose job is to produce cash, via dividends and distributions, which I can reinvest to create my own growth through compounding. The “Rule of 72” will determine how fast my income will grow. If I can collect and reinvest yields at a rate of 10%, as I’ve been able to do over the past year, then I’ll double and redouble my income stream every 7.2 years, since 72 divided by 10 equals 7.2. If I “only” collect and reinvest at 8% (which is still pretty good) then my income stream would double and redouble every 9 years, since 72 divided by 8 equals 9. So a $10,000 investment, yielding 8%, that doubled and redoubled every 9 years, would see its income stream reach 16 times its original amount in 36 years. That’s why a strategy like ours works just as well for a 25-year-old just starting to save and invest for retirement, as it does for old codgers like the author, and everyone in between.
Mister Darcy Knew How To Invest
Until relatively recent times, investors focused on their income, rather than on the value of the assets that produced that income. Literature buffs will recall that Mister Darcy, the eligible and wealthy suitor in Jane Austen’s Pride and Prejudice, was described as having an income of £10,000. There was never any reference to what the assets were worth that generated such an income.
A famous economist from the 1930s, John Burr Williams, first articulated the idea, now a basic pillar of corporate finance, that an asset’s economic value is the discounted present value of the entire income stream that asset would produce over the course of its life. As suggested earlier, this principle applies to office buildings, factories, businesses, and, of course, stocks and bonds.
The implications of this for investors may not be immediately obvious. But what it really means is that the “economic value” of our assets is derived from those assets’ ability to create income; and the market value, if the market is rational, will eventually reflect that economic value. The emphasis in that sentence should be on the two words: “rational” and “eventually.” So if we focus on the income our assets produce, eventually that will be reflected in its market value, but in the meantime it’s the income the assets generate that really matters and makes the assets “valuable” to us.
Most people understand this intuitively, which is why throughout much of our lives we tend to judge how well we ourselves, our friends, family and others are doing financially by the size of our incomes.
Until relatively recently, most people took that approach to planning their retirements. Most of our parents and grandparents were fortunate enough to work at a single job for much of their lives, and it was typical for employers to provide what were known as “defined benefit” pensions for their employees. That’s where retirees received a fixed amount for the rest of their lives, based on their years of service and the amount of their salaries prior to retirement.
The total focus was on the amount of an employee’s income, both before and after retirement. How big an investment portfolio was required to generate that income was somebody else’s problem; namely the employer and the professional investment firm they hired to invest and manage their pension plan. There was also a government insurance agency created to protect pensioners in case the “professionals” got it wrong, screwed up their investment strategy, and came up short.
Between those defined benefit pension plans, and Social Security, which is a defined benefit pension plan from the government with the added advantage that it is inflation-adjusted (which most private pension plans are not), the average retiree had their former employers, third-party managers and the government worrying about all the details of how much money was required and what to invest it in to deliver the promised retirement income. They were not dependent on a “self-invested” portfolio for their retirement income. Obviously, many people did have investment portfolios, but except for wealthier individuals, those portfolios tended to be relatively small and were “icing on the cake” in terms of contributing to most people’s retirement income.
Enter 401Ks and IRAs
With the introduction of “defined contribution” plans just over 40 years ago, this has all changed. Now the individual owners of these 401Ks and IRAs have essentially become their own pension plan managers, and most of them no longer have professional money managers doing it for them as previously. There are still some legacy “defined benefit” pension plans still offered by a few large companies, but they play a smaller and smaller role in the whole pension picture as more longer-term older workers retire, and as fewer younger workers stay at the same job long enough anymore to build up much of an eventual pension, given formulas that depend so heavily on longevity. Now most pension plan beneficiaries themselves (i.e. all of us) are responsible for making sure our own IRAs and 401Ks are up to the task of providing us with the pension payments we’ll need in retirement.
This in turn has led to an explosion in retail investors’ interest in the “how to” of investment management, and the growth of an enormous industry of (1) financial publications to advise investors how to invest (e.g. Seeking Alpha and other sites), (2) providers of hands-on money management services (e.g. banks, brokers, financial advisors, etc.), and (3) financial media to provide news and data, as well as “keep score” on a continual basis (like CNBC, Bloomberg, Fox Business News, etc.).
Every new retail investor is taught from the get-go that “keeping score” or measuring their investment performance revolves around market value growth. CNBC and other investment media have adopted the ESPN sports network model and reports the prices of various stock and bond indices as well as the individual prices of major securities on a routine basis throughout the day. This business model makes total sense if your goal is to maximize viewership and have as many eyeballs per minute glued to your screen and avidly following market ups and downs all day long.
It would have been far less relevant to Mr. Darcy or the other investors in Jane Austen novels. Nor is it of much interest to Income Factory® or other income-focused investors who care mostly about growing their income stream and are less concerned about short-term price movements.
Case In Point: 2022
This past year was a good test of our Income Factory® strategy. The S&P 500 Index ETF (SPY) had a yearly total return of -18%, while yielding 1.5%. My own personal portfolio, which includes all the funds, BDCs and ETFs that are included in our model portfolios, as well as other positions that I own and report on regularly to our members, had a total return (loss) of -16.8%, which is fairly close to the -18% total return (loss) of the S&P 500.
But there were two primary differences between my strategy and a typical equity strategy:
- While the S&P 500 was generating a yield of only 1.5%, my Income Factory was generating a distribution yield of 10% that I was able to reinvest and compound at that rate. That meant over the course of the year, even though I suffered a “paper loss” just like an equity investor, my cash income steadily grew, month to month throughout the year, at an annual rate of 10%. So my portfolio’s “economic value” as we described earlier, has grown even though the market value dropped. This has made it a lot easier to sleep at night all year (and turn off CNBC) than if I had only been collecting a cash yield of 1.5%, while suffering a similar drop in market value.
- But even better, had I been a retiree dependent on collecting and spending income from my portfolio, and had been invested in equities only earning a minimal yield, I would have had to sell off assets to fund my living expenses. This is what many retirees do who have equity portfolios that they need to take cash out of regularly. Ideally, in a market that is rising, they can sell off capital gains as they earn them, in order to fund living expenses. But during bear markets and other periods of declining prices, when there are no capital gains (like this past year), it often means having to sell off “core capital” at what may be the market low-point or close to it; essentially “eating your seed corn” to pay yourself a dividend, as I have described it elsewhere. With a high-yielding portfolio, we can pocket our 8 to 10% distribution without touching the capital that generates it, leaving our portfolio intact to both (1) continue generating the “river of cash” it already produces, and (2) to be fully available to recover in price once the market finally begins to move upward (as it has so far this year, although nothing’s assured).
This is one of the main advantages of a high-income generating strategy over one that depends on capital gains. We all know that “total return is total return,” whether it consists of cash dividends and distributions, or whether it is produced by capital gains. In other words, I can earn a total return of 10% from a portfolio with a distribution yield of 10% and capital gains of zero, or from a portfolio that has capital gains of 10% and a distribution yield of zero. At the end of the day, “math is math” and the return is the same, no matter how it’s generated.
But it can make a huge difference emotionally and psychologically, as hundreds of investors have told me how much better they sleep at night knowing their income is slowly and steadily increasing, as they “give themselves a raise” each month by reinvesting and compounding their cash distributions, regardless of what market prices are doing. Meanwhile, many equity investors are nervously watching and waiting for stock prices to turn around, while only earning puny dividends of 1 or 2%.
Looking Ahead in 2023
There is still enormous uncertainty in our financial markets, as well as in our global economy and geopolitical spheres. That’s why I have maintained a distinct credit tilt in my personal investing as well as in my Inside the Income Factory® model portfolios. As most readers know, credit is far less risky than equity, since credit incorporates the issuer’s “existential” risk (will it pay its debts and survive, or fail to do so and go bust?), whereas an equity investment includes BOTH the existential risk (will the issuer survive and pay its debts?) PLUS the “entrepreneurial” risk (will the issuer not only survive, but will it also grow its earnings and dividends and, ultimately, its stock price?).
In other words, a lot more has to happen for an issuer’s stock to go up. It has to not only survive, but also thrive and grow. A bet on credit is merely a bet that corporate debt issuers will manage to muddle through and survive, whatever we are faced with in terms of a recession or economic downturn, as well as other macro issues that might hurt markets. Lots of things can happen that might tank a company’s stock, but as long as it muddles through and pays its debt, my credit investment will be just fine.
So if I can make 8 to 10% (lately 10%+) merely betting on credit, and don’t have to take the extra risks involved in betting on equity, that looks like a good choice. The asset classes I have focused on most recently include:
- Senior secured corporate loans, where closed-end funds like Apollo Senior Floating Rate Fund (AFT) and Blackstone Long-Short Credit Income Fund (BGX) offer secured, floating rate corporate loan portfolios with distribution yields of 10% and discounts of -12%.
- High-yield bonds, where a closed-end fund like KKR Income Opportunities Fund (KIO) offers a distribution yield of 10.9%, at a discount of -10.9%, or Prudential’s PGIM HY Bond (ISD) pays out 9.8% and sells at a -8.5% discount.
- The business development company (“BDC”) world offers lots of good value, with solid companies that do senior secured corporate lending selling at discounts (often big ones) and paying distributions over 10%. Check out Barings BDC (BBDC), Blackstone Secured Lending (BXSL), or Bain Capital Specialty Finance (BCSF), all at discounts and paying in the 10 to 11% range.
While you’re collecting your high distributions and sleeping well at night, enjoy the peace and quiet of less CNBC. [Disclosure: I still watch it a bit, but not nearly so much as I used to before adopting an Income Factory® strategy.]
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