From David Fabian: Many investors are familiar with the GARP acronym, which stands for Growth At A Reasonable Price. The basic definition is to uncover stocks with reasonable fundamentals (undervalued) that have sustainable growth potential. The methodology seems sound and is essentially a way of saying – don’t chase price simply for the sake of recent performance.
On the flip side of that ideology is a perilous path that I have seen many investors tread in recent years. I call it “Yield at Any Price” or YAAP.
YAAP is essentially someone saying – I don’t care what the price or fundamentals are doing, just get me a 7% yield. The benefit in their minds is that they are receiving an above-average income stream to fund a certain retirement lifestyle or simply watch dividends pouring in each month. Yet, there are a surprising number of downsides to this strategy that many don’t consider before they take the plunge.
The foremost is that the higher the yield you are trying to seek, the higher the risk of capital invested. There is no free lunch in the income world. Every incremental step you take out on the yield spectrum adds another layer of potential price volatility. That can work in your favor as risk assets grind higher. However, it can also be a very swift and frenetic waterfall of capital deprecation on the downside as well.
A perfect example of this is high yield bonds (also known as junk bonds). The companies that are paying yields of 7, 8 or 10% on their debt are doing so because they have a lower credit quality rating than investment-grade companies. It’s like giving a loan to someone with a 500-credit score. You hope they pay it back, but in the meantime, there is going to be a premium interest rate for the privilege of taking your money.
Having tunnel vision for a specific factor, such as dividend yield, often leaves you blind to obvious flaws. I liken it to marrying someone just for their looks rather than the sum of all their positive qualities. It’s important to ask yourself several questions before you own any high yield investment so that you understand the potential risks and what drives the underlying price action.
- Is the investment credit sensitive?
- Does it move with interest rates?
- Is it a deeply undervalued debt or equity play?
- What is your risk management philosophy if it ultimately doesn’t work out?
The point of this analysis is to provoke an awareness of current price levels versus yields and ultimately what the expected outcome will be. I review portfolios all the time where someone is holding some junior tanker company or master limited partnership that is paying an 11% yield. They swoon when they tell me about how much money it has paid them over the last two years. However, when I pull up a chart, the investment has depreciated 50 or 60% in value.
What sense does it make to hold something for income when it’s cratering in price?
It’s also likely in this scenario that the dividend is going to get cut because the underlying fundamentals or cash flow can’t support the yield. That’s when things get truly ugly.
A level of caution must be warranted when prices of high yield investments become stretched on the upside as well. There is a counter-intuitive mindset that must be upheld when considering adding new money to closed-end funds, MLPs, REITs, preferred stocks, and junk bonds when they have already made a big move higher. Patience and discipline are going to be your allies when seeking out new entry locations for these asset classes – just like in stocks.
I’m inclined to believe we are closer to that turning point of bullish sentiment and overbought prices at this juncture than an attractive entry point for new money in many high yield areas of the market. The chart below demonstrates the one-year price study of the PowerShares CEF Income Composite Portfolio (PCEF), iShares High Yield Corporate Bond ETF (HYG), iShares Mortgage REIT ETF (REM), and Alerian MLP ETF (AMLP).
The slow grind higher in prices over the last year has now depressed yields along the entire credit spectrum. That means generating a total portfolio yield in excess of 6 or 7% now requires an even deeper plunge into speculative risk assets.
As a manager of income portfolios, I aim to be strategic about selecting investments that work in harmony together to attain the right balance of risk and reward. You are never going to fully eliminate every negative variable. However, you can enhance your chances for success by being wary of likely headwinds and using probabilities to your advantage.
It’s also beneficial to remove the stigma of yield for a more reasonable goal of total return (dividends and capital appreciation). This will likely see you pair both high yield and high quality positions together to help smooth out volatility and strive for cumulative gains.
The Alerian MLP ETF (NYSE:AMLP) was trading at $13.18 per share on Thursday morning, up $0.12 (+0.92%). Year-to-date, AMLP has gained 4.60%, versus a 2.64% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of FMD Capital.