Dear Daily Crux reader,
If you're investing for income, you might be making a big mistake.
So says our colleague Dan Ferris, editor of the income-focused 12% Letter.
Thanks to the Federal Reserve's zero-percent interest rate policies, it's harder than ever to earn a decent return on your money… and investors have been rushing into the last "safe" sources of income in the market today: bonds and blue chip dividend stocks.
But Dan thinks many investors are taking on much more risk than they realize. Read on for the details…
Good investing,
Justin Brill
Managing Editor, The Daily Crux
www.thedailycrux.com ––––––––––––––––––––––––––––––––––––––––––
Two huge mistakes income investors
The Daily Crux: You recently warned 12% Letter readers that many income investors are blindly making two big mistakes today. What are they?
Dan Ferris: Actually, in a way, investors are making the same mistake in two different assets: bonds and quality dividend-paying stocks.
How it is possible they're making the same mistake in two investments that are so fundamentally different? It's simple, and it's all about value.
Let's start with bonds. I believe it's clear to anyone who's paying attention that the bond market is in a bubble.
Investors have been rushing into "safe" U.S. Treasurys and investment-grade corporate bonds, despite the fact that they've become so expensive – and yields have become so low – they are practicallyguaranteed to produce negative real returns after inflation.
The investors buying these bonds are literally choosing to lose money on their investment over time. That's Bubble Investing 101.
The key defining characteristic of a bubble is when the price of a security or the asset becomes totally unhinged from its fundamentals.
For example, during the housing bubble, home prices where I live in southern Oregon went up by 25% or more each year for several years in a row. Historically, home prices in my area have gone up by only 1% or 2% a year on average.
There was no rational reason why they should have suddenly started rising by 25% a year. It was clear we were in a bubble to almost anyone who was paying attention.
This is the same situation we have in bonds today. Prices are high and completely out of touch with fundamentals. When people are falling over themselves to make negative real returns, there's no question to me we're in a bubble that could burst at any time. Investors buying Treasurys and most corporate bonds today are likely making a terrible mistake.
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Crux: So buying bonds is the first big mistake you see… But you also believe it's a mistake to buy many of the world's best stocks today. Coming from someone who recommends those stocks almost exclusively – and even coined the term "World Dominating Dividend Grower" – that's a surprising statement. What's the story here?
Ferris: I can understand that might sound shocking, but I can assure you my feelings about quality dividend-paying stocks have not changed. Again, it's about value.
World Dominating Divided Growers – my name for companies that dominate their industries and raise dividends year after year like clockwork – are fantastic investments… But you still have to buy them at the right price.
These stocks have done very well recently. Our 12% Letter portfolio of World Dominating Dividend Growers has outperformed the broad stock market by 12 percentage points over the past year.
These stocks don't usually make big short-term moves. That's actually a wonderful trait – they're much more stable and allow you to reinvest your dividends and compound your wealth over a long period of time. But it's often seen as a negative. They're seen as boring, and they're often passed over in favor of riskier stocks with high current yields or huge growth stories.
But from time to time, even these "boring" stocks come into favor. Now that many of these stocks have rallied significantly, the investment world is taking notice. It's human nature to want to buy what's doing well – what's going up – and sell what's falling.
The investors who bought them when they were unpopular are probably feeling pretty good… and maybe a little greedy. Surely, it wouldn't hurt to buy a little more? After all, these are safe, dividend-paying stocks, right?
And the people who ignored them earlier because they were "boring," are getting interested now… because, hey, maybe they're not so boring after all. This strategy may work for short-term momentum traders, but it's a disaster for investors.
The simple problem is that many of these stocks have rallied so much, they're no longer the great values they once were. High share prices are the enemy of the long-term investor. The higher the price you pay, the lower your rate of future returns.
Crux: If bonds and many top dividend-paying stocks are too expensive to safely buy today, what's your best advice for income investors?
Ferris: The best advice I can give is to be extremely selective.
This isn't a radical idea… Serious income investors should always be selective about what they buy and how much they pay, but it's more important than ever.
While bonds and the best dividend stocks are generally expensive, there are always exceptions when it comes to the market. There are still some great values out there… they've just become much harder to find.
Bonds are not my primary area of expertise, but I know S&A's True Income advisory has an incredible track record of uncovering value in corporate bonds. If you're determined to invest in bonds today, that's a wonderful place to start.
Many of the stocks we own in The 12% Letter are currently too expensive to buy today, but there are still two World Dominating Dividend Growers that are great buys right now. I'm biased, but I think they're the absolute best place for new money today.
It wouldn't be fair to my subscribers to reveal them here… But at just $39 for a one-year subscription toThe 12% Letter, we've made it affordable for everyone to access these stocks.
Finally – and most importantly – if you can't find any great values, don't be afraid of cash. As an individual investor, you have no reason to be fully invested all the time. Just hold cash – a portion of which should be in physical gold – and you'll be fine until better opportunities come along.
Crux: Great point. Thanks for talking with us, Dan.
Ferris: My pleasure.Editor's Note: To sign up for The 12% Letter – without watching a long promotional video – click here.
Sunday, 12 August 2012
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