“Separate the wheat from the chaff.”
This famous idiom alludes to the ancient practice of winnowing grain. When applied to investing, it also can mean to choose high quality over lower quality. In the case of investments that pay dividends, it’s always a wise practice to do your homework on every asset to be purchased for a portfolio where income is a primary objective. Knowing whether an underlying asset can pay out a specified amount of annual income from organic growth is paramount in filtering out sheep from the goats, the men from the boys, etc.
Careful selection from top-down analysis is a proven method of finding income-paying instruments that have real legs, not just in up markets, but also displaying durability during market corrections. Taking a view of macro trends, identifying those industries and sectors that are leveraged the most to those trends and then filtering out those stocks, funds, exchange-traded funds (ETFs), master limited partnerships (MLPs), business development companies (BDCs) or other investments that will come under accumulation because they have leadership qualities is a time-tested way to pick assets. Such assets typically outperform on the way up and hold the line better than most other income assets on the way down.
People panic out of stocks because much of the time they don’t have a strong knowledge base of what they own and why they own various securities. As a result, those investors lose faith in their portfolio holdings very quickly at the first sign of trouble. This kind of behavior finds the majority of investors piling in at the top of a major move and bailing out near the end of a steep decline. And since fear is a stronger emotion than greed, knowing what makes each investment holding tick can help prevent unwarranted anxiety attacks that trigger bouts of selling that are regretful in retrospect.
Take for instance the Select Sector SPDR Utilities ETF (XLU), a basket of America’s finest electric utilities. The top 10 holdings power up the majority of the nation’s homes and businesses and are unquestionably a cornerstone in long-term institutional pension plans. At the 2007 market top, shares of XLU were trading at $45, followed by a dramatic waterfall 50% sell-off to trade at $22.50 at the March 2009 nadir. Today, the same shares trade back at $45 after posting an all-time high of $50 this past January and sport a current dividend yield of 3.14%.
Now, I understand why investors flee from high price-earnings (P/E) ratio stocks that specialize in whiz-bang technology, the latest fashion statements or systemic collapse of home prices and other leveraged areas of the economy. Many of those stocks never rebounded and some went out of business altogether or trade at pennies on the dollar, a la Fannie Mae and Freddie Mac. But while huge budget sacrifices will be made during a recession, the electric bill is one that Americans typically will always pay. Those investors that took the other side of that trade when the XLU reached $22.50 on March 9, 2009, are ahead by more than 100% on that purchase, locking in a better than 6% yield at that level and getting paid all along the way for doing so. Wheat-from-the-chaff investing is simply backing up the truck when the market takes everything down, even the bluest of blue chip companies that provide the very things and services that no one can live without. In the event the market endures another correction like that of 1987, 2000 or 2009, which is highly likely, don’t blink if the XLU trades down by 50%. Just get in there and buy, buy, buy.
In case you missed it, I encourage you to read my e-letter column from last week about how the right domestic stocks can still be profitable. I also invite you to comment in the space provided below my commentary.
I invite you to join me at the MoneyShow Las Vegas, May 12-14, 2015. With stock picking taking on renewed importance as the market shows signs of volatility, this event offers an opportunity to hear from a number of experts, including my Eagle Financial Publications colleagues Mark Skousen, Doug Fabian and Chris Versace.
Be a guest of Eagle Financial Publications and register for FREE by using priority code 038657 and calling 800-970-4355 (toll free in the United States and Canada) or signing up online.