Income investors have a rough life these days.
The yield on the S&P 500 Index is just 1.9%, while 10-year Treasuries languish at 2.5%. Other havens for high-income investing, such as mortgage real estate investment trusts (mREITs) and energy master limited partnerships (MLPs), look unsound when you take a closer look.
Investors can blame monetary policy (after all, there are few havens from Janet Yellen)…
But they can also blame the growing Wall Street trend of replacing dividends with stock buybacks.
Stock buybacks are largely an American phenomenon… And, unfortunately, they offer nothing to individual investors.
Luckily, there’s an incredibly easy way to avoid being looted…
Avoid the Stock Buyback Trap
Stock buybacks have grown like crazy in the last 10 years, running far ahead of research and capital expenditures, and reaching $338 billion in the first half of 2014. Amazingly, some companies, such as Hewlett-Packard (HPQ), have paid out more than their net income over the last 10 years in stock buybacks.
Why is this so bad for shareholders? Well, the principal cost of stock buybacks is that they’re pro-cyclical. Companies, like the rest of us, are poor economic forecasters, and they tend to buy back stock at the top of the market and suspend buyback programs – or even issue more stock – in the next downturn.
When you put it all together, stock buybacks are, on average, a direct looting of shareholder value. The main beneficiaries are members of top management, who have stock options and benefit directly from buybacks. Not surprisingly, these same people dislike dividends, which go to ordinary shareholders but not option-holders.
All of this may sound bleak for the typical investor, but there’s a simple solution: Invest in countries where the culture of stock options is weaker and where management still rewards shareholders with cash dividends.
For starters, companies in these jurisdictions tend to be more solid. They won’t pay out all of their earnings in stock repurchases and, therefore, will be less leveraged, with better cash positions, going into downturns. (Even many U.S. companies with cash piles, like Apple (AAPL), have their cash entirely overseas, and thus can’t repatriate it without a whopping tax bill.)
I recommend investing in Europe, where valuations are less overextended than in Asia and the stock repurchase program is less entrenched than in the United States.
Two Winners in European Market
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There are two primary problems with Asian countries, even though they’re less prone to stock buybacks than U.S. companies. First, several Asian markets are selling at high P/E ratios, so even if they’re paying dividends, the yields are low. For instance, the iShares MSCI Japan (EWJ) fund yields just 1.4%, even less than its U.S. counterpart.
Second, a number of Asian countries (such as Thailand, where democracy has recently been suspended) suffer substantial political risk. Dividend investors, by definition, want to hold their positions for a long period, collecting income from them – which means that countries with political risk threaten dividend investors much more than active traders, who can spot problems coming and move quickly.
On the other hand, the EU economy is showing signs of recovering from its credit crisis over the last few years, and the European Central Bank is committed to keeping liquidity flowing.
Now, you don’t want to buy shares in bad actors like France, which is breaking its EU deficit targets and appears dedicated to ever more expansion of its bloated government. Instead, Sweden – iShares MSCI Sweden (EWD) – and the United Kingdom – iShares MSCI United Kingdom (EWU) – have yields that an income investor should seriously look at.
Sweden has cleaned up its act a great deal since getting in trouble around 1990, and its government is now less socialist than many European countries and a lot more honest. (Yes, the Social Democrats have returned to power, but the current ones are a pretty moderate bunch.) The Economist reckons that Sweden will grow 2.3% in 2014 and 2.8% in 2015, which is pretty solid.
Sweden also has a thriving collection of industrial companies such as Ericsson, Atlas Copco, and Volvo, all of which are among EWD’s top 10 holdings. Based on its most recent 12 months, EWD has a yield of 3.6%, a P/E ratio of 16, and an expense ratio of just 0.5%. That means new investors can get a fine combination of yield and likely solid growth.
Meanwhile, in the U.K., David Cameron’s Conservative-Liberal coalition government has faced a few grim years… but the economy has begun to perform much better recently, indeed the best in the EU. The big political risk, Scotland voting for independence from the rest of the U.K., has gone away. The only concern now is that the election next May could bring the Labor party back to power, but The Economist still forecasts growth at 3.2% in 2014 and 2.8% in 2015.
One final note: EWU nominally yields 6.1%, but that’s a little misleading since it’s based on a big dividend paid in June from Vodafone’s sale of Verizon Wireless. Based on the previous year’s results, the yield is around 3%, while the fund has a P/E ratio of 15 and an expense ratio of 0.5%.
Bottom line: Without blowing the trumpet too loud for my native land, I think it looks like a pretty sound investment right now.