Dividend Portfolio – In Search of Yield

Pathetic Interest Income (Yield)

In order to obtain some sort of return on my cash I built a “bond ladder” out of brokerage CD’s. By this I bought CD’s with various maturities, and as each one came due, I bought a new CD. Due to the 2008 market crash, a lot of my highest yielding CD’s inadvertently came due early as the underlying bank was seized by the FDIC which results in the funds being returned to you early along with accrued interest through the date of seizure.

Currently yields on CD’s are frankly pathetic.

1 year – 1%
2 years – 1.2%
5 years – 1.8%

Given that CD income is treated as “ordinary income” with a tax rate (state and local) of up to 40%, this return becomes frankly negligible after tax on even a $100,000 CD. Note that on stock dividends, they are currently taxed at 15% (for now), so stock dividends look very favorable. The S&P 500 (see the SPY ETF ticker) is currently 1.98%, which is higher than the 5 year return and after tax is significantly higher (1.8% * (1-.4)) = 1.08% for the 5 year vs. (1.98% * (1 – .15)) = 1.68%.

One benefit of the CD’s, however, is that you can’t lose money (unless the Federal government collapses, in which case we all have bigger problems to worry about), a fact that was proven when the stock market cratered in 2008 and many bonds and REITS and other investments did, as well. While many banks and individual CD’s failed (including several in my portfolio), I did not lose a penny nor was my interest income impacted (up to the date of failure).

Dividend Portfolio

I started by looking at dividend ETF products. I purchased DVY, a dividend focused ETF, as soon as it came out, many years ago. DVY peaked at about $75 / share back in 2007 and plummeted to $30 / share in the depths of 2009, a hair-raising loss of 60%. Note that in order for the ETF to return to its 2007 peak, the price would have to rise 150%, which is why percentage return can be misleading (compared to absolute return from purchase price). The DVY ETF was hurt particularly hard due to the number of financial stocks in its portfolio, which went from long time high dividend players to either bankrupt or mostly severely diminished in their ability to pay dividends. DVY is currently at $58 with a 3.5% yield.

In addition to wanting dividends for yield, I wanted to try to do the following:

1) diversify a higher percentage of funds away from the US dollar (DVY is all US stocks, although many have large overseas operations)
2) capture some of the “tax loss” advantages that you can get when you have a portfolio of individual stocks

For point one, US dollar diversification, this can be accomplished by buying non US ADR’s. There is withholding on ADR’s (see posts on this topic) but you can mitigate this somewhat by picking ADR’s from more withholding friendly countries like the UK and ensuring that you take advantage of the foreign tax deduction on your taxes.

For the second point, you can deduct up to $3000 / year in tax losses against ordinary income, and you can carry forward these losses for future years. These losses are first deducted against gains, which is the first thing to do in order to reduce taxes as well. If you buy an ETF, you can only capture this loss if the entire ETF runs an overall loss at which point you’d need to sell enough shares to get your loss. Since most of my investments were ETF’s, I really wasn’t taking advantage of this $3000 / year deduction against ordinary income. To put this in perspective, a $3000 deduction at a 40% effective rate is worth about $1800 which is more than what you’d receive in interest after taxes on $100,000 at our current 5 year rate, so it is nothing to sneeze at.

How you would do this is to have a portfolio large enough to be relatively diversified, say 10 or more stocks, and then you could sell individual stocks running a loss. If you have other stocks with gains, you could be net “neutral”, but you can sell the losers and then replace them with other dividend paying stocks (not the same stock within 30 days, or you’d be subject to the “wash rule”) and then capture this loss.

Thus I started a portfolio with 11 stocks. They are listed below. My plan was to sell individual stocks that fell below 10% (to capture the $3000 loss against income, noted above) and also to ensure that my entire portfolio didn’t plummet (like they did in 2008-9) which would make this entire process useless. You don’t want to lose 10% of your money to try to capture a 3% dividend yield.

Being a pessimist, I didn’t think too much about when I’d sell if the stock rose, but the market started jumping about the time I built this portfolio in mid July so soon I had to think about when it was time to sell the stocks. I started with a goal of a 25% gain, but I later reduced it to a bit more than 15% if I thought the gain had stalled. This isn’t a long term growth portfolio, it is a “dividend yield” portfolio, so if something went up I wanted to take the gain off the table.

So these are the stocks and the gains and losses so far. I am trying to get a mix of US and non-US stocks to diversify the currency exposure (I am not “predicting” for individual currencies, just want about 50% non US). There were 4 stocks that ran up big gains (greater than 15% in short order, see schedule above):

– Siemens (ADR – Germany)
– SK Telecom (ADR – South Korea)
– Taiwan Semiconductor Manufacturing (ADR – Taiwan)
– Walgreen (US)
– Westpac Banking (ADR – Australia0

There were also 2 losers.

– Canon (ADR – Japan) – this was painful because I bought it to replace a “gain” stock I sold and it immediately lost 10% in value – this is part of the problem with viewing a volatile stock as a proxy for a debt instrument on yield
– Vale (ADR – Brazil)

Currently the portfolio is yielding a bit over 3%. The portfolio has gained about 10% in less than 4 months, a pace of gains that is not sustainable. Given that this is to replace a CD if the stocks kept falling in the portfolio I’d probably liquidate overall when we got near the $3000 total net loss (after taking into account all gains). Note that in the worst case I would have lost 10% in short order if the market immediately went against me which would have been quite painful even after the tax loss.

Conclusion

Dividends are upside down due to ZIRP and crazy low interest rates. Stocks in the S&P 500 are yielding almost 2% and many companies can borrow at 3% – 5%. For companies with higher dividends (note that the S&P 500 has many companies that pay NO dividends, like Google, so the average is less than many of the higher yielding companies). In addition, companies are able to deduct interest paid on debt (assuming they have income to offset, which companies paying dividends almost always do) so if you pay 5% interest on debt and have a 30% corporate tax rate then effectively you are paying only 3.5% “net”. Thus companies may be borrowing at super low rates and essentially paying it out at roughly the same amount in the form of dividends. While the cash many not be the same exact cash (it isn’t in and out) you can be de-facto accomplishing the same thing in economic terms.

For people who follow history, the high dividends paid today has some precedent, but these dividend yields compared to rock bottom returns has no equivalent. We are in uncharted waters, which drives a conservative person like me to try something novel like this dividend portfolio (with implied gain and loss targets) to get some extra return.

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