Summary
- Every type of investment method has defining characteristics.
- Whenever I evaluate the market or an investment, it is through the lens of an income investor.
- Today, we look at the defining characteristics of an income investor.
Co-produced with Treading Softly.
When I was in college, I had to take numerous public speaking classes in “speech” as part of my minor. The courses were designed to give me a strong hand in the art of stage performance – be it in acting, public speaking, teaching, or anything of that nature.
In one of the classes, we were forced to give educational speeches on various topics – providing important facts to be known or “how to’s” without belaboring any point or fact too heavily. Keep it flowing and on point. The students in the class eventually called it our “3 points and a poem” requirement. We had to break down a subject into the three most important facts and find a relevant example to use at the beginning or end to tie it all together.
Today, I want to embark on a similar idea for income investing. We’re going to look at the 3 “musts” for an income investor when building their portfolio. I encourage even the most skilled among us to take a moment and revisit the basics, as often, they can be a good refresher.
One well-read book states that we should never move the ancient landmarks as those boundary stones help determine the edges of one property from another. The basics of income investing can help you stay within the zone you want to invest in and help you know where you might be taking liberties you don’t mean to.
Let’s dive in.
No Dividend? No Interest
The first basic guideline for income investing is the need for the investment to generate income.
Sounds logical, right? Yet often, income investors can get enamored by a potentially great investment that does not pay them a dime to be an owner.
While it might be a great investment for another type of investor, if you’re an income investor – it must produce income. Period.
Often we get asked about various investments in the comment section of our articles. We try to give our opinion on them if we have one. But when we look up the ticker and find that it pays you nothing to own it – I’ll give you a hint, High Dividend Opportunities won’t be interested in it.
An income investor, by their very nature, is someone investing to produce income from their holdings and, as such, demands that their holdings pay them. The market is filled with thousands of investment choices, many of which are great income sources. We recommend you hold no less than 42 at a minimum.
It’s simple, but it’s essential. You can’t be an income investor if you are not investing for an income.
Cash Flow Is A Vital Metric
Taking our thinking to a more granular level – when looking over all the various financial metrics companies provide, cash flow is vital to focus on.
Consider your own budgeting and cash flow. You focus on money in (income) and money out (spending). For a company to be able to pay you a sustainable income, they first have to earn it, and then have enough left over to pay you.
I especially like to look at the company’s free cash flow (‘FCF’). The cash flow after all cash expenses, including maintenance CAPEX, and excluding any non-cash items. Companies like Magellan Midstream (MMP
The more cash the company has after all their bills are paid, especially after they’ve paid their dividends to you, the better. That being said, an exceptionally-low yield that is very well covered is still less attractive than a high yield that is fully covered, as long as the revenue coming in is predictable.
Note that you can’t judge a company’s dividend coverage from GAAP (generally accepted accounting principles) earnings alone. That’s because GAAP earnings are often filled with non-cash impairments or earnings such as the value change of a building, a goodwill impairment charge, and other non-cash adjustments. While these are important to GAAP earnings, they do little to determine if a dividend is sustainable or paid from cash or debt.
GAAP earnings can be important to many types of investors and outlooks, but cash flow is king when it comes to income investors.
Time Is Your Best Friend
What is the most powerful force in the material universe? Excluding any faith-based or religious answers for a moment, the most readily recognizable force would likely be time. Given enough of it, almost all materials and objects are turned into dust and long forgotten. As humans, we seem to be in a constant battle against time to complete our desired tasks or find a way to leave a legacy that won’t be forgotten.
Time is routinely our foe.
“Not so fast!” cries the income investor, “I get paid to wait and paid to hold for a long time.”
It’s true! When looking at an investment, I start with a 2-3 years holding period as my baseline expectation. I would love to hold an investment for forever, but not all investments will allow you to do so. Shifting consumer sentiment, changing technologies, and shifting management teams are only a few of the reasons you may need to jump ship to better shores. Yet, when consistently maintaining a multi-year outlook, short-term price movements are no longer causes for panic and woe.
Dividends routinely arriving on your doorstep have a strong impact emotionally and psychologically. It’s easier to hold onto investments with rapidly shifting values when you’re still getting the originally desired benefit from it. I liken it to a home – while my home’s value may move and change daily, as long as I’m living there and reaping the benefits, its value determined by outside forces is of little concern to me.
Time becomes an ally as market sentiment can shift, and a holding that dropped in value can easily recover over time, all while paying me a healthy recurring dividend. Emotional or fear-driven decisions are often our worst choices and greatest source of regrets. Income investors work to mitigate those choices by befriending time and allowing dividends to make that easier.
Conclusion
If someone asked you: what are the three defining characteristics of an income investor? What would you say they were? Today, I want to suggest that they would be:
- One who demands every investment pays them an income.
- One who focuses on a company’s cash flow above other financial metrics.
- One who has found a way to make time for their friend.
I am an income investor because, in many ways, it “just makes sense.” When I worked a daily job, I got paid for my time, and in turn, I made a budget around that income. When I invest, I demand that I get paid for my money – which I earned by giving my time to a company – and, in turn, make a budget around the income my investments are earning me.
Retirement is already an exciting time and a massive milestone for us. There is no need to add a complication by changing how you live your daily life by adding an entirely new perspective on finances. Yet, countless retirees will throw out the “live below your means” handbook that was drilled into them, and instead, they are focusing on slowly dismantling all their savings to pay their bills.
That’s an entirely new paradigm to master at a time when you simply want to enjoy your golden years.
Instead, I recommend keeping the paradigm the same but changing your income source from your employer to your investments. That’s the beauty of income investing and how it can revolutionize your retirement.
Photo by Razvan Chisu on Unsplash