The market has declined by 25% in nine months. No one is particularly happy about that, but the rapid reset of prices does provide an opportunity to remind investors about basic investing math. In this case, the issue is expected future returns after a sharp move in the market, either up or down. And that math is somewhat paradoxical. Consider, for instance, investment in the income stream—the dividends—of a diversified portfolio of stable publicly traded companies. The cash yield at time of purchase in 2021 is 4%. Fast forward to September 30, 2022, and the price of the portfolio has declined by a quarter. The new yield for reinvested dividends or new money in the portfolio has become 5.33%.
That is, the expected annual cash return has increased by a third. That assumes all other things being kept equal, including no dividend growth or cuts in the interim or in the immediate future. In this particular instance, with the economy slowing, even typical, non-cyclical, dividend payers will eventually be affected. Dividend growth may slow. Some companies may even cut their distributions. But in a diversified portfolio context, the likelihood of a material reduction in the portfolio’s overall distribution is small.
So, as a practical matter, a decline in the market price of a portfolio income stream necessarily leads to an increase in the expected future cash return of said income stream. That math runs counter to the stance of typical investors who shudder at the thought of any share price decline. It runs counter to Wall Street’s scoring system that focuses on asset prices—measured daily—not asset utility. It runs counter to a fee system based on asset values—the amount you pay your broker is based on the value in your account, not the income generated by it.
Of course, it is true that even for investors focused on income streams, the share price very much matters at the time of purchase (when low is much better) and at the time of sale (when high is much better). But in between those two points—whether it is 5 months, 5 years or 5 decades—share prices matter a good deal less than the amount and direction of the income stream. And temporarily lower share prices in the intermediary period actually allow for higher future returns for the reinvestment of dividends from a given income stream. This logic has its limits. As long as the income stream increases or at least does not decline materially, there is a floor to the share price. Otherwise the yield gets too high and opportunistic investors rush in.
Let me be clear: I’m not rooting for down markets, but the math is the math. So back to 2022. If you happened to own a diversified portfolio of material income producing equities coming into the year, your NAV may be down this year. And given the looming economic downturn, a portfolio’s dividend growth might slow temporarily. Still, reinvested dividends or new money is buying essentially the same income stream at a lower cost. For most investors, that’s a good deal.
Now let’s compare this dynamic to what happens when stocks without income streams suffer a sharp decline . Does the expected future return increase? Perhaps. I don’t know. There’s no cash return to calibrate your expected future return. You can always hope for the recovery of the P/E multiple to get the stock price back up, but that requires the agreement of thousands of people and computers buying the share back up to the prior P/E multiple. That may or may not happen, and it’s a very different investment case compared to one anchored around a material income stream.
Like all investors, I’m looking forward to an eventual recovery of the markets. Dividend focused investors will benefit from the increased cash return of reinvested dividends or new capital put to work. Happy hunting.