Co-authored with Hidden Opportunities.
The financial markets are one of the greatest wealth generators in human history. Globally, there are thousands of public companies that we can invest in to participate in their growth and prosperity. Outside individual companies, there are thousands of diversified securities in the form of index funds, mutual funds, ETFs (Exchange-Traded Funds), and CEFs (Closed-End Funds). There are plenty of strategies, techniques, and methods that we can adopt so you secure returns from the markets.
One such method is the Income Method, which we have adopted in our private Investing Group. It is an investment strategy that focuses primarily on generating regular income from investments, typically through dividends and interest payments. Even within income investing, we prioritize those that offer high yields, either through the structural design of the securities or through market prices being at deep discounts against the intrinsic values. Some notable types of securities that match our style include:
Real Estate Investment Trusts (REITs): REITs own, operate, or finance real estate assets and have no income tax obligations at the corporate level. Instead, these companies are required to distribute at least 90% of earnings to shareholders in the form of dividends, often resulting in very high yields. Realty Income (O), NNN REIT, Inc. (NNN) are notable equity REITs with decades of delivering growing dividends to shareholders.
Master Limited Partnerships (MLPs): MLPs are publicly traded partnerships primarily involved in the energy midstream business, such as pipelines, storage facilities, and processing infrastructure, generating stable and predictable cash flows. They are pass-through entities. They don’t pay corporate income tax, but instead distribute the income to shareholders, resulting in higher yields for investors. Due to regulatory restrictions and the complex tax reporting requirements (e.g., Schedule K-1), many institutional investors and mutual funds cannot or choose not to own MLPs. This often results in comparatively attractive valuations for these securities. Enterprise Products Partners (EPD) and Energy Transfer (ET) are large midstream MLPs with extensive networks of pipelines and storage facilities across the country and large and growing distributions.
Business Development Companies (BDCs): These are similar to banks but focus on lending to small and medium-sized corporations and distressed companies. Their investments are often backed by the borrower’s cash flows, equipment, intellectual property, or other assets. BDCs avoid corporate income taxes by distributing at least 90% of their income to shareholders, making them an excellent fit for income investors.
Ares Capital (ARCC) and Main Street Capital (MAIN) are two notable blue-chip BDCs with market-beating long-term total returns and massive yields.
Other Dividend Stocks: Outside the specific asset organization types discussed above, many corporations prioritize the regular distribution of profits in the form of dividends. Often, these are established companies with a track record of stable earnings and recurring cash flows. This includes companies from energy, utility, telecommunications, pharmaceuticals, and consumer staples. Exxon Mobil (XOM), Verizon (VZ), Edison International (EIX), Walmart (WMT), Johnson & Johnson (JNJ), and Altria (MO) are notable dividend stewards in corporate America.
Preferred Stocks: These are hybrid securities with characteristics of bonds and common stocks. They have priority in terms of dividend payments and are placed higher in the company’s capital stack in the event of liquidation. Preferreds often pay fixed dividends for a specified duration, making them a good fit for income investors. For more details on preferred securities, please refer to our recent article. Banks and insurance companies like Bank of America (BAC), JPMorgan Chase (JPM), Allstate (ALL), and energy firms like Enbridge (ENB) are leading issuers of preferred securities.
Bonds are debt securities issued by governments, municipalities, and public and private corporations that pay periodic interest payments and return the principal at maturity. They are typically guaranteed by the issuer’s credit and are placed higher on the capital stack. We have recently discussed strategies around individual bonds and the importance of maintaining a bond ladder.
Closed-End Funds (CEFs) and Exchange-Traded Funds (ETFs): There are thousands of diversified funds with the primary objective of delivering current income to shareholders. These funds typically diversify across income-oriented securities, as discussed above, or pursue active management to realize gains from their holdings and distribute the proceeds to shareholders. In our recent article, we discussed CEFs as a great tool for passive income.
Now that we have discussed the common types of investments that fit our high-yield strategy, let’s examine some of the biggest mistakes investors make while pursuing income investing.
1. Chasing Yield
It is a common misconception that high-yield strategies simply involve picking the investments with the highest yields. The security offering the highest yield among peers is not always the best investment. It is critical to evaluate the fundamentals of the company (or sector) and assess its ability to continue paying those dividends. Likewise, it is also important to learn to distinguish between temporary headwinds and structural failures that impact the dividends, Investing in stable, resilient businesses with strong cash flows and sound management helps secure reliable income and long-term growth.
2. Timing the Market
The financial markets are a complex institution as-is. This is why the Income Method aims to simplify things with a steady stream of dividend income. Attempting to time the market to purchase at the bottom and sell at the top is incredibly difficult to repeat and sustain. Moreover, it leads to lost dividend income, which also causes you to lose the compounding effect, where reinvested dividends buy more shares into your account, eventually increasing the subsequent dividend amounts.
Furthermore, every time you sell an income-payer, you lose the income associated with it and need an equivalent yield and risk profile. This can be difficult depending on market conditions. This constant need to replace lost income could lead to unnecessary portfolio churn and mental stress, negatively impacting your financial and personal well-being.
3. Not Reinvesting Dividends
Even if you are comfortable with your income stream, it is essential to reinvest a portion back into the markets to ensure its organic growth and provide protection against inflationary pressures. A stagnant income stream will slowly but surely erode your purchasing power.
Our Investing Group recommends implementing the rule of 25, where at least 25% of the income is reinvested into the markets to enhance the passive income stream over time. This not only provides protection against inflation, but it also lets you take advantage of market volatility by lowering your cost basis and securing higher yields.
4. Not Understanding Basic Concepts
The media often makes unfounded and illogical assumptions that sink into the mindset of the average investor. The blanket statement “high yields are risky” is misleading and inaccurate. An investment isn’t exactly risky because of its high yield. Risk is a result of fundamental issues with the company, which put the dividend at risk and raised concerns about the company’s operations and profitability. These risks can surface whether the yield is high, low, or if the company doesn’t pay anything at all.
If you are speculating in the markets to score a home run and use yield as the only criterion without a study of the fundamentals or future prospects of the company, then that yield is just as defensive as a tinfoil hat.
Income investors must understand that companies declare dividends (or distributions) in dollar amounts. The yield is a percentage of that dollar amount against the market price and is bound to change every minute the markets are open. Similarly, it is critical to understand how the company or security earns the distributions it makes and if there is an adequate buffer for the payments.
Return of Capital (“ROC”) is one of the most misunderstood components within distributions, as investors assume it is the steady release of one’s own investment dollars. ROC is a tax concept, not an economic one. For example, diversified funds that invest in partnerships and trusts are taxed at the fund level. They pass on the proceeds to shareholders as distributions. Similarly, all the distributions made by midstream MLPs are considered ROC due to heavy depreciation and amortization in this business. These are non-cash expenses that shrink the taxable earnings but don’t affect the cash flows. Cash flows support distributions, and investors should learn to study them. Eaton Vance has a well-articulated explanation for those who seek additional information on ROC as a tax concept. ROC offers significant advantages to shareholders through deferred-tax treatment on the distributions.
5. Not Understanding Tax Implications
We discussed several securities and corporation types earlier in the article. Payments from these entities can be qualified or ordinary dividends. They could also be distributions comprising long—and short-term capital gains, or ROC. Payments from REITs are 199A dividends, eligible for favorable taxation for eligible investors. Interest payments from bonds are taxed as regular income.
While tax-sheltered accounts mitigate most of the above considerations, holding MLPs in such accounts can create unnecessary complexities due to UBTI (Unrelated Business Taxable Income).
The tax situation is very different for non-U.S. investors, as dividends from U.S. corporations have a tax withholding based on the tax treaty between the U.S. and your country of tax residence. Additionally, MLP distributions experience withholding at the highest individual tax rate. Interest payments from U.S. bonds do not experience a tax-withholding for international investors.
Not all investments are suitable for everyone; for every type of account. It is critical to allocate your investments appropriately so you generate in an optimal and tax-efficient manner.
6. Relying on Past Performance
While a solid track record and history can strongly support an investment thesis, it’s important to remember that past performance is never an indication of future results. We have seen investors and analysts rely excessively on elite status tags such as Dividend Aristocrat and Dividend Challenger.
After 64 years of delivering growing dividends to shareholders, 3M Company (MMM) pursued a brutal 54% payment reduction following a significant spin-off of Solventum (SOLV). Similarly, Walgreens Boots Alliance (WBA) ended its 47-year streak of consecutive annual increases by shocking the investor community with a 48% dividend cut in Q1. Our recent article provides a more elaborate description of this matter, but the essence of the discussion is that the track record doesn’t exactly reduce the investment risk, nor does it provide any assurance of future income sustainability.
7. Not Diversifying
I saved the most important one for the last.
“Don’t put all your eggs in one basket.”
Strategies fail, companies underperform, industries face headwinds, the political climate shifts, and companies change course. There is so much that is not in our control. As individual investors, we have no influence in the decision-making within our companies. So, it is critical to have multiple sources of dividends so any problem with one of our sources does not adversely affect our lifestyle.
Conclusion
There are many ways to make money in the financial markets. So, you have chosen to be an income investor, well done! You are walking towards financial independence and setting yourself up for retirement on your terms. While income investing reduces the stress of everyday market volatility, there are several pitfalls to be cautious about to achieve success in your pursuits.
Our Investing Group operates on the principle of “more the merrier.” We diversify our income sources by maintaining a diligently crafted “model portfolio” of +45 securities across all the asset classes discussed earlier in this article. As I mentioned, we focus on high yields from fundamentally sound investments, and our portfolio targets a +9% overall yield.
Remain focused on your long-term investing goals, remain vigilant about potential pitfalls, and continue to make informed decisions. With this mindset, you can successfully navigate the path to financial independence and secure a comfortable retirement. This is the beauty of income investing.
