An Investment Tip for the 2010s

HARGALOGAMMULAEMAS.BLOGSPOT.COM:The turbulent 2000s gave us two stock crashes, a real estate meltdown and broad financial mayhem. If you haven't yet lost faith as an investor, consider the merits of losing it now. The recent throes in financial markets, I believe, mark the end of a long period that has rewarded what I'll call faith-based investing, and the start of a period that will favor faith's opposite in the investment world: income.

The past two decades have given a skewed view of what investment returns look like. Over five years ended January 2000, the S&P 500 index tripled in price. Its dividend yield shrank to less than 2%. Over six years ended 2006 U.S. house prices doubled. The nationwide rent yield (rents as a percentage of purchase prices) shrank to about 4%. Investors have come to believe that the real money is in rapid price gains, and that income is a pleasant if puny extra.

The assets themselves have come to reflect this distorted view. More than one-quarter of S&P 500 companies pay no dividends. These aren't young start-ups that need all of their cash for expansion. These are America's largest companies, including ones like Apple (AAPL: 211.61, +2.57, +1.22%) and Google (GOOG: 622.87, +4.39, +0.70%) that sit on giant cash hoards. Why exactly should I pay more than 70 times earnings for Amazon (AMZN: 139.31, +0.84, +0.60%), a retailer with profit margins slimmer than those of Wal-Mart (WMT: 53.98, +0.38, +0.70%), when Amazon pays me nothing? Solely in hope that someone else will pay more for my shares? The houses we built during the boom didn't consist mostly of multifamily structures that produce big streams of income or even modest single-family houses that maximize the implied rent the owner saves as a percentage of the purchase price he pays. They were large, luxurious houses with tiny implied yields.

Now consider what normal returns look like. Over two centuries ended 2002, dividend yields on U.S. stocks averaged 4.9%, according to a study by Robert Arnott and Peter Bernstein. During that span, a $100 investment grew to $700 million, or $37 million after subtracting for inflation, assuming dividends were reinvested. If dividends were spent, the $100 grew to only $2,099. If dividends were spent and we ignore the massive price run-up that occurred during the last 20 years of that period (the 1980s and 1990s), the $100 grew to only about $400. In other words, throughout most of the history of stocks, income was just about everything.

Dividends, I've noted before, created stocks, not the other way around. Early merchant shippers had share-owning investors who met them at the docks upon return to split the profit and dissolve the venture. Only by paying dividends did the Dutch East India Company become a perpetual share-issuing company just over four centuries ago, requiring the creation of the world's first stock exchange (in Amsterdam) so that investors could swap its shares. It wasn't accounting standards, faith in management or blind hope that retained earnings will be put to good use that turned short-term profit-splitters into long-term shareholders. It was dividends.

As for houses, between 1890 and 2004 they increased in price by 0.4% a year after inflation, according to Yale professor Robert Shiller. That number is higher than it should be, because the period ends during a bubble. Logic says house prices should match the rate of inflation over long time periods, because inflation is a rise in the price of ordinary goods and a house is an ordinary good -- just wood, bricks, metal and so on. It doesn't sit up nights scheming about ways to make itself more valuable. It just sits. (If we're being picky, it also deteriorates, but only slowly, so house prices should trail inflation by a barely perceptible amount.) That's not to say people of means shouldn't buy big, posh houses. They should regard them the way they do big, posh cars: as money-depleting but enjoyable luxuries, not investments.

About gold: It has become popular because people have lost confidence in governments to protect their currency, but it's the ultimate faith-based investment. It pays no dividend and generates no rent, real or implied. The belief that gold is a store of value is owed to a happy coincidence of chemistry, not inherent worth. Gold simply proved the best element for money when coins were made by hand. No nation today uses gold as the basis for its money, and the metal has few industrial uses. Its price can go sharply higher, but today's buyer can do little but hope that someone will pay more tomorrow. Be cautious about gold, and about other commodities. Better to invest in companies that produce commodities, and companies that turn them into items of greater value.

It's a difficult time to be an income investor. Safe, meaty yields are scarce. Recent price gains aren't. Stay choosy, though, because prices across most asset classes are high. Buy sparingly and find decent yields where you can. If the 2010s resemble the 2000s, you'll be glad to have a stream of income to reinvest when prices plunge. I recently highlighted oil partnerships that pay 7%. Inflation-indexed Treasury bonds pay only 2%, but it's a real 2%, which might prove as good as a nominal 5% or more in coming years.

Common stocks are among the best income investments, because prosperous companies can increase their dividend payments over time. Although the S&P 500 yield has slipped below 2% again, more than 90 index members have yields over 3%. Seek them out, or check my Stock Screen columns , where I regularly search for yield. Income investing, remember, isn't just for people who spend the money. It's for investors who think "return" means money should regularly come back to them.

Jack Hough is an associate editor at SmartMoney.com and author of "Your Next Great Stock."

ARTICLE SOURCE: http://www.smartmoney.com/