For most of our clients, we believe in and currently recommend stocks that meet a very specific criterion over bonds and commodities for some important reasons. The main reason we do not currently favor bonds is the interest rate environment. Bond prices move inversely to interest rates and interest rates are historically low. Clients who own bonds may continue to receive a historically low rate of return in the form of interest payments with very little to no appreciation, or bonds could decline in market value when interest rates increase. Both scenarios appear relatively dim in terms of potential. The problem with commodities in general (i.e. gold, oil and corn) is that their values are based on their usage. They do not increase wealth through efficiency and innovation the way people do within a business. Historically, commodities have high short-term risk, with low long-term returns. When it comes to equity, we recommend utilizing a disciplined philosophy and methodology that focuses upon finding companies that:
- Appear fundamentally sound (in solid financial condition with investment grade debt, if they have debt).
- Have historically paid increasing dividends which increase faster than the rate of inflation and are well-covered by free cash flow.
- Operate generally mature, defensive businesses (providing products or services that customers tend to patronize in all kinds of economic environments).
- Most importantly, offer the potential to consistently raise their annual dividends.
We recommend companies that pay cash dividends out of after-tax earnings verses companies that maintain or increase their dividends using money generated from activities outside the company’s primary business of producing goods or services (for example, by selling assets or increasing borrowings). In addition, we recommend companies that increase their earnings year after year generating growth in free cash flow. Free cash flow is basically more cash than is required by the company to pay its bills and employees, invest in its business, and maintain facilities and equipment. This is because dividends are paid (and increased) out of free cash flow.
History has shown that investing in stocks of high quality dividend-growing companies over long periods of time has been a successful strategy to help investors building wealth, although there is no guarantee that this will be the case going forward. Receiving cash dividends up to four times a year with the prospect of dividend increases at least once a year from a properly diversified portfolio helps investors participate in the wealth building potential of the stock market and stay in during uncertain or volatile times. When it comes to the value of a company, earnings are very important. And when it comes to earnings, we value a consistently rising cash flow.
Another reason we prefer recommending individual stocks to our clients is because of transparency. When our clients own individual securities as opposed to financial products such as a fund, they can clearly see on each statement what they own and all costs associated with their accounts.
Communication is important in any relationship. We communicate with clients who implement our recommendations in a very unique and personal way. When the board of directors of a corporation votes to raise their dividend to shareholders, we inform our clients who own shares of that stock. Doing this provides a friendly reminder to our clients that the companies they own are still earning and they are paying out more cash as a result.
TAX EFFICIENT STRATEGIES
Regarding taxable financial assets, tax payers in a higher bracket understand that there are tax consequences for all investment related decisions. Even though we do not provide legal or tax advice, we certainly consider the tax consequences of our recommendations and make our clients aware of them before action is taken. With funds, investors lack the capacity to utilize the individual unrealized gains and losses within their portfolio as it relates to the other factors in their life such as selling rental property. Owning individual securities provides our clients with more flexibility when utilizing tax efficient strategies.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments, An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.