A Special Kind of Investment Sensitivity Study

This extends my investigations into a special kind of investment: high income producers that return capital.

High Income Producers

My earlier article has generated considerable discussion at the Morningstar Income & Dividend Investing discussion board. ADVDX has really created a sensation. And it has generated a tremendous amount of confusion.

I believe that I came very close to describing its behavior accurately. Expect ADVDX to provide the steady high income stream that is needed in the early years.

This fills a critical need.

There are other high income investments that can also serve this need. Some are Master Limited Partnerships. Some are Closed End Funds. For specifics, I refer my readers to the Morningstar Income & Dividend Investing discussion board, the “Morningstar Dividend Investor” newsletter and Ben Stein and Phil DeMuth’s book, “Yes, You Can Be a Successful Income Investor!”

In this sensitivity study, I introduce a lower yielding Investment that has a stable or slowly growing dividend amount. I examine three variants for Stock A.

Definitions

Investment Return = initial dividend yield + dividend growth rate (annualized).

Speculative Return = capital gains or losses associated with changes in multiples (price to earnings ratios).

Total Return (approximately, at Year 10, after adjusting for inflation) = Investment Return + Speculative Return – Inflation.

Variations

Growth Kicker 1: Stock A

Yield = 4%.
Growth = 6% per year (annualized).
Inflation = 3% per year (average).
Investment Return = 4+6-3 = 7% (annualized).

Growth Kicker 2: Stock A

Yield = 3%.
Growth = 8% per year (annualized).
Inflation = 3% per year (average).
Investment Return = 3+8-3 = 8% (annualized).

Growth Kicker 3: Stock A

Yield = 2%.
Growth = 10% per year (annualized).
Inflation = 3% per year (average).
Investment Return = 2+10-3 = 9% (annualized).

AND

Investment B1

Yield = 13%.
Growth = -5% per year (annualized).
Inflation = 3% per year (average).
Investment Return = 13-5-3 = 5% (annualized).

Investment B2

Yield = 8%.
Growth = 0% per year (annualized).
Inflation = 3% per year (average).
Investment Return = 8+0-3 = 5% (annualized).

Investment B3

Yield = 8%.
Growth = 2% per year (annualized).
Inflation = 3% per year (average).
Investment Return = 8+2-3 = 7% (annualized).

Growth Kicker 1 was my original Stock A investment type. It has a 4% yield and a 6% per year dividend growth rate. Growth Kickers 2 and 3 trade off 1% of yield for 2% of growth. Growth Kicker 2 has a 3% yield and an 8% per year dividend growth rate. Growth Kicker 3 has a 2% yield and a 10% dividend growth rate.

Investment B1 was my original Investment B. It has a 13% yield and a declining dividend. Investments B2 and B3 correspond to Master Limited Partnerships with 8% yield and dividend growth rates of 0% and 2%, respectively.

TIPS Account

I put money into and drew money out of a TIPS account to maintain a steady cash flow (after adjusting for inflation). The TIPS had a 2% real interest rate.

Results

There were no purchases or sales of either Stock A or Investment B. Any excess in dividends and interest was invested into the TIPS account. Any deficit needed for a withdrawal was taken from the TIPS account.

Growth Kicker 1: Stock A: 60%.
Investment B1: 40%.
2% TIPS: 0%.
Withdrawal Rate: 5.8% real.

Growth Kicker 2: Stock A: 50%.
Investment B1: 50%.
2% TIPS: 0%.
Withdrawal Rate: 5.7% real.

Growth Kicker 3: Stock A: 40%.
Investment B1: 60%.
2% TIPS: 0%.
Withdrawal Rate: 5.5% real.

Growth Kicker 1: Stock A: 50%.
Investment B2: 50%.
2% TIPS: 0%.
Withdrawal Rate: 5.7% real.

Growth Kicker 1: Stock A: 40%.
Investment B2: 60%.
2% TIPS: 0%.
Withdrawal Rate: 5.7% real.

Growth Kicker 2: Stock A: 30%.
Investment B2: 70%.
2% TIPS: 0%.
Withdrawal Rate: 5.7% real.

Growth Kicker 3: Stock A: 20%.
Investment B2: 80%.
2% TIPS: 0%.
Withdrawal Rate: 5.5% real.

Growth Kicker 1: Stock A: 25%.
Investment B3: 75%.
2% TIPS: 0%.
Withdrawal Rate: 6.7% real.

Growth Kicker 2: Stock A: 20%.
Investment B3: 80%.
2% TIPS: 0%.
Withdrawal Rate: 6.8% real.

Growth Kicker 3: Stock A: 10%.
Investment B3: 90%.
2% TIPS: 0%.
Withdrawal Rate: 6.9% real except 6.8% in Years 30, 31 and 32.

I have placed pictures of the (truncated) Excel spreadsheet into my Yahoo Briefcase. They are Microsoft Word documents. They are in the “Income Stream Pictures O” file of the “Allocators” folder.

Yahoo Briefcase

Analysis

The TIPS balance should start at zero in all instances. Investment B has a high enough yield to permit this and it has a higher Investment Return than the TIPS.

Notice the interaction between Investment B and the Growth Kicker (investment type Stock A).

With Investment B1 (13% yield, -5% dividend growth), the Growth Kicker 1 was best. It has an initial yield of 4% and a 6% per year dividend growth rate.

With Investment B2 (8% yield, 0% dividend growth), the Growth Kickers 1 and 2 were best. Growth Kicker 1 has an initial yield of 4% and a 6% per year dividend growth rate. Growth Kicker 2 has an initial yield of 3% and an 8% per year dividend growth rate.

With Investment B3 (8% yield, 2% dividend growth), the Growth Kicker 3 was best. It has an initial yield of 2% and a 10% per year dividend growth rate.

The highest withdrawal rate with Investment B1 was 5.8% (real, including adjustments to match inflation). The highest withdrawal rate with Investment B2 was 5.7% (real). The highest withdrawal rate with Investment B3 was 6.9% (real) except 6.8% in Years 30, 31 and 32.

Investments B1 and B2 had equal Investment Returns of 5%. Investment B3 had an Investment Return of 7%.

Although the comparison is not perfect, this suggests that it is best to choose an Investment B with a higher Investment Return so long as the initial yield is adequate and a higher initial yield when the Investment Returns are equal.

Additional Comments

Retirees who reinvest most of their dividends are likely to do better than I have indicated. But this is uncertain. ADVDX managers should be able maintain a long term total return comparable to the market as a whole, which is higher than the 2% real return that I used for TIPS. There is no history that shows whether ADVDX can maintain a high enough income stream during a significant market decline.

A similar uncertainty applies to Master Limited Partnerships and other high income choices.

The Special Kind of Investment does not need to be a superior investment when it is part of a blended strategy. It helps if it does.

The best choice among Growth Kickers (initial yield and growth rate combination) is not immediately obvious. It depends upon Investment B and how it grows.

For retirement planning purposes, I recommend careful review of the combination of Growth Kicker 1 and Investment B3. Each has an Investment Return of 7% (real). You should be able to come close to matching these numbers. Even better, they provide a continual withdrawal rate of 6.7% (plus inflation). However, I advise caution in the early years. Protect yourself against unanticipated failure mechanisms.

Have fun.

John Walter Russell
March 10, 2007