REITs and Conflicts of Interest

There’s an old saying in real estate:

“At the beginning of the partnership, the General Partner has the experience and the Limited Partners have the money.  At the end of the partnership, the General Partner has the money and the Limited Partners have the experience.”

Real estate investment trust (REIT) investors should be careful that something similar doesn’t happen to them.

REITs can be managed in two ways:  (a) by an outside adviser, or (b) by management employed by the REIT.

Some REITs are managed by an outside adviser.  In this arrangement, a successful real estate company decides to raise money from the public using the REIT structure.  The real estate company signs an agreement to provide management services for the REIT in exchange for a fee.

Other than its fees, the real estate company has nothing at risk in the REIT. It is free to conduct outside businesses, including possibly competing with the REIT for attractive real estate acquisitions and deals.  When an attractive investment opportunity is discovered, will management put the interests of the REIT ahead of their own?  Probably but maybe not.

In addition to its regular fees, will the real estate company direct the REIT to pay brokerage fees to its affiliates every time the REIT buys or sells a building?

While it is impossible to eliminate all conflicts of interest, having the REIT employ directly its own management team seems likely to reduce them. With this approach, the REIT’s board selects a Chief Executive Officer to manage the REIT who then populates the ranks of management.  Ideally, the CEO has a stake in the REIT either having invested his own money in the REIT or through a grant of incentive stock options.

We believe investors would be well served by understanding the management structure of the REITs in which they invest.  We prefer internal management over an outside adviser.

What every investor needs to know about the amygdalae

If you think you are rational when it comes to investing, it is time to learn about your amygdalae.

The amygdalae are a pair of small structures that appear in the brains of many vertebrates, including people.  They are deeply involved in emotions, memories and decisions.  Their role should be of paramount concern to the investor.  Specifically, the amygdalae appear to be involved in the process of assigning negative emotions to certain memories and thereby conditions the individual to avoid certain fear-inducing stimuli.  They are also involved in memory consolidation.  The brain does not retain all memories equally; instead, some are “consolidated” into long-term memory.  The amygdalae have a role in memory consolidation.

The amygdalae exert a powerful effect on investment decision making. There is no one “perfect” investment strategy.  All of them produce negative surprises from time to time.  One must endure the drawdowns for the hope of a recovery.  The investor who abandons strategy after strategy on encountering drawdowns likely will dissipate his wealth.  Thus, the challenge for the investor is to stick with an investment strategy through the bad times.

Unfortunately, the amygdalae generate strong fear emotions precisely when the investor’s strategy loses money.  The greater the loss, the more profound the fear.  At best, the investor will be miserable.  At worst, he will abandon an otherwise sound investment strategy.

Several years ago a paper tested the financial decision-making capabilities of two individuals with damaged amygdalae.  The experiment presented the test subjects with a series of investment opportunities.  The opportunities involved varying prospects for significant gains and for significant losses.

As expected, the control group were more willing to invest in opportunities that offered high potential returns and low potential losses.  They were less willing to invest in opportunities that offered low potential returns with high potential losses.

In contrast, the two people with damaged amygdalae were far less discriminating in their investment preferences.  While they demonstrated some aversion to high potential loss / low potential gain situations, their level of aversion was much lower than the control group.

Fear and uncertainty often cause investors to shun certain investment opportunities.  To the contrarian investor, such opportunities may offer the best returns.  If so, all that stands in the way is the amygdalae.


What we are reading on 1/30/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Fertility rates are coming in lower than expected.
Thoughts about how to deal with the investment research fire hose.
A border tax could be a regressive tax.
Fed watching is up in the air until fiscal policy becomes more certain.
One of the original card counters.
The pension plan cuts are starting, even for retirees.
Have multinationals had their run?
Physical activity is linked to happiness.
The aging workforce presents an economic challenge.
Wisdom from different types of professionals.
Older investor risk tolerance may vary too much.

What we are reading on 1/27/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Institutional money management can be as challenging as retail.
Treasury bills outperform most stocks?!?!
Generalize protective momentum backtests
U.S. Senators made a lot of money off insider trading.
Self promotion is sweeping science.
The community college to 4-year college pipeline is growing.
How Dementia affects Identity.
An evaluation of generalized protective momentum.

Guide to Dividend Investing

In the current low-interest rate environment, many investors have turned to dividend-paying stocks for income.  Investing in such stocks is not as straightforward a proposition as some people seem to think.  In this guide, we explain the intricacies of investing in dividend paying stocks:

The Components of a Dividend
Income, Growth and Total Return
Sustainable Income
Dividends and Mental Accounting
Spending, Risk and Mental Accounting
Dividends in Excess of Earnings
Dividends in Excess of Sustainable Earnings
Dividends and Return of Capital
Dividends and Depreciation
Dividends and Earnings Quality
Dividends and Capital Intensity
Financed Dividends
Alternatives to Dividend Investing

The Components of a Dividend

Some people think of a dividend as income from an investment. That may be true and often is true, but it is not always accurate. This inaccuracy can result in bad investment decisions.

We think the following is a better way to think about dividends:

  • A dividend is a distribution of property to the owners of an equity security;
  • The distributed property may take one of several forms including cash, securities and tangible property; and
  • From an accounting perspective, the distribution could be income, a capital gain or a return of capital, or some combination of the three.


We define a dividend broadly as the distribution of property to the owners of an equity security. An “equity security” could mean common or preferred stock in a corporation or a partnership interest.

“Equity security” does not mean a loan, note or bond issued by a corporation or partnership. Loan holders, note holders and bond holders can receive distributions of property; however, such distributions usually are characterized (for tax purposes) as interest income.


A distribution of property often takes the form of cash, but not always. Subject to its own bylaws and possibly to other laws and regulations, a corporation in theory could distribute any corporate asset: not just cash, but other securities owned by the company, accounts receivable, inventory, real property and equipment.


From an income tax accounting perspective, the distributed property may be income, a capital gain or a return of capital. If the security is held in a taxable account, distributions characterized as income or capital gains may be taxable. In contrast, a return of capital is not likely to be taxed.

Income, Growth and Total Return

Some people believe there are two basic investing goals: income from capital or growth of capital. Retirees tend to favor income; people who are accumulating savings tend to favor growth.


The income investor tends to look favorably upon stocks that paying a generous dividend now.  In contrast, this type of investor may eschew certain types of opportunities, such as stocks that presently have neither earnings or dividends but have a promising future.

This approach may lead to suboptimal results in some cases. For example, imagine a company that historically has made profits and paid a dividend consistently over many years. The company encounters difficulties, loses money and eliminates the dividend. After a period of time, the stock becomes deeply undervalued.  Profitability starts to recover and the company is expected to reinstate the dividend in the near future. Instead of buying early when the stock is still undervalued, the income investor may delay because the stock has no dividend now and miss the opportunity for price appreciation.

Alternatively, a company in long-term decline no longer has the earnings to support the payment of the dividend. The stock has a high yield because the investment community collectively believes it is only a matter of time before the dividend is cut. Some income investors will buy such a stock strictly because of its high yield, notwithstanding the poor prospects of the investment.


This type of investor wants to own growing companies. By investing early in the next Facebook or Google, he hopes to multiply his capital as the company’s revenues, cash flow and earnings expand ten-, twenty- or one hundred-fold.

The growth investor may be just as self-limiting as the income investor, but in a different way. It is true that one can multiply capital by investing in a growing company. But one can also multiply one’s capital by investing in stocks trading at prices that are significantly less than intrinsic value.

For example, imagine a company that dominates a low growth business. The company’s real estate and other non-core assets are recorded on the balance sheet at values significantly less than fair market value. After many years of dithering, management is ready to monetize these non-core assets for the benefit of the shareholders. The stock does not reflect any of the good news. Concerned only with revenue growth, the growth investor might pass on this stock even though it has the potential to appreciate significantly.


Both income and growth investing have limitations. Therefore, we favor a third approach: investing for total return. We want to see our money produce even more money. We don’t really care if the new money is called a dividend, an interest payment or a capital gain. We just want to increase our money as much as possible (after taxes) for a given level of risk.

Sustainable Income

If the income investor focuses too heavily on maximizing his income and then spends all of the income, he risks diminishing his purchasing power over the long-term. To maintain purchasing power, some portion of the income must be reinvested in productive assets. The importance of reinvestment cannot be overstated. Compounded over many years, even modest rates of inflation will erode significantly the value of a fixed income.

For the investor who wants income from investments in companies, there are two basic reinvestment approaches:

  1. The investor reinvests on behalf of himself.
  1. The company reinvests on behalf of the investor.

Each approach has certain advantages and disadvantages:


The investor owns shares in companies that pay out all of their income. Rather than spending every last penny of income, the investor reinvests a fraction of the dividend. The reinvestment hopefully leads to more income in the following years, which offsets the effects of inflation on purchasing power.

For an investor in stocks, the success of the reinvestment depends on the ability of the investor to identify attractive investment opportunities. If the investor can reinvest at high rates of return, he will have good prospects for maintaining his purchasing power. On the other hand, if the investor cannot find attractive opportunities, he may fail to maintain his purchasing power notwithstanding his reinvestment program. He might as well have just spent the money on his lifestyle.

Finding attractive investment opportunities may depend on circumstances beyond the investor’s control. The price paid for the investment may be the single most important variable. The higher the price paid, the lower the future return. Sometimes prices for most assets are too high and future returns are unattractive. In those cases, it may be very difficult to sustain purchasing power.


In this approach, the investor owns shares in companies that pay out just a portion of their income. The companies reinvest the remainder in their respective businesses in order to grow; if successful, their growth leads to future increases in revenue, cash flow, earnings and dividends that offset the effect of inflation.

Management has the important task of determining how much to reinvest. Most managements will make the decision based on their ability to find investments that offer a return in excess of the cost of capital. Management determines the cost of capital. In theory, it is the rate of return “required” by the investors in the company. Management attempts to guess intelligently the what minimum rate of return the investors require.

Management determines the cost of capital. In theory, it is the rate of return “required” by the investors in the company. Management attempts to guess intelligently the minimum rate of return the investors require.

If the cost of capital is 8%, management will invest in projects that have a projected yield better than 8%. In a perfect world, they will start with the highest return projects and work down the list, stopping once the projected return equals the cost of capital.

If management has excess cash and cannot find opportunities with a return in excess of the cost of capital (in this case 8%), they may hold on to the cash in hopes of finding a suitable opportunity in the near future. Since the cash likely will earn far less than 8%, holding cash will reduce the average returns of the corporation.

Alternatively, management may decide to give the excess cash back to the shareholders through a dividend. This passes the responsibility for finding an attractive investment to the shareholders. Some shareholders may be successful at finding attractive ways to invest the cash. Others will not, and those shareholders likely would prefer that management had invested at a lower rate of return (6% or 7%) because it was better than what the shareholder himself could find.

Management can also dispose of excess cash through stock repurchases. In this case, the company simply buys its own stock in the open market. The return on the investment depends on the price of the stock. If the company repurchases its stocks at a price significant below intrinsic value, the rate of return could exceed the 8% cost of capital. On the other hand, repurchases of overvalued stock could result in a rate of return far less than the 8%.

A repurchase allows the shareholders to tailor their decisions according to their own opportunity set. Stockholders with access to better opportunities than the company could choose to sell their stock during the repurchase and invest elsewhere. Other stockholders can stay put.


If we assume a reinvestment requirement, we think most investors would benefit by delegating the responsibility to company management for two reasons:

  1. The company can reinvest directly in its business or in its own stock, whereas the investor can only invest in the stock.
  1. Management has access to proprietary information that should position them to make a better decision than the investor.

Dividends and Mental Accounting

Mental accounting is the phenomenon by which an investor treats money differently depending on its source. Dividend-focused investors sometimes think that it is acceptable to spend dividends, but not acceptable to spend capital.  The thought is that the spending of capital is like eating the seed corn. Once the seed corn is gone, one cannot plant a new crop of corn. By spending only the dividend, the investor thinks he is preserving his seed corn for year after year of crops.

We don’t agree.  Corn and money are not the same thing.

Cash is fungible – my $20 bill is worth exactly the same amount as someone else’s $20 bill. Thus, a $20 cash dividend is in reality exactly the same as:

  • $20 of cash earned through one’s labors,
  • a cash gift of $20,
  • $20 of cash received from a scratch lotto ticket,
  • $20 of cash received from the sale of real property, and
  • $20 of cash received from the sale of a common stock.

Yet some investors believe that cash from one source is somehow different than cash from another source. It is “reasonable” to spend $100 of dividend income, but a very bad idea to spend $100 of capital. Mentally, people account for the two differently – spending income is OK, spending capital is not OK.

For the unsophisticated dividend investor, mental accounting can create a trap.  Some people assume that dividends are income, but in reality dividends and income are unrelated. Some less-than-scrupulous Wall Street companies exploit this misunderstanding to profit at the expense of the unsophisticated investor.

They start by identifying investors who are desperate for income but do not want to spend capital.  They create securities that have artificially inflated dividends.  The investor makes the error of assuming that the dividend is income.  But the dividend is not entirely income.  It also includes a return of some of the investor’s capital.

Spending, Risk and Mental Accounting


Mental accounting also affects the spending and risk decisions of some investors.  For example, the investor has one million dollars and “safe” yields are 4%, for a “safe” income of $40,000. Yet the investor’s living expenses are $80,000. What should one do?

Because spending capital is unthinkable for people engaged in mental accounting, they may reach for yield. That means investing in assets that offer a sufficient income to cover living expenses, even if the investments are quite risky. If in reaching for the extra income the investor is very likely to lose $60,000, then the investor might as well have stuck with the “safe” investments and simply spent some of the capital.

Thus, for the investor who engages in mental accounting, spending capital may be bad, but losing even more capital on a risky income investment is reasonable. In reality, the better outcome may be sticking with the safe investments and spending a little capital.


In the remainder of this paper, we review some elementary errors committed by unsophisticated dividend-focused investors:

Dividends in Excess of Earnings

One of the many pitfalls confronting the income investor is the company that pays dividends in excess of earnings.  Such dividends may have an above average chance of being reduced or altogether eliminated.

The stocks of such companies may offer very high dividend yields.  The reason for the high yield is that most investors are worried that management will reduce the dividend to a level more consistent with the near-term earnings of the company.

Thus, if the company’s stock price is $10.00 and pays a $1.00 dividend, the stock appears to have a juicy 10% yield.  However, the company earns just $0.70 per share.  To pay for the excess dividend, management must either scrimp on reinvesting in the business, sell assets or borrow money.  None of these options suggest a sustainable situation.

The consensus of investors may be that the dividend will be reduced to just half of earnings ($0.35) for a 3.5% yield.  At that level, the yield is well within the norms of what would expect to see from a common stock.

Of course, the earnings today may not reflect the company’s long-term prospects.  Perhaps for the past five or ten years, average annual earnings per share was $2.00 and the current earnings shortfall is, without a doubt, merely a temporary blip.  In that case, management likely will keep paying the dividend in anticipation of the earnings recovery.

On the other hand, more than a few CEOs slip into denial in the face of permanent erosion in the profitability of their businesses.  They likely will convince themselves that the upturn is just around the corner.  Being excellent salesmen (all too often that’s how the CEO gets his job) he likely will convince the dividend investor of the same.  In that case, the dividends are not a sign of a viable business; rather, the payments are like a slow liquidation of the company.

Dividends in Excess of Sustainable Earnings

Most income investors understand that dividends come from income (“earnings”).  If the company cannot produce the earnings, at some point it will not be able to pay the dividends.

To determine if the earnings exceed the dividends, most knowledgeable investors will look at the financial statements.  Specifically, they will look at the income statement and find the “Earnings Per Share” calculation. They will compare the “Earnings Per Share” to the “Dividends Per Share.” If the earnings exceed the dividends, the dividend likely is safe.  Or maybe not?

As more than a few accountants have said, earnings are not a fact. Earnings are an opinion.  The income investor should scrutinize a company’s income statement and its footnotes for temporary “earnings” that do not indicate sustainable support for future dividends.

Such temporary or unsustainable earnings include (among others):

  1. One-time, non-recurring gains on the sale of property.
  2. Gains on foreign currency translation.
  3. Revenues from contracts that involve selling prices that are substantially above normal selling prices.
  4. Excessive dependence on one customer.
  5. Management forgoing salary in favor of stock-based compensation that is not fully reflected in the income statement.
  6. Revenues recorded when there is material doubt as to cash collections.
  7. Unusual inventory build-up suggesting understated absorption of costs.
  8. Liquidation of low-cost inventory layers.
  9. Overly optimistic depreciation of capital assets.
  10. Excessive capitalization of software development costs.

Sometimes earnings sustainability issues reside outside of the income statement.  For example:

  1. Competitors add too much long-term productive capacity, thereby pressuring profit margins.
  2. A competitor develops a new product that renders existing products obsolete.
  3. Regulations change, damaging the intrinsic profitability of the business.
  4. Customers consolidate and gather too much bargaining power, harming profitability.
  5. Suppliers consolidate and gather too much bargaining power, harming profitability.

One may identify unsustainable earnings by carefully reading the financial and other reports of a company, plus the same documents issued by a company’s competitors.

Dividends and Return of Capital

Presidential candidate Ross Perot once said of politicians, “they want to buy your vote with your money.” If one is not careful, something similar can happen with dividends.

More often than not, dividends are distributions of a company’s, trust’s or partnership’s income. As a distribution of income, the dividend is taxable as income. If the shareholder is a taxable person, the dividend likely will create a tax liability. If the shareholder is exempt from tax (e.g., a charity, a pension or perhaps an individual retirement account), the dividend may not trigger income tax.

However, as we have seen earlier, distributions need not be of income. When a partnership terminates its business activities and returns the money to the partners, it “distributes” whatever income has accumulated plus the capital that the partners originally invested.

Investment mistakes can be made when a company commingles a distribution of some capital with a distribution of income. For example, imagine REALCO has income of $5.00 per share and a dividend of $2.00 per share. REALCO is not particularly noteworthy in any respect. Perhaps the market conditions are such that a company of this type merits a stock price of twelve times per share income. In this case, the stock trades at $60 per share. The dividend yield is 3.3%.

Now let’s imagine a second company, FAKECO, similar in every respect to REALCO but management wants the stock to trade at a much higher price than $60. Maybe $100 per share. In the eyes of sophisticated and knowledgeable investor, nothing about FAKECO merits a stock price other than $60 per share. But unsophisticated investors may focus only on the dividend yield.

Accordingly, management raises the dividend from $2.00 per share to $9.00 per share. The company’s income is only $5.00 per share. So the new dividend vastly exceeds income. Management “supplements” the income part of the dividend by adding to it a $4.00 return of capital. If the stock trades for $60 per share, a $9.00 per share dividend translates into a 15% yield. Unscrupulous stock brokers promote the stock to unsophisticated investors, driving the stock up to $100 per share. At that point, the stock’s dividend yield is 9%. The “yield” is much better than the “lousy” 3.3%.

Promoters may go even further by pointing out that some of the dividend (the part that is a return of capital) is tax free!

This may seem far-fetched, but we have seen this play out over and over again. Too often, unscrupulous promoters take advantage of unsophisticated investors by designing a company or a partnership with dividends in excess of income.

If one wants to avoid these problems, one should compute the dividend yield using only the income portion of the distribution. Ignore the portion of the dividend that is a return of capital.

Dividends and Depreciation

“Depreciation” is an expense of doing business. It arises because certain types of costs provide economic benefits that span more than one accounting period. Instead of recognizing all of the cost in the first period, one spreads the cost over the relevant time period using one of a few different accounting methods.

For example, imagine that a company spends $300,000 on a building that has an economic life of 30 years. The company’s tenant has signed a 30-year lease for rent of $15,000 per year. Without depreciation, the company has revenue of $15,000 in the first year offset by a $300,000 cost for the building, for a loss of $285,000. In subsequent years, the company would have $15,000 in revenue but zero costs.

These numbers do not represent economic reality. Instead of losing all of its value in the first year, the building slowly loses value over the term of the lease. A better way to account for this is to “depreciate” the building over the thirty years. A simple method of depreciation divides the capital cost by the building life. Thus, a $300,000 building depreciated over 30 years incurs a depreciation cost of $10,000 per year. Rent is $15,000. The difference is taxable income: $5,000 per year for 30 years.

For accounting purposes, “depreciation” shows up as an expense that reduces taxable income.  However, other than in the first year no cash is being paid out for depreciation. It’s a “non-cash” expense in the second and following years. The owner of the building receives the full $15,000 and has no cash expenses. But for income tax accounting, the owner can offset the income to the extent of annual depreciation. The cash flow is $15,000 but the income is only $5,000.

The depreciation expense reflects the deterioration in the value of the building over time. If the owner wants to maintain the value of the building, then he will need to put money back into it in the form of repairs and upgrades. If costs do not change, the annual expenditure required to maintain the value of the building should be approximately equal to the annual depreciation expense.

An unsophisticated income investor could easily confuse cash flow and income, to his detriment. As a matter of policy, management can choose to distribute all available cash flow and not reinvest to maintain the value of a partnerships assets. In this case, the assets will have no value on termination of the partnership because they have not been maintained. The investor may be surprised to discover that he received generous dividends for many years, but that his capital has disappeared in the end.

An unscrupulous promoter may go even further by describing the dividend as partly “tax free” on account of the depreciation expense.

If one wants to avoid these problems, one should compute the dividend yield using only the income portion of the distribution. Ignore the portion of the dividend that is depreciation. One can identify the depreciation by reading the statement of cash flows.

Dividends and Earnings Quality

Just because a company has a consistent record of past earnings and dividend payments does guarantee the future security of the dividends. Analyzing earnings quality can provide clues as to the safety of future dividend payments.

In analyzing earnings quality, one should consider three different approaches: the nature of the business itself, changes in the character of earnings and management’s accounting policies.


Some companies by their very nature enjoy high and stable profitability over time. Such companies tend to have leading market shares in their industries and sell products that are consistently in demand. Such companies may be among the most consistent payers of dividends over the long-term.

Other companies may have lower average levels of profitability and somewhat less stability. These companies may have leading market shares but sell products for which demand is more cyclical. Alternatively, they may an average or below average market share in a stable position. The dividends of such companies may be at greater risk over time.

Finally, some companies have low average levels of profitability and/or highly cyclical earnings. They may operate in brutally competitive businesses and/or may sell products that experience booms and busts in demand. The ability of such companies to pay consistent dividends may be highly suspect.


A dividend investor should consider paying attention to potential changes in the character of earnings over time. Companies that have demonstrated consistent earnings and dividend growth over time face great pressure to continue such trends over the long term. If the business starts to deteriorate, management may resort to short-term fixes to maintain the appearance of growth.

For example, imagine a soap company for which investors expect $40 million of earnings to grow 10% in the coming year, just as the earnings had grown 10% in each of the past ten years. Management has a plan to grow earnings to $44 million but an increase in competition make it more likely that they will earn just $42 million. To meet investor expectations, management sells some land and books a $2 million capital gain. Earnings are on plan ($44 million) and investors may overlook the deterioration in the business.


The dividend investor should also consider management’s accounting policies. Financial statements are much more a “point of view” than an incontrovertible “truth.” The dividend investor can take greater comfort from a company that achieves consistent earnings growth with conservative accounting policies than from a company that achieves erratic earnings growth with liberal accounting policies.

Dividends and Capital Intensity

Many managements want their company’s stock price to be as highly valued as possible. A popular and efficient way to achieve this is for the company to grow over time, year after year. The key point is that the total return of a stock is the sum of its growth rate and its dividend yield.

  • Total Return = Growth + Yield

For example, let’s imagine two companies that pay a $4.00 dividend. Investors want a 5% rate of return. If the first company cannot grow, the stock price will be $80.00 per share ( = $4 / 5% ). The sum of the growth rate and the dividend yield = 0% + 5% = 5%.

The second company can grow just 2% per year. For a 5% total return, the dividend yield must be 3%. For a $4.00 per share dividend, a 3% dividend yield implies a stock price of $133.33 per share ( = $4 / 3% ).

Adding just a little growth can have a dramatic positive effect on the expected stock price.  In our example, for a 5% total return moving a company from no long-term growth to just two percent long-term growth lifts the stock price by 66.67%!

Growth usually requires at least some capital.  The amount varies by industry. Industries like consulting do not require much capital to grow. But growth in other industries consumes vast quantities of capital. Growing a portfolio of real estate assets – land and buildings – obviously requires lots of capital. The assets often found in publicly traded master limited partnerships (MLPs), such as pipelines and energy assets, also require large amounts of capital.

Tax-advantaged capital intensive industries like real estate investment trusts (REITs) and MLPs can be problematic for the income investor.

The U.S. Federal Tax Code bestows a special tax benefit on REITs and MLPs: the exemption from corporate level tax. For REITs, the exemption requires that the REIT distribute to its owners nearly all of its annual income. For MLPs, the incentives are a little different but as a practical matter MLPs also distribute large shares of their income.

Lush dividends mean REITs and MLPs seldom have sufficient capital on hand to fund growth initiatives. But management teams still want to grow, because even a little long-term growth can so dramatically improve the price of a stock. To come up with the capital, the management teams borrow what they can. They will also have to raise fresh equity capital. Unfortunately, each offering of equity may harm the REIT and MLP investors by diluting their shares.

Financed Dividends

When a management team insists on paying dividends in excess of a company’s earnings power, cash on hand will decline. At first, the company may have sufficient cash on hand to fund the dividend payments, notwithstanding the earnings shortfall. When management depletes the company’s cash on hand, they will have to find financing if they plan on continued and large dividend payments.

Financing a dividend can be achieved in three ways: selling assets, borrowing money or selling equity.

Selling Assets

If management does not have the money to pay dividends, they can raise the cash by selling corporate assets.  In the beginning, the corporation may own some assets that are unrelated to the core business.  At some point, management will have to sell off vital parts of the business. Dividends become increasingly difficult to sustain as key operating assets are sold off.


A company can borrow money from different types of investors. Smaller companies may rely on banks. Larger companies may have the flexibility to tap the banks or to sell bonds to the investing public.

In either case, the result is the same: The company is taking money from one set of investors (the creditors) in order to pay out cash to another set of investors (the shareholders). The creditors may acquiesce to this situation for a while, but eventually will pull the plug because the payments to shareholders reduce the likelihood that the company has enough money to pay off the creditors.


If a company cannot or will not sell assets or borrow money to pay unearned dividends, they can sell equity. Management finds people who want to invest in the company’s stock and sells new shares to them. The proceeds from the stock sales help pay dividends to the all the shareholders, the new ones and the old ones.  Such arrangements lack long-term economic viability.

Selling equity to pay dividends may work for a little while, but eventually the shareholders will figure out what is going on. At that point, new stock investors may be impossible to find and the dividend will have to be reduced.


One can determine if a company is financing dividends by inspecting its financial statements. Specifically, find the financial statement that has the title, or a title like, “Statement of Cash Flows.” The Statement of Cash Flows has three sections: (a) Cash from Operations, (b) Cash used in investing and (c) Cash from Financing.

Asset sales usually appear in the “Cash used in Investing” section of the Statement of Cash Flows.

The investor can find changes in borrowing, changes in equity and dividend payments in the third section of the Statement of Cash Flows (cash from financing). If the company is obtaining cash from equity and borrowing in an amount that appears significant in relation to the company’s dividend payments, further research may be warranted.

It is possible that the Statement of Cash Flows may not have all the information necessary to evaluate financing and dividend sustainability. In that case, a reading of the entirety of the financial statements (including the footnotes) may be necessary.

Alternatives to Dividend Investing

In an environment of low-interest rates, some investors have become much more focused on investing in stocks that offer attractive dividend income. Dividend-paying companies have many ways to play games potentially to the detriment of investors who focus too much on the dividends and not enough on other aspects of the investment.

We favor an alternative approach: while not dismissing dividends altogether, we suggest that the dividend investor consider two other questions: (a) is the stock price significantly less than the intrinsic value per share of the company and (b) does management have a track record of making wise use of the company’s cash.


There is considerable evidence that undervalued stocks tend to do better than overvalued stocks over the long-term. Dividend yield is one way of measuring valuation, with high-yield stocks possibly being a better value than low- or no-yield stocks. However, it is not clear that dividend yield is the best way to measure value. Other metrics such as Price-to-Sales (P/S), Price-to-Free-Cash-Flow (P/FCF) and Enterprise-to-Earnings-Before-Interest-and-Taxes (EV/EBIT) may be more effective at predicting returns than dividend yield. One may be able to develop a better valuation model by using one of these metrics or by diversifying across several metrics (using an amalgamation of them, possibly including dividend yield).


Investing the shareholders’ cash is one of management’s most important jobs. The dividend investor should ask: (a) does the company have good future investment opportunities and (b) does management have the ability to identify and exploit the opportunities?

One cares about a company’s future investment opportunities, not past investment opportunities. The company’s profitability metrics (e.g., return on equity, return on assets, pretax margins, etc.) today reflect the decisions of the past. Tomorrow’s opportunities may or may not offer the same potential.

It is not enough for a company to have good future investment opportunities. Some management teams have poor ability to recognize and to exploit such opportunities for the benefit of the shareholders. A past track record of success may indicate management investment competence. On the other hand, past success could be the product of an average management team stumbling upon great opportunities.

REIT Valuation

As befitting a website titled “Undervalued Stocks,” we do not like the idea of overpaying for an investment.  For many types of stocks, that means we look at a variety of valuation ratios including price-to-earnings, price-to-free-cash-flow and price-to-sales, among others.

Many investors in real estate investment trusts (REITs) focus on somewhat different variables including dividend yield and price-to-funds-from-operations (P/FFO).  We rate dividend yield as the least attractive method for valuing REITs, because a high dividend yield often raises questions about the sustainability of the yield.  If we had to choose, we would focus on P/FFO.

But P/FFO has its problems.  P/FFO may offer a reasonable basis for comparing REITs, but differences in perceived future growth rates can result in dramatically different P/FFO ratios.  For reasons outlined in this post, we tend to distrust REITs with a “growth” story.  In a nutshell, real estate is a capital-intensive business and REITs pay out too much of their earnings in order to fund a meaningful growth rate internally.

If one is willing to do a little work, one could attempt to value REITs using a private market value approach.  The idea is to determine the private market value of all the real estate assets owned by an REIT, net of liabilities.  If the REIT shares trade at a price below the private market value per share, perhaps one should consider buying the shares. Alternatively, if the REIT shares trade for more than private market value, perhaps one should consider selling the shares.

Of course, the trick is determining the private market value of the REIT’s assets.  It would be a daunting task to obtain appraisals of each one.  A simpler approach is to compute the public market “cap rate” and compare it to the private market “cap rate.”

The “cap rate” is the annual net operating income of real estate divided by its total market value (i.e., not just the “down payment”).  On average, high-quality institutional properties might have a cap rate three percentage points above the yield on the 10-year U.S. treasury.  Thus, if the 10-year Treasury yield 2.5%, the cap rate on high-quality institutional properties perhaps should be about 5.5%.  In that case, if the property produces $1 million of net operating income, then its private market value should be about $18.2 million.

This approach could translate well to publicly traded REITs.  Start with pretax income and add back interest expense to arrive at net operating income.  Divide the net operating income by the “enterprise value” of the REIT:  the market value of the equity plus the value of the debt, less cash on the books.  Compare the resulting cap rate to the yield on the 10-year Treasury.  If the cap rate is materially more than three percentage points above the Treasury yield, perhaps the REIT is undervalued.

In adopting such an approach, one should be careful to review thoroughly the REITs financial statements and financial statement footnotes for other factors that could affect the company’s valuation.  For example, look out for unusual accounting practices or significant contingent liabilities.

The 3 Ingredients for Investment Success

If we had to boil down what it takes to succeed in investing to as few variables as possible, we would suggest three:  technical knowledge, controlling cognitive bias and emotional discipline.

Technical Knowledge

One must have a good command of the technical aspects of investing.

To start, one must have a solid grasp of the various investment products and how they operate:  stocks, bonds, options, futures, mutual funds, exchange traded funds, closed-end funds, currencies, etc.

One must have a good understanding of how markets operate, how to trade and how to control trading costs.

One must also have a thorough understanding of what factors tend to influence returns:  value, momentum, quality, size and other variables for stocks.  For bonds, credit ratings, maturities, embedded options and other indenture features.  For options, the interactions of volatility, strike prices, expiration dates and other variables.  Each type of product has its own drivers that can influence future returns.

One must have an understanding of volatility and how different investment products interact, so as to control overall investment portfolio risk.

ConTROLLING COgnitive Bias

The human mind operates with certain heuristics to increase efficiency. Heuristics are mental shortcuts that allow us to make decisions quickly without having to think through complicated problems.

Heuristics are essential to our survival and go back millions of years.  For example, let’s imagine a situation where a caveman sees a friend die from eating a purple berry.  Such a traumatic experience could give rise to a heuristic of “don’t eat purple berries.”  Thereafter, our caveman doesn’t waste time weighing the pros and cons of various possible courses of action with respect to purple berries.

The many heuristics employed by the brain cause perceptible cognitive biases for investors.  As much as we would like to believe that we are rational thinkers, a large body of research indicates we are not.  Our recent post on confirmation bias explores one such bias.

Emotional Discipline

We believe that the final ingredient to investment success if having emotional discipline.  Strong emotions like greed and fear can warp people, causing them to take actions that they would otherwise not consider.

The ability to control emotions is fundamentally a question of willpower. Recent research on willpower suggests that how we manage our lives can alter the levels of willpower we have available to us.  We use up our daily willpower reserves on the many things we do in our lives, including investing.

For all people, making investment decisions requires willpower.  Some investment strategies require more willpower, others less.  If one structures an investment program that consumes a lot of willpower at a time other significant life challenges, one could have great difficulty following through on the investment program.

What we are reading on 1/25/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
There’s a lot to think about when planning for retirement …
Trump could have a big impact on the bond market.
The appealing economics of some overlooked law schools.
Ad blocking is a real threat to the economics of many websites.
A strategy for avoiding confirmation bias.
Niccolo the trend follower?

Confirmation bias

It isn’t what we don’t know that gives us trouble, it’s what we know that ain’t so.

Will Rogers

As with any stock, it had its positives and negatives. On balance, the positives outweighed the negatives to a significant degree, so you bought the stock. The price rose for a few weeks then started to fade. Eventually, it produced a loss, about 10%.

Concerned but not alarmed, you revisited your investment thesis. Reviewing the news and the company’s filings, you saw that there were some new developments. However, the weight of the evidence still supported your investment thesis. The stock stabilized for a while and then rallied up to a point just short of what you paid for it. You felt vindicated. Then it faded again, only this time a bit faster and shed 15% of its value. The investment thesis still holds …

You may have fallen victim to one of the most insidious biases in the practice of investing: Confirmation bias. Confirmation bias is the tendency of people to filter new information in ways that tend to support, to confirm and to entrench pre-existing beliefs.

If you have faith in the management of a company, you will tend to see only what they do or what they say that positively impresses. Mistakes and incompetence may be overlooked. If you believe in the potential of a new product, you will discount news that casts doubt on its prospects.

The information filtering effects of confirmation bias operate silently and invisibly in the background of your mind, coloring your judgment in ways that seldom contribute to investment success.

We believe the following strategies may help reduce the effects of confirmation bias:

  • Make your investment process less subjective. Include buy and sell rules that de-emphasize subjective evaluations in favor of clear decision signals. For example, only own stocks with a yield of at least 3% and have a positive one year return.
  • If your investment process cannot be made less subjective, consider using stop-loss orders in an attempt to limit the damage that confirmation bias can cause. For example, when you buy the stock, imagine the lowest price at which you can see the stock trading. Below that price you would have to be wrong. Set a stop loss order 2% below that price.
  • Do not maximize information; optimize information. Most investment theses can be boiled down to a few key points. Bring your focus on those points. Confirmation bias may lead you to think that extraneous information is very important and reinforces what you already believe. To improve your chances, consider writing down no more than three reasons why you own the stock and verify regularly that those conditions still hold.
  • Make a serious argument for the opposite point of view. If you think a stock is attractive, write a research report explaining why it is unattractive.

Inflation monitor as of 1/23/2017

Inflation has been trending downwards for decades.  We think the following factors have created this long-term trend:

  • an aging population that buys less
  • wage competition from third-world countries, due to globalization.

With talk of border taxes and rolling back globalization (at least partially), can we assume that the downward inflation trend will continue from here?  We don’t know, but we intend to track the numbers.  This post reviews a wide range of market-based and statistically derived measures of inflation.

Our takeaway:  inflation is probably in the 1.5%-2.5% range with an upward bias.

Backward-Looking Measures

Consumer Price Index (CPI) – changes

The CPI is calculated by the government.  More than a few investors view the index with a degree of skepticism.

CPI:  +2.10%

Median CPI:  +2.58%

Core CPI:  +2.21%

Sticky CPI:  +2.58%

Core PCE:  +1.10%

Producer Price Index (PPI) – changes

The PPI is calculated by the government.  Some investors regard it with suspicion:

Finished Goods:  +1.98%


Wages are very important because they account for such a large portion of the cost of goods and services.

Average hourly earnings:  +2.93%

An increase in average hourly earnings does not translate into an equal amount of inflation.  Increases in productivity can offset (entirely or partially) the inflationary effect of higher wages.

Billion Prices Project

The billion prices project estimates the annual rate of inflation by using prices posted by online merchants.

As of the last publicly available data point, BPP estimates the U.S. inflation rate at annualized rate of about 0.0%.

Purchasing Manager’s Index

The Institute for Supply Management publishes the results of a monthly survey of their members, including a price diffusion index.  A diffusion index doesn’t tell us the rate of inflation, but rather what percentage of the survey respondents are seeing prices go up or down.

The survey results suggest no significant inflationary pressures.

Manufacturing Prices:  65.5

Services Prices:  57.0


Certain Regional Federal Reserve Banks survey businesses on a variety of trends, including prices.

Diffusion Indices – past month

The following are diffusion indices, a simple difference of the percent reporting price increases less the percent reporting price decreases.

New York Prices Paid:  22.6

New York Prices Received:  3.5

Philadelphia Prices Paid:  32.5

Philadelphia Prices Received:  26.8

Kansas City Raw Materials:  29.0

Kansas City Finished Goods:  13.0

Dallas Raw Materials:  18.1

Dallas Finished Goods:  14.7

Estimated inflation – past month

Richmond Raw Materials:  1.23

Richmond Finished Goods:  0.22

Forward-Looking Measures

Treasury Inflation Protected Securities

In addition to ordinary bonds, the U.S. Treasury issues inflation-protected securities (TIPS).  By comparing the yields, one can infer the inflation forecast of the capital markets.

Ordinarily one should assign high credibility to this type of information. However, caution may be appropriate given extensive central bank manipulation of the credit markets.

Five Year Forecast:  1.86% per annum (5Y Treasury Yield5Y TIPS Yield)

Ten Year Forecast:  2.00% per annum (10Y Treasury Yield10Y TIPS Yield)

5-Year, 5-Year Forward Inflation Expectation Rate

Inflation expected from 5 years from now to 10 years from now:  +2.14%

Fed Regional Manufacturing Surveys

Certain Regional Federal Reserve Banks survey businesses on a variety of trends, including prices.

Diffusion indices – 6 month forward estimate

The following are diffusion indices, a simple difference of the percent reporting price increases less the percent reporting price decreases.

Kansas City Raw Materials:  41.0

Kansas City Finished Goods:  24.0

Dallas Raw Materials:  40.2

Dallas Finished Goods:  26.0

Estimated inflation – 6 month forward estimate

Richmond Raw Materials:  1.30

Richmond Finished Goods:  1.46

Michigan Consumer Sentiment

1-Year Expected Rate of Inflation:  +2.6

5-Year Expected Rate of Inflation:  +2.5

ECRI U.S. Future Inflation Gauge

ECRI -0.6

Trend-based indicators

Crude Oil:  Uptrend = inflationary pressure

Copper:  Uptrend = inflationary pressure

U.S. Dollar:  Uptrend = deflationary pressure