Don't Let Your Returns Fly the Coup

In the '90s, most people were involved in appreciation-based investment strategies. This made sense with the economic climate, particularly in the latter half of the decade, when a physician-investor could reasonably expect to buy a stock for one amount and sell it a while later for much more. However lucrative this may have been at the time, it was not a true income-producing strategy.

Income represents the means to perpetuate your lifestyle and living standard, which is determined by cash flow. Dividing an investor's portfolio-generated cash flow by their income needs helps to measure their percentage of income from dividends and interest. A retiree will use this income to replicate their lifestyle. As they mature, the need to rely on additional cash flow items will increase. For the '90's investor, the total return mentality dictated striking a balance between appreciation and income from interest and dividends. But in the past 2 to 3 years, performance evaluation has changed from simply looking at performance to looking at cash flow generated through dividends and interest.

DELIGHTFUL DIVIDENDS

Declared dividends, issued by the directors of corporations, are a hotly debated issue currently. Stocks paying a 3.5% to 4% dividend in a 7% money market environment were somewhat attractive in the '90s. However, in today's 1% money market environment, a 3.5% to 4% dividend-paying stock has become paramount to the success of an investment portfolio. Assuming the passage of the proposed tax cuts, dividend-paying stocks will become much more attractive. As the majority of investors begin to grasp this fact, more and more money will begin to flow into dividend-paying investments. This trend would continue with a magnitude unseen since the Tulip Mania of 1637.

Dividends are important to consider when monitoring performance and valuations based on cash flow. Beyond dividends' current moment in the spotlight, physician-investors should also explore the other facet of cash flow investing: interest-bearing investments, such as bonds and bond instruments.

DYNAMIC MARKET SHIFTS

However, in pursuing interest-bearing investments, recognize that there is added risk inherent in these kinds of investments that simply didn't exist 3 years ago. Rates are so low today that if they move sideways or upward, bond investments could lose principal value.

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Consequently, the stock market has made the dynamic shift from an appreciation vehicle to a total-return vehicle. As such, the types of items physician-investors should be holding in their portfolios have changed to reflect bond investments' added risks. Even more important, physician-investors should resist the old temptation to calculate performance by measuring their portfolio growth against the S&P 500, an unmanaged index generally considered as representative of the entire stock market. The new basis of calculation should be, "What amount of cash flow does my portfolio produce through dividends and interest?" An investor may not directly invest in an index.

TOTAL-RETURN PORTFOLIO

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Let's consider a sample $1-million portfolio. With $300,000 invested in stocks yielding 3.5% dividends, the investor earns $10,500 a year. With an additional $400,000 invested in convertible bonds yielding 6.7%, the investor earns $27,000 a year. If the remainder of the portfolio generates an additional 1% in interest, that adds another $3000 for the year, which brings the total cash flow generated to $40,500 a year (ie, roughly 4% of the $1-million portfolio). If there is even modest growth in the underlying investments, the portfolio has achieved a total-return function. ( This information is for illustrative purposes only, and should not be considered a specific recommendation. Rates of return are hypothetical in nature and not indicative of an actual investment. An investor's results may vary.)

The point is that cash flow investing is no longer a simple investment decision. Rather, it has become a performance-evaluation metric, focused less on appreciation as compared to the S&P and more on the underlying cash flow the account generates. After all, this is how an investor gets paid.

ASSURANCE IN INVESTING

Because of the uncertainty in the market, the only firm investment instruments still poised to provide lucrative cash flow are extremely short-term CDs, short-term corporate bonds, and convertible bonds. Consider a new way to achieve total-return and evaluating performance: Abandon measuring performance against the indexes alone; instead, embrace measuring the level of cash flow that each portfolio generates.

In days past, whether or not your portfolio generated cash flow was inconsequential in light of the great appreciation of most investments. Today, a portfolio without cash flow is in serious trouble. For example, an investor who wants to take 8% per year out of their $1-million portfolio is going to have a hard time meeting this goal if they aren't paying attention to cash flow. If they need $80,000 (8%) and they have cash flow–generating investments producing $40,000 (4%) a year, then they need only rely on appreciation equal to roughly 4%. A 4% appreciation is realistic in today's market, whereas a 7% to 8% growth rate is much less likely to transpire.

POSSIBLE SAFER ROUTES

For those who might be apprehensive about selling out of long-term bond positions, consider the following. If you own a 10-year bond and you agree that a very real potential exists for the bond market to sell down by as much as 20% in the short term, why not sell the 10- year bond now and buy it back down the road? Or consider selling the 10-year bond and buying a 4-year bond with the same yield. Another available option would be to sell the 10-year bond in favor of a 2-year convertible bond that enjoys decent upside potential.

The goal is to realize the unrealized appreciation by selling the longer-term issues at the right time and replacing them with instruments providing yields comparable to your current yield. This way, you're reducing your exposure to interest risk without sacrificing yield. Plus, you're gaining some potential upside.

Shifting from straight appreciation stocks to dividend-paying stocks, and shifting from long-term corporate bonds to short-term convertible bonds helps create cash flow. These strategies are helpful in reducing risk and providing exposure to some potentially impressive upside gains. Consult with a knowledgeable advisor to see if these methods will benefit your portfolio.

John Valentine specializes in portfolio management and developing high-net-worth strategies. He is the principal investment advisor at the Valentine Capital Asset Management of San Ramon, Calif. He welcomes questions or comments at 925-275-0200 or www.vcrpg.com.