Saturday, December 11, 2010

The Myth of the Income Play

These are the words that define our trading: Short-term trade, long-term trade, income play, dividend play, capital gains play.

And on and on in a tangled forest of verbiage that distracts from Goal One: Profit.

Time to deconstruct.

Over the years I’ve tended to divide my trades into capital gains plays and income plays.

A capital gains trade, my thinking ran, is generally short-term, involving stock options, with a tightly limited commitment of capital. An income trade is a place to park the bulk of my funds, in the expectation that they’ll sit happily in my portfolio, drawing a dividend each month or quarter.

This had the benefit of allowing me to focus on producing large gains from a small portion of my portfolio, secure in the knowledge that the bulk of my holdings was safely drawing income.

Capital gains: Short time horizon, small money commitment, radical strategy, big risk.

Income: Long time horizon, big money commitment, conservative strategy, small risk.

That has been my mental universe. And it’s all nonsense.

My biggest losses, the past few years, have, in fact, been on the income side of the ledger. My only losses in the great crash of 2007/2008 that launched the Great Recession of 2009/2010 was in funds that invested in high-dividend stocks.

Love the divdends! Hate the capital losses! That has been the anguished cry rising from my trading platform each time a “conservative” income trade turned sour.

I mean, what does it profit a trader to gain a 2% quarterly dividend if he loseth 30% in a four-day decline?

Successful trading is all about picking the right stuff to trade at the right time.

Pick one stock the week before a 30% happy earnings surprise, and you’ve made a profit and spent the rest of the day laughing maniacally and saying things like “Booyah!!!”.

Pick a different stock, before the company announces that it’s issuing new shares after firing the CEO, and you’ve earned a loss and the right to spend the afternoon weeping into your venti coffee in a steaming cardboard cup from Starbucks.

But the words we use to characterize trades have little to do with picking the right trading vehicle at the right time.

For example, the words having to do with time -- long-term, short-term -- are relevant only because gains on a position held for a year or more are taxed at 15% (in 2010), while those on positions held for less than a year are taxed at the ordinary rate, 28% for most middle-class people.

My mental division between conservative income plays and risky capital gains plays is clearly a metaphor for the most fundamentals ways of earning a living, as old as Cain and Abel.

A stock or bond held for income, the image goes, is like a field, which, once the seed is planted, lies passively under the sun waiting to be harvested each season (quarter) as it puts forth a crop (dividend).

A capital gains play, by contrast, is an active beast, like a deer, to be hunted and pursued.

I’m never surprised when a capital gain bounds away. I expect my prey to get away from time to time, for such is the thrill of the hunt.

I’m always shocked to see the price of a dividend play collapse. Fertile fields are not supposed to turn into sinkholes.

The question, then, is how do income plays and capital gains plays really behave. To study it, I’ve set up a one-year weekly chart with a technical analysis tool that tells the percent move every four weeks.

I chose one year so as to avoid the huge dislocations in the credit markets of 2007/2008 and carrying over, in some cases, into 2009, where some of the funds and stocks moved by 20% and more, both up and down, with the extremes often occurring within weeks of each other.

(Regular readers will recognize the selections below as being the Income Plays section of my Watchlist, with two additions: TLT, an exchange-traded fund that tracks U.S. Treasury bonds with maturities of 20 years or more, and JNK, which tracks high-yield corporate debt, generally known as junk bonds.)

Income Plays
symdivmax gainmax lossnow

Hardly a passive field happily growing crops. In seven of the 11 cases studied, the maximum capital loss in a month exceeded the annual dividend.

Next, I turn to some capital gains plays. Actually, they’re more specialized then that. These are earnings plays, where I buy a few week before the announcement in the hope of a happy surprise.

They’re growth stocks, selected because of a return on equity in excess of 20%, very low levels of debt, and high levels of institutional ownership.

A surprising number pay dividends, a few of them at respectable levels. But I didn’t consider dividends in selecting them as earnings play candidates. And my positions, where I opened them, were stock options, which don’t receive dividends.

The chart is identical to that used for the income plays.

(Readers will recognize these from the Growth Plays section of my Watchlist, with a few completed plays from Futures File tossed in.)

Earnings Plays
symdivmax gainmax lossnow
CMG* 30.6%-10.4%1.8%
LULU* 44.9%-18.0%44.9%
PCLN 44.7%-27.1%1.2%
URBN* 24.9%-12.7%13.1%

Some of the earnings plays clearly have greater swings than the income plays do, but not always. INTC and PAYX, for example. Perhaps it is no accident that those two stocks have the highest dividends on the list, 3.3% and 4.1%, respectively.

Let’s look at a few popular stocks, just for the fun it.

Big Names
symdivmax gainmax lossnow
AAPL 20.9%-10.5%4.1%
GOOG 22.7%-14.5%-1.8%

Those big names are closer to the dividend plays in their volatility. Actually, for the most part they’re considerably less volatile.

So at this point I can say that income plays are usually less volatile than earnings plays, which are more volatile than big names, but not always.

And I can conclude that in nearly all cases, any dividend can be wiped out completely by a month’s worth of capital losses.

That being the case, the fact-based trader will go for the higher dividend yield to cover the high chance of a capital loss and will keep reasonably close stop-losses in place in order to trade out to avoid large capital losses.

In other words, income plays can’t be treated as being, by definition, long-term plays. They must be treated like any other volatile position: Ease in fearfully and run like jackrabbit if things turn sour.

Also, I conclude that the trader, in selecting income plays, will go for the stocks that have the better fundamentals: High return on equity, low debt and high institutional ownership. This will tend to bias price moves to the upside.

At this point in the analysis, my rules for selecting income plays have morphed into my growth and earnings plays rules. They’re identical, except for the dividend. High risk, short time horizon.

When I run a search using my basic parameters of a 20% or more return on equity and no higher than 0.1 debt to equity ratio, I get 54 hits in my search for growth stocks, with a minimum average volume of 1 million shares (for liquidity because I trade the options) and no dividend requirement.

Using the same basic parameters, but with a 100,000 share minimum volume and a dividend requirement of at least 8%, I get four hits, three of them closed-end funds.

And that puts me in a dilemma.

To get a reasonable selection of high-yield stocks for income plays, I have to lower my standards. I can increase the number of hits to 10 by removing the debt restriction.

But even if I also remove the return on equity restriction, I still get only 33 hits. And without any finance-based restrictions, I’m back to a selection of income plays that are as prone to capital losses as any poorly managed company.

This is not the answer.

The bottom line, I think, is this: Income plays, as long-term parking places for money, are a myth. The only kinds of plays are winning plays and losing plays. Winning can be from capital gains, and it can also be from dividends.

There is no long-term trade or short-term trade. There’s only the right-term trade: Get in when the is low, and get out after it has risen and before it turns again.

Once the money comes in, your cash account doesn’t know whether it came from dividends or capital gains. It’s only money.

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