Buying on dividend yield, good or bad?

Sometimes we select stock base on dividend yield. We might say this business looks to be able to generate good and stable cash flow over previous years. Even the growth is not high, but it is slow and steady, at least without severe drop as it seems historically. Due to that, in low interest rate environment, we might think that 6, 7 % dividend yield return is a very attractive rate. In other cases, we might find other small company that can provide dividend yield up to 8% to 10%. Again look at the historical track record, it seems quite stable.

But is it really safe? Unexpected can happen. Even the strongest business can drop in challenging economy time. Earning can turn and cash flow reduce. Even if the company is still strong and stable, the drop in cash flow will prompt the management to reduce the dividend payment, hence drop in dividend yield. Bear in mind that challenging economy comes in cycle, some very long that we can't recall the history if we are not aware of it. When it come, it can stay long too. We are not just suffering from drop in dividend yield return, but also drop in share price. Many times, the drop can be severe and takes a long time to recover. Even more so apply to small company. Small company is vulnerable to strong economy headwind. When the headwind is strong enough, it is common for those small companies that once afford to pay dividend into losses. If the challenging economy last for long, it can bankrupt the companies.

Hence, i feel buying into dividend is not very good. We need to buy into business/company that has visibility future growth prospect that offer undervalue price, or buy into stable business that offer substantial undervalue price. If really want to buy into dividend yield, buy those strong and stable business that can afford to pay over 10% dividend yield, because most of the time, it is undervalue. Only undervalue stock provide margin of safety cushion, not dividend yield.

Search for the Bottom

Taiwan’s God of share market 胡立阳 say there are 4 stages when Fed tapering the QE. First is the rumour of QE tapering, second is the reaction of the stock market increase volatility because the rumour is getting more real, 3rd is the actual tapering of QE where the stock market plunge further, 4th is the increase of interest rate where not only stock market plunge further, the housing market also drop.

I believe we can apply some of this concept on the search for the bottom as well. First is the initial plunge of the stock market. 2nd is people enthusiastically ask about bottom fishing., but stock market continue to plunge 3rd is stock market continue to plunge, most of the people already sold and they will warn anyone who want to buy not to buy. There is so many pessimism and skeptical surrounding as there is no recovery hope. 4th stock market range bounce at certain level with great volatility and volume rise. That is when there is huge change hand of stock ownership from those pessimistic people to optimistic people. Stock ownership structure change to those savvy and long term investor. That should be the bottom! Of course those skeptical and pessimistic people remain their believe. They will always ask, can drop further or not? don't put all in one basket etc etc. They only started to want to come in after the stock market has rebound significantly.

Deep discount stock?

I believe we will always better off buying a operating business than buying a undervalue non operating asset. Non operating asset is like a dead pool of water. Operating asset is like free flowing of water. We won't get anywhere betting the dead pool of water. However, we explore new things constantly by following the flow of the water. I want my resources to follow the flow of water, not the dead pool of water, because I don't know when the dead water will get refreshed. In other words, I don't know when the non operating asset value will get unlocked. The owner may not really want to unlocked the value forever, may be because of family tussle, ownership pride, or conservativeness etc. By waiting for the unknown, I feel it is like buying jackpot, too much uncertainty. Investing should be base on certainty of return. I rather buy good operating asset with good price than buy non operating asset with deep discount price.

When the tide goes out

I am starting to worry about the interest rate rising. It is not about the timing of QE tapering. We can see US unemployment trend is getting better, which mean US economy is gradually improving, and prospect is looking good. Interest rate will eventually rise when the economy gets better. And I predict the interest rising trend has started.

Whereas China continue to face slow down problem. It's rampantly heavy public investment has hit wall. Many of those investments are getting tiny return. It is clear that China has grow to a size that they can't just invest on any thing and get good return. From now on, every investment will have to be carefully evaluated the risk and return. This will be different from previous 3decades of flying growth story. Growth should return to normal 5 to 8 percent. But before that can happen, China has to solve other problems. Huge state province debt, highly not local affordable housing price, and over capacity of many major industry sector. Those problems will certainly drag down growth in may be 2 to 3 years time. Besides, the implementation of economy structure reform will ultimately determine the sustainability of China long term economy growth story.

While China has its own battle to fight, the predicted slow down of China in few years ahead will affect surrounding regional countries. The major hit will be commodity base countries. Further more, India has its own tough economy situation (currency depreciation, high inflation, increasing debt). Commodity demand such as metal, edible oil, will have tough time for recovery. Previous few years of commodity price boom has created a wealth for commodity country such as Malaysia and Indonesia. They thus have started their high growth plan in infrastructure construction and housing construction. Centered in high growth in China, the wealth effect has draw in huge foreign investment into many Asia emerging market. In addition, high ambition of those Asia emerging countries has been borrowing money to increase spending on construction to boast growth. Of course, those happened during past few years of very low interest rate environment. All of this resulted in increase of asset prices. When asset prices increase, the process repeated and create a vicious cycle of uptrend asset prices.

That's why I am worry about the rising of interest rate. US is still the largest economy by far in the world. When the largest economy improve, regardless of the state of others, interest rate will follow US economy situation and rise. When interest rate rise, the money will flow back to US. Now with the emerging markets had show signs of weaknesses, foreign money may find more reason to pull out from emerging market back to developed market to avoid risk. This will further exacerbate the emerging market problems (slow growth, high inflation, low commodity price, high borrowing). When interest rate rise, bad loan will emerge, falling asset price may then follow on.

As Warren Buffet said, "when the tide fade, you will discover who's been swimming naked."