Every investor pursues at least one of the following objectives:
- Capital appreciation
- To increase the long-term value of one’s wealth
- Income generation
- To generate current income
- Capital preservation
- To maintain the real value of one’s wealth
Investors who are focused on capital appreciation may assume growth risk by investing in stocks, while those going after capital preservation might only invest in ultra-safe assets like government bonds. Investors seeking income generation might land somewhere in the middle, investing in assets like corporate bonds, which bear higher interest rates than government bonds.
But what approach should investors take if they have more than one objective? Many are looking to increase current income while also having the potential for long-term growth. There are three primary approaches that investors can take to achieve both objectives at the same time: investing in preferred stocks, allocating to dividend stocks, and utilizing yield-enhancing strategies.
Invest in Preferred Stocks
Income-seeking investors often buy bonds and other interest-bearing assets to satisfy their objectives. Because bonds generally have fixed interest payments, they are useful for those who want to earn stable and consistent returns. However, bonds also have fixed principal amounts, so they have limited potential for capital growth.
Preferred stocks may be a better alternative for those going after income and growth objectives. Preferred shares are just like the common stocks that most people own, except that they have priority with respect to dividends and liquidation of the company. Put simply, if a company wants to issue a dividend, then its preferred stockholders must be paid before any profits can go to the common stockholders. And if the company ever goes through liquidation (e.g. in bankruptcy), then the preferred shareholders have a senior claim over the common stock.
While preferred shareholders are generally senior to the common shareholders, they are still subordinate to the bondholders. This intermediate position puts preferred stock somewhere in the middle, bearing features of both equity and debt assets.
Preferred shares have other unique characteristics that may vary from company to company. Like bonds and unlike common stock, most preferred shares don’t come with voting rights. However, some preferred shares may be converted into common stock. There are also cumulative and noncumulative shares, which differ with respect to the life of their dividend claims. If a company misses its dividend payment in a given year, then cumulative shares are entitled to that receive that dividend amount in the future, while noncumulative shares cannot carry the claim forward.
Allocate to Dividend Stocks
Dividend stocks are another type of equity that can achieve income and growth objectives simultaneously. Dividend stocks are not a legally-distinct class of shares. Rather, the term dividend stocks refers to the common stock of companies which pay substantial yields. Companies like AT&T, Walgreens, and 3M that pay annual dividends between 4-6% are popular dividend stocks nowadays.
You should be careful not to make some common mistakes when it comes to dividend investing. For example, some stocks offer high dividend yields north of 10%, but these companies are usually financially-unstable and risky. Focusing on mature companies with an established track record of issuing and increasing dividends is a safer approach to dividend investing. Companies that do this for 25 consecutive years are included in the S&P 500 Dividend Aristocrats Index, which has historically outperformed the S&P 500 on a risk-adjusted basis.
Increasing your asset allocation to dividend stocks can be a smart way to balance your investment objectives. Tools like Morningstar’s stock chart can be useful for attributing what portion of a stock’s historical return comes from dividends or price appreciation.
Utilize Yield-Enhancing Strategies
A third approach for generating income without jeopardizing growth potential is by using yield-enhancing strategies. The most popular approaches these days are selling covered calls, monetizing shareholder votes, and lending your shares.
For every 100 shares of stock you own, you can sell 1 call option to create what’s referred to as a covered call position. When you sell a call option, you’re making a bet that the price of the stock will not rise above a certain level, known as the strike price, within a fixed period of time. If you sell a call with a strike price above the stock’s current price, then you stand to make money if the stock stays exactly where it is. If the stock drops, you’ll also make money from selling this call option.
The only time the short-call option might lose money is if the stock rises above your strike price. But don’t worry, there’s a reason why they call it a “covered”call. Because you also own an equivalent number of shares, any losses from the short call will be offset by gains in the stock.
The main downside to a covered call is that it limits your upside exposure if the stock rallies beyond the strike price of your option. Any increases beyond your strike price won’t affect your overall profit, which will remain fixed because the long stock and short call offset one another.
Another way to boost yield comes from the fact that shareholders have the right to vote in a company’s general meetings. However, most investors don’t exercise their shareholder voting rights because they are passive. In fact, nearly 72% of retail investors don’t use these rights each year. So instead of wasting their votes, many investors are now selling their voting rights to generate supplemental income on top of ordinary dividends. Shareholder votes can be traded on financial exchanges like Shareholder Vote Exchange, and they are generally worth between around 1-2% of the share price. Investors who don’t use their votes can sell them to extract tangible financial value.
Finally, investors may also take advantage of stock-lending programs to earn interest on their assets. Institutional and retail investors often use margin to increase their long or short exposure. But in order to do so, they must borrow shares from other people who own them. That’s where you and your investment broker step in.
If you enroll in one of these programs, your broker will lend your shares to other investors who need them to increase their leverage. That investor will then pay interest for borrowing your stock. Most brokers now offer these services, which are an easy way to make extra money from your assets. The main disadvantage of this approach is that it creates counterparty risk between you and the lender. It may also affect the tax treatment of dividends you receive, and you may lose voting rights while your shares are lent out.
About the Author:
You can read more from Preston Yadegar on Medium and Substack, where he analyzes developments in financial markets, corporate governance, and shareholder activism. Feel free to connect with him on social media.