Navigate Through Your Rocky Cash Flow

Thomas R. Kosky

Physician's Money Digest, June15 2004, Volume 11, Issue 11

With all the turmoil goingon in the world today,physician-investors findthemselves trying to seekout a safe haven to insulate themselvesfrom volatile global markets. Eventhough the US economy seems to berebounding and corporate profits are upnicely from the prior year, fears of inflationand rising short-term interest rateshave once again begun to rattle thebroader markets. In fact, as of the writingof this article, the prominent marketgauge, the Dow has closed under 10,000for the first time since December 2003and is down year-to-date by more than4%; the S&P 500 is down by a fractionmore than 1%; and the technology-ladenNasdaq is down nearly 4%.

Impatient Forecast

If you had money broadly diversifiedin the stock market among the differentasset classes in 2003—from large capgrowth to small cap value—you likelyenjoyed a nice return on your investments.But so far this year, returns have been, inmost cases, flat to slightly negative. Long-termhistory has shown us that the performanceof common stocks has surpassedthat of other types of financial instruments.But what if you are nearing retirementand don't have 20 years or more toride out the market volatility?

When listening to some of the foremostauthorities concerning the anticipatedperformance of the stock market,investing in common stocks just does notlook all that exciting. Depending on whoyou listen to, it seems that the consensuson returns is that they will revert back totheir mean, or less, which translates intolonger-term annual rates in the range of6% to 8%. If this is true, it brings forththe question, "Is subjecting myself to thevolatility inherent in the stock marketjustified for a 6% or 7% annual rate ofreturn?" If your answer is no, then youmay want to adjust your investmentstrategy accordingly.

In addition, we are also faced withrising interest rates. As such, bondswith intermediate- to longer-term maturitieswill more than likely decline invalue, as they have most recently, andcan end up being just as risky or moreso than investing in common stocks.Therefore, if considering investing inbonds or bond funds, stay with thoseinstruments whose maturities are shortterm (ie, 2 to 3 years or less). With suchinstruments, yields of 3% to 4% can beexpected, but very little if anything willbe realized in appreciation, since rateswould have to decline further.

Another choice could be the reliableCD. However, given the fact that we arefaced with rising inflation and yields areminimal, this is not an option unlessyou have a need for short-term liquidity.Otherwise, investing in CDs in alow-yielding inflationary environmentonly means loss of purchasing power.

Therefore, if CDs are yielding virtuallynothing, intermediate- and long-termfixed instruments (ie, bonds) areeliminated from the equation becauseof interest rate risk, and you are gunshy of common stocks that appear to berisky in a volatile stock market, whatare your safer options?

Cash Flow Focus

When looking at investments, focuson those instruments that generate acash flow. Admittedly, common stocksare volatile, but if you look at thosecommon stocks that are value-orientedas opposed to growth-oriented, andthat simultaneously generate cash flowin the form of dividends, then such aninstrument becomes a viable candidatefor inclusion in an investment portfolio.For example, Southern Companyhas a dividend yield of 5% and a price/earnings (P/E) multiplier of only 13.4,while Genentech has no yield and a99.5 P/E multiplier.

Another consideration is to investigatepreferred stocks in companieswhose common stock pays dividends.Preferred stock is often referred to as ahybrid security, as it combines the featuresof common stock and debt. Thissecurity ranks senior in claim to a firm'scommon stock, and junior in claim to afirm's debt issues. The reason for choosingpreferred stocks in companies whosecommon stocks pay dividends is becausedividends must be paid in full on the preferredstock before the firm can pay anyto shareholders of common stock. Preferredstock issues usually have a cumulativedividend feature, which meansthat if dividends are missed, they becomecumulative, and must be paid first to theholders of preferred stock before dividendsare paid on common stock.

Another rationale for issuing preferredstock is that corporations, particularlyutilities, may have a high-dividendclientele that finds preferred stock moreattractive than the utility's commonstock. This is because dividends composea greater percentage of the preferredstock's return.

Preferred stock has optional redemptionprivileges similar to those found indebt issues at the option of the issuingcorporation. It gives the firm the optionto redeem the preferred stock at a statedprice per share—usually $25—which isfixed at the time the stock is issued.Lastly, preferred stock is much lessvolatile in price than common stock.However, preferred stocks are interestrate–sensitive, but less so than fixed-incomeinvestments. Also, with preferredstock, you will see little if anything in theway of capital appreciation.

This strategy is not necessarilyappropriate for someone many yearsfrom retirement who is seeking long-termgrowth of their assets, unless theyare risk-averse and seeking to preservecapital. Rather, it is for the physician-investornearing retirement who needsto generate income as their primaryobjective, with capital appreciation takinga back seat. Then it may be worthwhileto look into this strategy.

Thomas R. Kosky and his partner,Harris L. Kerker, are principals ofthe Asset Planning Group in Miami,Fla, specializing in investment,retirement, and estate planning. Mr.Kosky teaches corporate finance inthe Saturday Executive and Health Care ExecutiveMBA Programs at the University of Miami.