CasPhotography/iStock via Getty Images

(This article was first shared with members and free trial subscribers of Inside the Income Factory on June 21st.)

Some of us have been having a "chat conversation" about the current investing environment and how it might affect our strategy going forward. Enough questions were raised that I thought an actual article might be appropriate to try to address some of them. That's particularly true because I realize that our readership/membership consists of a whole spectrum of people with varying degrees of understanding about our strategy, its basic tenets and what we're trying to achieve.

How we regard a market where

(1) The prices of our holdings have been steadily dropping, while

(2) Our cash distributions continue and our reinvestment rate increases,

will depend a lot on what our understanding, expectations and investment goals are. And especially, on how "bought in" readers are to our Income Factory philosophy and strategy.

At this point, I would urge any members who may not understand what an "Income Factory" really is, to take a moment and read this article, which is a re-publication of Chapter 2 from my book, and tells you in a nut shell what the economic and intellectual basis is for where I'm coming from, and why.

As economist John Burr Williams originally articulated back in 1938, markets value investments (stock, bonds, office buildings, oil wells, toll roads, etc.) based on their future cash flow generation. In theory, the value of the stock, bond or other asset is the discounted present value of the future stream of payments that asset will generate: dividends, interest, net lease payments or oil royalties, etc., plus whatever residual value is obtained when the asset is sold or otherwise disposed of.

Anyone who ever took a finance or investing course, or read a book about it, probably encountered that idea early on, but it is easy to forget when you get out into the "real" world where the media and other commentators focus on short term changes in market prices, and on the factors that might affect market prices in the short to medium term (like earnings, interest rates, macro-economic and geo-political events, etc.).

We often introduce our strategy by pointing out that when Ford Motors builds a new manufacturing plant, nobody except the back office accountants ever think about what the plant's "resale value" is once it's completed and put into service. Ford focuses on how much output it produces and how to increase that going forward. Ford knows that its output of cars and trucks is what gives the plant value, and not some arbitrary book value or "mark-to-market" price. That's pretty much true of other major investments, like office buildings, where the owner looks at the long-term lease rentals, net of costs, as the source of the building's investment value, not whatever its re-sale value would be from day-to-day.

Combining the common-sense approach to valuation of Ford Motors and the owner of that multimillion-dollar office building, we come up with our strategy of investing in funds, stocks or other investments that produce all or most of their total return (we aim for a target of 8 to 10%, over the long term) through high distribution yields. This means we don't have to depend on "the market" (which can be pretty fickle as we have seen recently) for our total return, but can achieve virtually all of it via cash distributions. Of course we have the option then to reinvest some, all or none of our distributions, depending on whether we are in an accumulative or redemption mode (i.e. growing for the future, spending in retirement or a combination of both).

I have never claimed that an Income Factory approach is BETTER than other buy-and-hold strategies, like Dividend Growth Investing ("DGI") or indexing as developed by Vanguard's founder John Bogle and others. All of these strategies, if pursued relentlessly and faithfully through all sorts of markets, have proven to be successful ways to achieve a long-term equity average total return of about 9 or 10%. I developed my approach because, frankly, I found that I did not have the steel nerves needed to hold a portfolio of solid "dividend growth" stocks, with typical yields of 2 or 3%, through downturns where market prices were falling and all you got was your puny 2 or 3%. I found through experience that if I traded off future growth for higher yields, and eventually found myself holding funds that paid yields in the 8-10% range, where I was getting my entire "equity return" through the generous yield, that it made it a lot easier to sleep at night even when prices were dropping.

Thus the Income Factory was born, not because of any particular "financial advantage" (i.e. I don't expect to make a higher return than a traditional equity investor), but because of the psychological and emotional advantage of having more feeling of "control of my own investing destiny," so to speak, as I collect my river of cash each month, regardless of whatever "paper losses" may accumulate. Being able to reinvest and compound that cash stream each month, and at bargain prices (and higher yields) to boot, when the market drops, merely increases the emotional and psychological advantage.

This year is a good example. My own personal Income Factory, is currently down in terms of total return since the end of the year by about 18%. However it is earning me a yield (and providing a current re-investment rate) of over 10%. So month to month and quarter to quarter, as I reinvest my steady cash distribution stream, I am giving myself a steady "raise" at a 10% per annum rate.

So I feel "wealthier" each month as my investment earnings increase, even though the paper value of my portfolio (my "factory") may be lower. If I owned a portfolio of dividend growth stocks, that was down by 18% and only paying me at a 2 or 3% rate instead of a 10% rate, would I be as confident about hanging on, even though I'd be repeating the time worn mantra that "time in" the market beats "timing" the market? I know from experience that I would not.

This requires a certain leap of faith that John Burr Williams is right, and that value does indeed follow income, and that reasonably efficient markets, over the long run, will reflect that. I have no problem making that particular leap of faith.

My whole strategy only works if we can find a reasonably steady, dependable source of distributions. This obviously requires, number one, diversification. Here are some scenarios showing what various levels of distribution cuts would do to a diversified portfolio.

Rather than dwell on worst case downside scenarios, I'd rather focus on what I think are the more likely challenges we may face in the near future.

I recently was asked about the likely impact of recession on our Income Factory strategy in a chat room discussion. For those who missed it, here is what I said:

It's a confusing environment to try to figure out. Our economy has essentially been quite strong, especially given what we came through two years ago. Unemployment is low, and most of our inflation (our biggest problem) is a result of demand starting up immediately as the Covid threat moderated and the economy opened up, but the supply to meet that demand (being global and having slowed or shut down) required many months to start back up again (and still is far from having been re-established). So we are in a situation where our Fed is taking steps that will undoubtedly result in a slowdown or recession of some sort in order to fight an inflationary surge that has essentially been caused by the demand side of our economy being TOO STRONG for the supply side to meet, at least in the short run.

So the question is whether the steps the Fed takes to fight inflation (higher interest rates) ends up cooling down the economy so much and so fast that it kills the demand (as opposed to just calming it down enough to reduce inflation). If they kill it (i.e. "calm things down too much") then that will be bad for BOTH credit markets and stock markets. If they calm it down enough to address inflation and go a bit overboard and cause a modest recession, that will be bad for stocks, but probably not so bad as to cause so many defaults as to hurt the credit markets much. In other words, a lot of companies whose stocks will tank will probably be just fine from a credit standpoint, which is why I feel credit is the safer bet than stocks right now, especially if we can get a yield of 8-9-10% or so to reinvest while waiting for things to improve. Most companies of the sort we buy via our various funds (equity and credit) are big enough to muddle through all sorts of economic environments (as we saw in 2020 and in 2008/2009) without collapsing, even though their stocks may tank. Main Street America (restaurants, smaller businesses, etc.; in other words, where we LIVE but not where we INVEST) is a different story. Our economy can cause a lot of pain to a lot of people and small businesses, but "Wall Street", by which I mean the "Corporate America" we invest in, is a lot more resilient. So, as I said, betting on those "horses" (i.e. Corporate America) to survive and make it around the track, seems like the better bet to me at this point.

One member followed up and asked me for more specific insights on how a higher interest rate environment (as opposed to the low interest rate environment of the past 12 years or so) may affect the distributions of our portfolios. This is a fundamental question.

Clearly, higher interest rates will affect the prices of stock, bonds and other assets. If market prices (per John Burr Williams and now other studies) reflect the discounted present value of future cash flows, then higher interest rates generally mean we discount all future cash flows at a higher discount rate. So the same future income stream that used to be worth X, if now discounted at a higher interest rate (because investors, having adapted to the higher interest rate levels now expect a higher return on their investments) will have a lower present value.

The impact on funds' distribution levels is complicated. Higher interest rates mean bonds and loans will be issued with higher coupon rates (i.e. banks and lenders will charge more), so our credit funds (high yield bonds and senior loans, and CLOs that are built on portfolios of loans) should end up paying us higher distribution rates that reflect the higher interest rate environment (i.e. they should have higher net investment incomes or "NIIs"). We saw this in reverse back after the 2008/2009 crash, when some closed end funds, if you look at their distribution charts, ended up dropping distributions in the years following the crash; not because their portfolios were in trouble or experiencing losses, but because the macro-interest rate environment had dropped so much that as loans and bonds were renewed, the interest rates being charged the borrowers dropped. So our closed end funds, especially fixed income and credit ones, play their role as "pass through" vehicles and pass through to us as investors the interest their customers pay to them, as it goes up or down over time.

That's not necessarily a bad thing, and is why Bill Gross of Pimco (at the time) referred to the fact that lower interest rates (and the lower inflation that accompanied it) would result in a "new normal" as investors shifted their expected target rates down to reflect the lower interest rate structure. Now we are looking at the possibility of a "new normal" in the other direction, if rates move upward and stay there for awhile (which they either will or won't, depending on how successful the Fed is in bringing inflation back down).

The credit funds we invest in for the most part hold either:

(1) senior secured floating rate corporate loans, whose interest rates adjust almost immediately to increases in interest rates (there can be some stickiness to the extent they have "LIBOR floors" that rates have to exceed before an increase to the lender kicks in), or

(2) high yield bonds, whose terms are much shorter than investment grade bonds and therefore reprice within maybe 3 to 5 years (which means a diversified portfolio has some of them repricing at the higher rates constantly; while existing ones are generally paying a pretty high rate (compared to conventional bonds) to begin with. These funds are already paying us in the 9-10% and higher range, so I'm not worried about being "stuck" at those yield levels for a year or so while their portfolios reprice upward.

How equity funds will do in an inflationary environment depends a lot on their portfolio managers picking companies that have strong market positions ("moats," etc.) and customer bases so they can pass along their higher costs. I think the sort of funds and fund families whose equity funds we are inclined to buy are those with long track records who I suspect are way ahead of us in thinking through these issues.

Nobody can predict the future, but for the reasons I mentioned in the above italicized section, I estimate that if the Fed tips us into a recession (which is likely) as part of their fight against inflation, it will probably be a modest one which means the impact on the corporate sector in terms of defaults and business failures will not be on a scale anywhere near that of 2008/2009. And we know that investors (ourselves included) came through that pretty well.

So much for now. I look forward to continuing this discussion.

I launched Inside the Income Factory because many of my 12,000+ followers and readers of The Income Factory® (McGraw-Hill, 2020) asked for more interactive dialogue. Here's what members say: 

As a freelance writer and journalist my motto has always been "Complex Stuff In Plain English"  and that's what I try to do in Inside the Income Factory.

 Click here to learn more.

This article was written by

Bavaria introduced the Income Factory philosophy in his Seeking Alpha articles over the past ten years, drawing on his fifty years experience in credit, investing, journalism and international banking. His earlier book "Too Greedy for Adam Smith: CEO Pay and the Demise of Capitalism" exposes the excesses in the CEO pay arena. Both books are available on Amazon. 

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: My articles published on Inside the Income Factory or elsewhere on Seeking Alpha, including comments, chat room and other messages, represent my own opinion based on personal knowledge and experience. I am not an investment “expert,” counselor or professional advisor, and while my articles may reflect substantially the strategies I employ in my own investing, there is no assurance that these strategies will be successful, either for me personally or for my readers. In other words, while I do my best, there is no warranty or guarantee that the ideas expressed are correct or accurate, and I urge all readers to take my opinions for what they are – “opinions” – and to do your own due diligence on, and check out personally, every investment idea, stock or fund that I may present, so you can make your own informed decisions.