Dividends vs Capital Appreciation and Independence From The Herd
February 21, 2010
– Comments (49)
I'm bored. So I thought maybe I would try again to explore why some of us prefer income to capital appreciation. I've tried before. I think I can do better this time. First off, why do stock prices fluctuate? What drives changes in share prices? Suppose a company takes off and revenues and earnings start trending sharply upward. Fine. But the share price doesn't respond directly to that. The share price starts climbing when enough of the herd finds out and more people want to buy it. Nothing moves share prices by itself. Some very large investors can buy or sell enough shares to momentarily affect the price, but by and large the herd determines the share price. Whether the herd is responding to a great quarter or a disaster, or recent press release, the most direct driver of the share price is the interaction of buyers and sellers in a market folks like us have no control over.
Like it or not, traditional value investors, growth investors, smallcap, international, you name it, if you're hoping to find an opportunity to buy shares in a company that you hope to sell at a gain later, your return depends on the herd. You find an undervalued stock, or stock in a company you think will have outstanding growth, you snap it up...and wait. Maybe everybody else is preoccupied with other stocks or sectors for some indefinite period of time. Or you have to wait for the growth to materialize, and Mr Market to finally recognize an increase in value. So you wait. Eventually, if you chose a good investment, your wait will be rewarded. Now you have to try to outguess the herd and take at least some profits before everybody else does and causes the share price to fall. Good job. You made some money. The rest of the herd eventually came around. To all this I will return.
I have owned The Intelligent Investor in hardback for about twenty years. If I've read it once I've read it forty times. And will again. I'm not down on value investing. I do sometimes wonder if we are living in a time where value investing is becoming too popular to work as well as it did for Ben Graham. Also, he would spend days and weeks doing research we can do in a few hours. Makes me wonder. But I'm not knocking it.
I just found something I like better. And I think I can do a better job explaining why this time.
Income is more stable than prices
Share prices respond to a moody and whimsical public. At any given moment the price you may receive for your shares is determined by other people's perception of their value. Your portfolio is only worth what the herd is willing to pay for it. Period. And that value constantly fluctuates.
Leaving the herd
Years ago, Warren Buffet finally became rich enough to start buying entire companies, taking them private. In doing so, he gave up the opportunity to sell or trade these companies on the market. He further said his "favorite holding period was forever." In doing so, he gave up the potential to realize capital appreciation instead choosing to seek his returns outside and independent of the market. One aspect of Buffet's value strategy that eludes many investors is that Buffet is a fan of companies which distribute a portion of their excess earnings back to Berkshire. This allows Buffet to reinvest the proceeds into new companies which allows him to further compound his invested capital. You might think, "well, yeah but that's what he's doing with companies he owns outright." Really? He doesn't own Coca-Cola or the Washington Post outright.
Berkshire's average cost basis in KO is $6.49/share. Last year KO paid an annual dividend of $1.64/share, giving Buffet an annual yield on cost of 25.3%. 200M shares of KO brought in 328M in dividends for Berkshire last year. KO closed Friday at $55.72.
Berkshire's average cost basis in the Washington Post is $6.15/share. With an annual dividend of $8.60, Buffet is realizing an annual yield on cost of 139.8%. The Post closed Friday at $415.32.
Did you know Buffet's cost basis in the Post was 1/67th of today's share price?
What this has to do with me
I want to build a retirement income. And I don't want the volatile moods and unpredictable emotions of the herd to be able to screw it up. Look. Some people will point out that if you want income, you belong in bonds. I don't know a lot about bonds although years ago I used to read a lot about them too. But bonds probably don't have the potential to provide a growing income which can hopefully keep up with inflation. And I do believe many people smarter than I am think we're bound to have some inflation in the coming years. Which means when you gat the face value of your bond back ten years later, it's going to be worth much less than that same face value was years earlier when you bought the bond.
Anti-dividend people will point out that you can focus on building up a large enough portfolio and simply plan on it returning a certain average amount of growth each year and periodically sell off shares for income, saving the taxes you'd pay on the dividends along the way. There are two problems with this. The first one I wrote about in another blog, warning of the risk involved when you retire and start dollar-cost averaging in reverse. When you are living off the income from periodically selling off shares, if the share price goes down and stays there for an extended period, you will have to sell off more shares every month to provide the same amount of income. You have become the seller, and the market has become the buyer...dollar cost averaging off of you.
Here's the other problem with periodic selling of shares for income. Your return from sale of shares is comprised of two distinct components: A capital appreciation component and an income component.
The capital appreciation component depends on the value the herd perceives your shares to have at the time you want to sell shares. This component is subject to wide swings in price over a year, let alone decades of retirement.
The income component is simply the dividend income your shares bring in. If your chosen companies have significant competitive advantages and are well run, their financial strength and ability to pay those dividends is unaffected by the herd's constantly changing perception of their value.
If you depend too much on the capital appreciation component in retirement, every time shares are sold to eat or consume fewer shares are left to generate the income component, and the retiree becomes ever more dependent on capital appreciation. And no retired person should be more dependent of what others' perceptions of what their portfolio value is than on the income stream their portfolio can generate despite others' perceptions.
I will not in my lifetime be rich and able to buy entire companies like Warren Buffet. That doesn't mean I can't apply the same philosophy in a smaller way. Most of the companies Warren Buffet has invested in have wide moats, or durable competitive advantages. This is also the foundation behind the best dividend growth stocks. Only companies with strong competitive advantages can consistently grow earnings to provide long-term dividend growth, without a large need of frequent capital infusions. These companies' financial strength and ability to pay dividends is unaffected by the madness of the herd. The price swings in the value the herd places on your shares will fluctuate wildly over the years, but with well-chosen companies that pay dividends and increase them annually, your yield on cost will increase every year.
Independence. Dividend investors try to seek a large portion of their return independent from the market. Unthreatened by the insanity of the herd.
Do I try to "beat the market?" No. I don't. I don't care what the market does. If I own shares in a company and the share price drops, and the underlying company's financial strength and ability to pay the dividend remains unchanged, I want to buy more. When everybody's complaining about a flat market or a bear market, I'm buying. So far I've beaten the market, but not because I'm trying to.
A word to newbies
Dividend investors are constantly criticized for not having an exit strategy. This criticism is not unfounded if you don't make a hobby of reading and studying and educating yourself. No investing system is so simple "a caveman can do it." Learn how to read financial statements. Learn how to watch for things that should throw up a red flag and cause you to recognize when a company's ability to maintain and grow its dividend might be deteriorating. As long-term dividend investors, we hope to buy and keep. But if you can't recognize when you really ought to think about selling, you're likely to be burned some time when it could have been avoided.
Here's some great books
The Intelligent Investor by Ben Graham) Anybody that ever wants to buy individual stocks should read this. Dividend investing is not the same as value investing, but you'll still learn things valuable to any investor in stocks from this book. It's a classic, and rightfully so.
The Little Book That Builds Wealth by Pat Dorsey) Corny title, I know. You won't find a better, more complete book on "moats," or durable competitive advantages. There's a chapter on each of four different kinds of moats. There's a chapter on valuation. There's a chapter exploring the fact that some companies are by nature poor long-term investments, because some industries are just too fiercely competitive to allow them to sustain a competitive advantage over the long term. How to recognize competitive advantages. Pat Dorsey is head of equity research at Morningstar.
The Ultimate Dividend Playbook by Josh Peters) It is the only book on dividend investing you'll ever need. It is exactly what its title claims it to be. Valuing stocks, many tips on analysis and how to tell if a dividend is sustainable, and the easiest-to-understand presentation of what's known as the DuPont system of analysis I've ever seen.
Read articles here on Motley Fool, watching for tips on how to spot an endangered dividend. Also, over on Seeking Alpha, watch for and read articles by David Van Knapp, Dividend Growth Investor, And Dividends4Life. When researching a particular stock, check over on Seeking Alpha and chances are if its a good long-term dividend stock, Dividend Growth Investor or Dividends4Life has done an excellent write-up and dividend stock analysis on it.
Develop a reading schedule. And don't fall into the trap of chasing high yields. Be careful out there.
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