“There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.”
— Charlie Munger

Growth investing is fine, but it can be taken too far. As I see it there are no growth stocks, just stocks going through a growth phase. Eventually, their growth opportunities fade, and they must mature and generate excess cash to produce real value for their owners. If not, they aren’t high-quality businesses.

“The value of any stock, bond or business is determined by the cash inflows and outflows, discounted at an appropriate interest rate, which can be expected to occur during the remaining life of the asset.”
— John Burr Williams

The problem is that managements of “growth companies” continue to reinvest in their businesses even once their return opportunities dwindle. This destroys shareholder value. They also can destroy value with acquisitions and share buybacks that are not price sensitive. An awful lot of companies bought back shares at high prices before the financial crisis, and then were forced to issue new shares at much lower prices thereafter.

Most managements are not Warren Buffett. They can’t allocate capital to save their lives. Paying a dividend requires better discipline by management. It puts the capital allocation decisions in your hands. It also allows you to build yourself a paycheck. A partner in a business should receive a share of the profits in cash, to do with as he wishes.

Dividends for the Short Term and Dividend Growth for the Long Term

All of the other rules apply to dividend investing. You need to get a margin of safety and invest for total return. Bought at the right price, a company with a safe and growing dividend should generate capital gains that will be in line with the rate of dividend growth over the long term. A rough target for long term total returns can be expressed as: Dividend Rate + Dividend Growth Rate = Total Return Target.*

A 3% dividend growing at 7% a year gets you to a 10% total return target. Over a complete market cycle, this will be competitive with the S&P 500, and with less risk. The way I look at it, the dividends are my paycheck, and they should grow better than inflation. The dividends take care of the short term and the dividend growth will drive long term capital gains, taking care of the long term.

* This relationship tends to break down at very low starting dividend rates. It helps to target already significant dividends. I focus on current yields in excess of 2.5%.

Also see these two posts by Todd Wenning at Clear Eyes Investing:

Why Dividend Investing Works

The Most Important Metric for Dividend Investors