The Power of Dividends

15 Saturday Mar 2014

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“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

Two Ways to Win: Indexing and Active Stock Picking

24 Monday Feb 2014

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There is a lot of Balkanization between adherents of indexing and active stock picking. I don’t worship in either church — they both have their merits. Let’s take a look at each.

The Strengths of an Indexing Approach

An indexing approach has many strengths. It is tax efficient and low cost. It removes tracking error, or the chance that you will substantially underperform the market. Moreover, it is relatively simple and low maintenance. The primary chore is to rebalance if your target allocations get too far out of whack.

These factors make indexing a great bogey for most people. As Jack Bogle says, this is the only way to guarantee you will get your fair share of the market’s returns. Sensibly, indexing has attracted a growing torrent of money in the last several years.

The Success of Indexing Creates Opportunities for Stock Pickers

Ironically, the success of indexing is a gift to the stock picker, because it paints all stocks with the same broad brush. As Elliot Turner indicates in his post Lucky to Live in This Era of Indexation, this undiscriminating wall of money creates many inefficiencies to be exploited.

The popularity of sector ETFs has been a large part of this dynamic, by treating stocks in an industry as a basket and not differentiating between them.

Pitfalls of an Active Approach

If you go the active route, you open yourself up to tracking error. Higher turnover creates higher trading costs and tax inefficiency.

Don’t neglect the advantage that tax efficiency gives indexing. Some active managers attain impressive returns before taxes, but high turnover causes substantial tax leakage. You can’t eat before-tax returns. So remember to compare the after-tax returns from passive and active strategies.

This suggests a low-turnover active approach on the order of Todd Wenning’s Simple Formula for Investing Success: Investment + good company + right price + patience.

Nothing Works All of the Time

Occasionally, someone will discover an anomaly that can be exploited, such as the low-volatility outperformance propounded by Eric Falkenstein. The problem is, as it is discovered by the masses, a torrent of money gets thrown at the strategy and the outperformance gets arbitraged away, at least until the crowd sells and moves on to the next hot fad. So never fall in love with an investment.

The main thing is don’t be dogmatic — you should remain flexible. The king of flexibility was Peter Lynch, who some called the Chameleon. This was key to his success.

Make Love, Not War

In the end, indexing and active stock picking are not mutually exclusive. They coexist and benefit from the existence of each other. And they can easily be combined in some fashion. It doesn’t have to be either/or.

Lottery Tickets and Investing

21 Friday Feb 2014

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“The combination of optimism and overconfidence is one of the main forces that keep capitalism alive.”
–Daniel Kahneman, (via Jason Zweig’s Thought of the Day)

Kahneman is the psychologist who won the Nobel Prize in Economics for his work on behavioral economics and the development of Prospect Theory. His book Thinking, Fast and Slow is a classic. I celebrate the optimism and overconfidence that causes entrepreneurs to take risks. This is the mechanism that allows capitalism to create greater wealth and well-being for all of society over time.

As for my personal investing style, I take a different lesson from this. Optimism and overconfidence in investing is a recipe for disaster, particularly the overconfidence part.

In his book The Missing Risk Premium, Eric Falkenstein talks about the anomaly that low-volatility stocks have outperformed higher-volatility stocks over several decades, with less risk. This completely blows up the financial academic models that link risk with reward, such as the Capital Asset Pricing Model.

Why should this be? Ego and overconfidence of investors, combined with the lottery ticket effect of skewness. We all like to think we are above average investors and we are concerned about the perceptions of others. It is just more exciting to own Tesla or some one-drug biotech that could be the next Apple or Google or whatever. It is pretty hard to brag at a cocktail party that you own an index fund or Johnson and Johnson. So people tend to swing for the fences with the hot, new, exciting names.

It is also hard to get people to hand you their money to invest if you are recommending boring index funds or low-volatility stocks. You have to sell your superior knowledge and skill that allows you to outperform, or at least make claims that you will. This is why professional money managers sell complex strategies that you couldn’t possibly understand or execute as well as they can.

Falkenstein’s blog post Ego and the Low Vol Premium reaches the following conclusion:

Our desire to impress others causes us to take too much risk. On the bright side, this implies some rather simple strategies like low volatility investing, because I don’t see it going away.

Now, I’m not wedded to a low-volatility strategy per se, but this knowledge informs my style of investing. I love to find boring high-quality businesses that are hard to brag about owning. If I can find them at a favorable valuation and all of my other requirements are met, I’m in hog heaven.

You need to ask yourself: why are you investing? Is it for bragging rights or to make good risk-adjusted returns? I’m firmly in the latter camp.

The Cost Matters Hypothesis

17 Monday Feb 2014

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Jack Bogle, the founder of Vanguard and of the index fund, once said that his big idea is not the Efficient Markets Hypothesis, but the Cost Matters Hypothesis. And boy is he right. The following chart shows the difference in total return between an index fund and an actively-managed fund charging the average amount, assuming their gross returns are the same, which they are in the aggregate.

401kFees3

This is some brutal math. It’s 27 percent of your retirement going to Wall Street for nothing. Actually, less than nothing. Remember, about 80 percent of actively managed funds do worse than index funds after you take fees into account. It’s a Wall Street handout that you can’t afford to make.

Skip the fees, and save your retirement.

Keep your costs low. Unless you are getting stunning performance, it is likely to be your best move.

The Crushingly Expensive Mistake Killing Your Retirement by Matthew O’Brien

(h/t Eddy Elfenbein)

Keynes The Investor

13 Thursday Feb 2014

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John Maynard Keynes is best known as the 20th Century’s most influential and controversial economist. Less known is his great track record as an investor. He managed his own money and the endowment of Kings College at Cambridge University during some of the toughest times to be an investor. An analysis shows that he beat an index of British common stocks by 8% per year from 1921-1946.

More interesting is his uneven performance over that time leading him to evolve his strategy. He started with an effort to time the markets using a top-down (macro) approach, which primarily consisted of changing allocations between stocks, bonds, and cash according to changes in macroeconomic indicators. Poor performance in the late 1920’s caused him to change his strategy.

The 1930’s saw his evolution into a long-term value investor with a bottom-up, stock-by-stock approach. He emphasized small stocks and stocks with high dividend yields, and exhibited growing patience. He aimed to buy at a discount to intrinsic value, and he ran a concentrated portfolio. These changes caused him to consistently outperform the market.

This strategy echoes Graham and Dodd, so no wonder Warren Buffett and George Soros were admirers of his.

So to recap, a strategy as old as the hills that still works. Focus on:

1. Valuation.
2. Buy with a margin of safety.
3. Be patient.
4. All else equal, gravitate toward smaller companies and higher dividend yields.

There is more to successful investing than these factors, but you’ve got a head start if you begin with them.

John Maynard Keynes, Investment Innovator by David Chambers and Elroy Dimson