Dear Valued Clients and Friends,
Last week’s Dividend Cafe allowed me the chance to review the history of Dividend Cafe, the fundamental reasons I create it every week, and how the philosophy of dividend growth investing fits into the broad intent of Dividend Cafe. I could say it was coincidentally good timing to connect the Dividend Cafe to dividend growth investing since it came the same week as the release of my new book on dividend growth investing, but then what would I be implying about my regard for your intelligence? So yes, you know that I know that you know that I am writing about this right now because of the book’s release, but that’s okay. This investment philosophy and the strategy that flows from it are always going to be prominently featured in these pages, and hopefully they will always be cogently connected to the things on your mind and the things that matter to your financial goals.
Today I want to pick up where I left off last week and conclude this little two-part series about the major thrust of “profiting from the profits” – better known as dividend growth investing. Last week was more focused on laying the groundwork for the thesis itself. Today I want to tackle some of the objections, some more prima facie credible than others. And in the end I hope you will understand the very essence of the matter: what is to be done with the profits of a company. I could write ten more books and a thousand more Dividend Cafes on this subject and never, ever tire of it (though readers may beg to differ.) But this stuff animates me like no other topic in investing, and I welcome any and all questions you may have. I am not just a practitioner of dividend growth, but desire to be an evangelist. To that end, I work.
Let’s jump into the Dividend Cafe…
| Subscribe on |
Last Week
Beyond the history of Dividend Cafe and how a dividend growth mantra is reflected in all I do here, last week’s commentary reaffirmed the philosophical tenets behind the strategy: that investors generate a return on capital from profits, and the instrumentation that makes those profits relevant to their financial objectives is called a dividend. Applied to public equity markets, I suggested that the durability and sustainability of a growing distribution to the business’s owners is, all at once, a reward to the risk-takers who invested in the business, and a sign of a healthy business. It is a statement of confidence about the future and a reward in the present for the events of the past all rolled into one direct deposit (I actually didn’t say it that way last week, but I have had more coffee this morning).
Most of last week’s focus, and a significant focus in my new book, is on the dangers of de-personalizing and de-companying the nature of investing. What I mean by this is presenting our investing vocabulary as if “the market” did something or “the index” went up (etc.). It is all dangerous because it is all, well, untrue. A basket of individual companies can present a convenient investment “vehicle.” An index can present a potentially interesting “measurement.” But companies create value by profitably making and distributing goods and services that meet human needs. I believe dividend growth is more naturally centered and oriented towards this underlying reality, and for that reason better helps investors avoid true distractions, temptations, diversions, and sometimes outright absurdities that pass as investment options.
I alluded to the point that there are endogenous returns and exogenous returns in investing, and one is indisputably preferable to others. Endogenous returns are organic and intrinsic and flow from the thing itself – in this case, the underlying business that is creating value. Exogenous returns are separate from the thing itself, and in the investing context mean that we are trying to make money off the fans, not the players (I also didn’t say it that way last week, but now I really wish I had). Even though I recognize not all investors are doing it consciously, I believe many investors are trying to achieve returns that flow from the herd – from sentiment – from popularity. And if you buy something for $10 and it goes to $20, you may not care why it went up. But I would suggest that if it went to $20 because a bunch of people are hoping and liking and voting, that is somewhat (at least marginally and perhaps dramatically) less durable than if it went to $20 because a company doubled profits and shared them with you. And I believe the exit strategy required to do exogenous investing well is more or less the whole thing, and I don’t think many people do exit strategy well. But when something goes from $10 to $20 because of the results intrinsic to the thing itself, the underlying profits that flowed from a real company product, strategy, and business model, your durability is enhanced, and confidence can be sturdier.
I biographically reviewed how I discovered dividend growth in pursuit of a smarter withdrawal strategy, and upon finding that, I also found a smarter accumulation strategy. And once armed with an optimal withdrawal and accumulation strategy, discovered that it was, more than anything else, a company selection strategy that transcended anything else I had seen.
But What About …
Dividend growth is not without its critics, though some are less credible and serious than others. Over the years, some of the more trendy objections have included:
- Stock buybacks are an optimal way to return capital to shareholders
- Dividends are really bad because you have to pay taxes on them
- A company becomes less valuable when it pays out a dividend
- If dividends are so good, why doesn’t Warren Buffett (Berkshire Hathaway) pay them?
- Dividend investing is good for retirees, but young people wanting to grow need something better
A few comments are in order (and I will say, in the book, most of these things got a whole chapter dedicated to them).
Stock Buybacks That Aren’t Any Such Thing
I do believe that when an actual stock buyback happens (i.e., a company has profits and it uses them to reduce its share count, thereby creating “anti-dilution” for its owners – more ownership of the same profit-making entity), it has done a good thing. When the dividends are not reduced (i.e., gross dollar distribution stays the same – not “dividends per share), and yet shares are reduced, this creates a dividend increase, as well. But putting dividends aside and just focusing on share buybacks as capital allocation, there are three major issues with which to contend:
- For those investors who are withdrawing capital, one cannot eat, spend, or tangibly use a share buyback. There is no linearity between the share buyback and the mechanical value increase, and the objective of “periodic cash flow” is not met by it. This seems intuitively obvious to me, and I have never understood why more people don’t understand it. You can’t spend a stock buyback, you can’t eat a stock buyback, and you can’t buy USC season tickets with a stock buyback. You can sell your shares of the company you love to buy things, but if you love the company and it will do good things in the future, you may not want to do that. And when you sell your shares, you may or may not be selling at a good price. But you won’t be selling at a price that perfectly matches the impact of the stock buyback. In short, for withdrawers, stock buybacks are not in the same league as dividends mechanically, logistically, and practically.
- Most importantly, stock buybacks are exponentially more vulnerable, disposable, negotiable, and flexible than dividends. The tendency of companies to stop doing buybacks when things get tough (i.e., when they should be doing them most) is legion. For the true dividend growers, the ones we want to own, the social contract between these companies and their investors has led to exponentially more reliable activity – a resilience that is incomparable to the practice of stock buybacks. This is just historical and empirical reality when we look at periods of market distress and declining profits.
- And here’s the killer – even if #1 and #2 were not on my list … Stock buybacks barely even exist (if properly defined). If a company has bought back shares, that company should have fewer shares outstanding (let me know if you need me to explain this slowly). So when a company “buys back” shares, but has “more shares” outstanding at the end of it all, they – here we go – didn’t buy back shares. Now, I freely admit that someone can be taking water out of their swimming pool at one end even as they put MORE water in it at the other end, but I just want to assure you from all of my years of studying physics that such a thing is not called “emptying the pool.” When a company buys back 100 shares but issues 200 more shares, they have a net buyback of negative 100 shares. And why did they issue more shares than they bought back? Because they are issuing them for executive compensation, employee incentives, and all that good stuff. In other words, the vast, vast majority of this practice called “stock buybacks” are really offsetting the impact of new share issuance to reward executives. Now, I am not for one second criticizing the practice of using equity to incentivize or compensate executives, corporate managers, or employees! Stock options, restricted stock units, inventive comp, and all such things are wonderfully constructive developments in capital markets. They just aren’t a means of returning capital to shareholders. Period.
Death and Taxes
What about the idea that dividends are taxable and so as you pay taxes along the way you are eroding your after-tax return? Putting aside the fact that this is immaterial to a massive amount of investors (IRA’s, 401k’s, ROTHs, Defined Benefit plans, Endowments, Foundations, etc.), let’s evaluate it as it pertains to even taxable accounts. The tax rate for dividends and capital gains is identical. So for a person regularly withdrawing, we are not talking about any difference, either. But for the accumulator, what about the idea that unrealized gains are not taxed and dividends are taxed along the way? Isn’t that an argument to let it all ride?
An entire chapter in my book is dedicated to rebutting this bunk, though I call it bunk charitably. It is a prima facie good argument that dies on further scrutiny. Without exposing you to the length of the whole chapter, I will succinctly offer this: All the build-up of a large unrealized capital gain does is create a large future tax liability. Now, someone may die, and then they don’t have to worry about tax (and pass along a step-up to your heirs). And if that is your plan for your money – to die so you don’t have to ever worry about it – we can have another talk another time. But what I want to say is not that the dividend tax issue is tolerable, but actually clearly preferable to the alternative. The portfolio skew and malinvestment that a large embedded unrealized gain creates has produced such a massive opportunity cost for so many trillions of dollars in American investing; it is depressing to even think about. Essentially, as chapter seven of the book argues in long form, paying taxes along the way on that portion of your portfolio return is much better than the alternative, although I would prefer the answer be “none of the above.”
The Company Got Poorer
One of the worst arguments against dividend growth investing is that a company is worth $11 and when it pays a $1 dividend it is now just worth $10, so while you have $1 (from the dividend) and $10 (in value), it is no different than if the company just held the dollar and stayed worth $11. The math may be right, but the understanding of markets is entirely wrong.
A company’s value is more than the sum of its assets (including cash). It is the discounted value of expected future profits, combined with market expectations for the allocation of those future profits. You may believe that a company CEO holding on to your dollar is the same as you holding on to it. I don’t. I think many CEO’s set that dollar on fire. But let’s pretend. First of all, why not give the investor the choice? Why not let the investor who wants more of what the company is doing reinvest their dividend in more shares? Now, you may say, “You just contradicted yourself – why would we want to reinvest in more shares if we are worried about the CEO setting the dollar on fire?” But of course, I am way, way more worried about the CEO setting it on fire when he won’t give it to me than I am when he will … The very approach to capital allocation that says, “we will pay our risk-taking investors first” is the cultural indicator of capital stewardship that can give you confidence that they are not arsonists. But there is more. That value itself is not static; it is based on a belief about future profitability, and when we talk about a dollar of profits, we are talking about profits already earned. The company may have something to do with the dollar that represents a higher Return on Invested Capital than it would mean to the investor, but it may not. Those opportunities are not infinite for every company that functions within its own domain of expertise, experience, network, and so forth.
A company holding on to a dollar is not value-additive. A company deploying it in a bad way is a bad idea. A company deploying it in a good way is a good idea. And when we get past those three things, then returning cash to investors is a very good thing to do. Always and forever, the question is what to do with profits. And I will say, I really love the chapter in the book about this.
The Berkshire Fallacy
One of my favorite arguments is that Buffett never paid dividends, so if they are so good, why wouldn’t he do it? I love the guy, consider him one of the greatest investors in history, and yet just have to say that he is maybe the most notorious “do as I say, not as I do” person I have ever encountered. He is the largest (and most successful) active investor of all time, and yet spent decades telling people to just buy the S&P 500. He said derivatives and options are weapons of mass destruction, but became a massive user of derivatives and options. And yes, Berkshire, as a holding company, does not pay dividends. But it sure as heck receives them!!!!!!!! The operating companies that they, as a holding company, bought were and are very often dividend-paying companies, making Berkshire a dividend-receiving company. At the holding company level, their deal with their investors was not to pay a dividend (creating a higher form of permanent capital for their deployment). I have absolutely no problem with this whatsoever. But one cannot equate a holding company with the underlying operating companies that, themselves, have profits which need to be allocated. I would say that doing what Buffett does (profiting from the profits) is a good idea. It is an argument that has always done the opposite of what was intended.
And Finally …
“I want hot growth now – big, huge juicy returns where high flying things go up for years, and then, right when I retire, I want to sell them all, and then buy a nice dividend growth portfolio and I will live happily ever after.”
I hope when I put it that way I don’t have to respond. But as the whole chapter in the book dedicated to that absurdity suggests, there are some problems. Of course, the entire argument is “market timing” dependent, is “wishful thinking,” and it actually a textbook case of behavioral mistakes run amok. But it misses the major argument for dividend growth as an accumulation strategy: The build-up of Yield-on-Original Investment (YOI) that multiple decades of dividend growth represents. That this has empirically proven to be BETTER for total return than “high growth” investing is immaterial. That is is less volatile is immaterial. That the presuppositions in “growth now, dividends later” are all baseless can be temporarily ignored. If none of those things matter to you, and they all should, just the delay of accumulating a massive Yield on Cost is a tragedy and potentially fatal error.
Okay, I loved this chapter, too.
Conclusion
I did not write this Dividend Cafe to drive any of you to the book. We already sent one to clients, anyway, and I happen to know that our advisors are sending the book out like hotcakes to non-clients with whom they are engaged in conversation. Book sales are not exactly my day job. I wanted this two-part piece on dividend growth investing to do what I want every Dividend Cafe to do:
Argue for that which can make sense of investing in a complicated world.
To that end, we work. And thank God we do it with a philosophy we believe in. That shouldn’t be too much to ask.
Quote of the Week
“Everybody wants to be great until they see the invoice”
~ Inky Johnson
More to Chew on
- What is going on at Treasury?
- Stanley Drunkenmiller on prices and signals
- A national treasure writes about a national treasure
* * *
I will be flying back to New York City tomorrow after a week in California. I hope you are as excited for the opening weekend of college football as I am. I also hope your air conditioners are working, and that this ghastly humidity will end with August. Make it a great weekend, fight on, and I will be with you Monday yet again in the Dividend Cafe.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
