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“Income investing is investing; everything else is speculation.”
The quote is attributable to me. It has guided my investing philosophy for the past 25 years. I assert that income investing is investing because I can gauge with reasonable assurance the income my investments will generate. I’m less able to gauge what the price those investments will command at any particular time.
Because most of my investment income is derived from stocks, I’m keenly interested in dividends. I have a passion for dividend stocks that few investors share. I believe other investors lack my passion because they get dividends wrong. They have misconceptions.
For one, investors underappreciate dividends’ contribution to total return. Price appreciation is frequently the focus, which is understandable. Financial media chat up price above all else, as if price is synonymous with total return.
But total return is more than price … much more.
From 1926 through 1990, dividends contributed over 40% to the total return of S&P 500 stocks. After a 15-year interregnum – 1991 through 2006, where price appreciation contributed 83% of total return – dividends returned to prominence. In 2007 and 2008, dividends contributed 62% of the total return on the S&P 500. In 2011, dividends contributed 100% of the total return.
Many investors view dividends as a sign of weakness. When a dividend starts, growth stops, and high returns drift lower.
But that’s not really true. In a Financial Analyst Journal article titled “Surprise! Higher Dividends = Higher Earnings Growth,” Robert Arnott and Clifford Asness found that a high percentage of earnings paid as dividends failed to impede earnings growth.
The logic is understandable. Dividends are taskmasters. Dividends prevent management from empire building. Dividends remove excess cash and ensure that management focuses on the highest return investments.
Warehouse retail giant Costco (NASDAQ: COST) provides insight.
Costco began to pay a dividend in 2004. Costco had grown to the point that it was unable to invest all its cash at the same high rate it was used to. Management reacted smartly and responsibly: Instead of investing in lower-return projects, it returned excess cash to investors as dividends.
By continually returning excess cash, Costco has not only kept returns high on its investments, it has actually improved returns on investment. Last year, Costco’s return on equity was 20.7%; return on equity was 12.2% in 2006. Last year, return on assets was 7.2%; return on assets was 6.5% a decade ago.
Costco has hardly been punished for returning excess cash to investors instead of investing it in the business: Since 2004, Costco shares are up 400%. Over the same period, Costco’s annual dividend has grown to $1.80 per share from $0.40.
Management of high-growth companies will argue that theirs is a special business, with special opportunities (or special hazards). All cash must be retained.
But every business is a special business. Therefore, the argument more or less settles itself. You would have to conclude that there would be no situation by which shareholders should demand a dividend.
I argue that there is no situation where a profitable company should not pay a dividend. Financial theory tells us that capital is always available to profitable, high-return companies. What’s more, capital to invest in profitable, high-return companies need not be limited to retained earnings.
If you run a truly profitable, high-return business, lenders and equity investors will queue at the door to provide capital. What’s more, the more profitable the business, the lower the return the lenders and investors will demand for providing the capital. Apple (NASAQ: AAPL) borrows at 3%; Calumet Specialty Partners (NASDAQ: CLMT) borrows at 12%. Guess which one is more profitable and generates higher returns on investment?
I’m an unabashed fan of dividend stocks, and I’m in good company. To quote the father of investment analysis, Benjamin Graham: “I believe that Wall Street experience shows clearly that the best treatment for stockholders is the payment to them of fair and reasonable dividends in relation to the company’s earnings and in relation to the true value of the security, as measured by any ordinary tests based on earning power or assets.”
To that, I add, amen, and bring on the dividends.
Organize Your Dividends With One Step
Do you know when your next dividend stock pays out? Do you know when the dividend stock you want to buy more of pays out – and how much? We’ve put together a simple calendar that highlights many of the market’s best dividends into one easy to scan document. Read it once, and you’ll see how to set up a 12-month dividend stream to ensure income all year long.
Click here to see the full details of the Dividend Calendar…