Since
1930, dividend has been responsible for 42% (on S&P 500) of the
stock market return so there’s little surprise that it is one of the
main criteria we look for when picking stocks. However, in
investing, everything involves an opportunity cost. So the question to
ask is - Is focusing on dividend as a key selection criterion the right strategy for me?
Before
you decide if it is the right strategy, first we have to understand
what it is. Let’s think about a bathtub system. In a bathtub system, you
have water flowing in from the tap into the tub with some retain in the
tub (or stock) while the rest flows out through the sinkhole.
When you apply this to business, what do the inflows represent? It’s the earnings. Or more precisely, the return on capital (ROC) for the business. The higher the ROC, the bigger the inflows. Once the water flows into the tub, the management will ask “How much should we reinvest to grow the business and how much should be paid to our shareholders?” The amount of dividend that is paid out is the outflows. And for every dollar paid out to shareholders, there will be one less dollar retained to grow the business.
That
is the big picture. Dividend and growth come from the same pie (or the
same tap). You cannot have both at the same time. It doesn’t matter how
you cut or slice the pie, if the size of the pie doesn’t change, doing
more of one thing means less of the other. If a company pays out a
majority of their inflows as dividend, the future growth rate will be
low. Whereas if a company wants to focus more on growth, they either
have to 1) Reduce dividend or 2) Improve ROC.
So
that’s the opportunity cost. If your focus is on dividend stocks, there
will be less capital for these type of companies to compound future
growth for you. The same analogy can be applied to personal finance. If
you consume more of your savings today, there will be less for future
wealth. A dividend is a form of consumption. Yes, there are disciplined
investors that reinvest all their dividend but more often than not, most
dividends are being consumed unknowingly rather than reinvested. A
dollar of dividend that is not reinvested will lower your long term
compounding power. It is like a car always on the 1st gear going up the
hill. Here is an example.
Both
stocks, A and B have a ROC of 20%. Stock B is a dividend stock, paying
out 80% of their earnings and reinvest the remaining 20% for 4% growth
(Growth rate = ROC*Reinvestment rate) due to lack of opportunities.
Whereas stock A is a compounder. It is a small fish in a big pond and
given there are many opportunities out there, it can grow at 16%
(reinvesting 80%) and payout a conservative 20%.
You
would notice there’s a slight difference between both CAGR figures.
Stock B has a lower CAGR because the dividends are not reinvested. The
difference of around 3% doesn’t sound much, but on a dollar level, stock
A’s return is 80% higher than B after 20 years. Instead of $45 vs. $25,
think $450k vs. $250k, or $45 mil vs. $25 mil. Dividend that is not
reinvested might not amount to many each year year, but over the
long-term, it becomes exponential.
When
a company pays out a majority of their earnings, the weight shifted
from the management to the shareholders. If dividend is to be
reinvested, shareholders have to do the heavy lifting by finding similar
or better opportunities in the market. Sometimes, the timing of
dividend doesn’t always coincide with opportunities in the market, and
at times, runs in opposite direction. In a bull market, there will be
fewer opportunities as better earnings leads to higher dividend and
share price gets bid up in the process. The opposite applies in a bear
market. Shareholders also need to consider the time required to research
and find these opportunities because time is an opportunity cost. And
when time constraint and limited opportunities collide, there’s a
tendency to make rash decisions that lead to bad investments. These are
subtle risks that are less discussed when reinvesting your dividend but
are nonetheless real.
On
the flip side, dividend can be a better choice in some cases. If it is
the main source of income for an investor or if a company has limited
growth opportunities; poor allocation skills that lead to
diworsification; face highly uncertain future prospect or destroys
shareholders value by opting for growth that has a poor return, it makes
sense to focus on dividend over growth.
For
investors where dividend income is optional and can afford to wait
10-20 years, you can fully exploit this edge. The best way to do so is
to leverage on stocks that can redeploy most of their incremental
earnings at a very high rate for a long period of time - the
compounders. As the example shows, 2 stocks can have the same ROC (and
same cost of capital) but that doesn’t give you the full picture. The
one that can grow faster is going to be more valuable. Make no mistake,
compounders are the rare breed. Most companies cannot continue to
maintain a high ROC for a long time or if they succeed, size will
eventually prevent them from reinvesting all their capital. With that
said, it is good to keep in mind compounders should always be the one
you are looking for, especially during a crisis.
For
dividend investors, dividend will continue to play an important role in
determining long term return. The keyword is ‘long-term’. If you
remember the bathtub system, it is worth the time to pay more attention
and ask “How sustainable is the ROC in the long run?” rather than “What
is the current dividend yield?” because when the ROC gets eroded by
competitions, dividend will soon follow.
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