Monday, November 17, 2014

Should Dividend Investors own Non-Dividend Paying Stocks?

Dividend growth investing is the strategy I have been using for several years in order to reach my retirement goals. In order to be successful with a strategy and stick to it through thick and thin, investors need to understand its positives and limitations. One of the disadvantages of investing purely for dividends is missing out on spectacular price gains of hot new technology stocks. On the other hand, everyone can pick the best hot stock only after the fact. Most investors who look for the best growth stock are very often very wrong at the end. This is why I stick to the tried and true dividend champions and dividend achievers.

Apple (AAPL) is one of the best performing stocks over the past decade. The stock rose from a low of about $4/share in November 2004 to a high of about $100/share in 2012. If you look at any of the top performing stocks from ten years ago, one could notice that few of them even paid dividends, let alone maintained a streak of dividend increases. Opponents of dividend investing often use this fact as an argument against the merits of dividend investing. While as a dividend investor I am going to miss out on the next Apple, I also know that I am going to miss out on the next technology bubble, the next MCI Worldcom or the next company that will try to be the next Apple (or Google, Microsoft etc) but fail in the process. Most companies that are touted to be the "next something" end up failing, losing money for their investors and their worthless shares get delisted. Since those losers are not in the plain sight of ordinary investors, the lessons from their failures are soon forgotten by investors.

The world of technology changes very fast, which is why it is so difficult to maintain an economic moat that lasts for several decades. The companies that try to become the “next” Google, Apple or Microsoft often end up being nothing more than pipe dreams, which end up costing investors many dollars. In addition, the chances of selecting the best growth company over the next five years are really slim, unless you are a seasoned and well-connected Silicon Valley venture capitalist.

Looking at the best performing stocks over the past decade and then invalidating dividend investment altogether is not a very smart way of looking into things. This is because one is not comparing apples to apples. If instead we compared the results of dividend paying stocks to the results of non-dividend paying stocks, we could notice a stark contrast. Over the past years, dividend stock have consistently outperformed non dividend paying stocks.

The reasons behind this out-performance are somewhat counter-intuitive:

1) Dividend paying stocks are typically mature companies, which generate excess cash flows that they do not know what to do with. As a result, these companies return this excess cashflows to shareholders in the form of dividends. Some, like Procter & Gamble or Coca-Cola have increased dividends for over 50 years in a row each.

2) The boards of these dividend paying companies realize that companies cannot reinvest new money at the same rates of return. Investing new funds is important to maintain and grow the business, but unfortunately there are physical limitations to expanding business indefinitely and forever. Due to laws of diminishing returns, once you add in an extra dollar of investment that does not result in much profit, you should be better off doing something else with the money. In other words, if you are Starbucks (SBUX) and you already have four coffeehouses on a busy intersection, chances are the adding a fifth one is not going to result in a 20 – 25% automatic increase in total sales.

3) Because dividend companies are mature enterprises, their growth prospects are not going to be very high. As a result, these stocks are often trading at low price-earnings multiples. This allows investors to purchase these quality companies at a discount, and thus enjoy better compounding of capital. The companies which have very high earnings growth projections often sell at a premium price, which has high earnings growth already baked in to the stock price. The reason why Altria (MO) (which was called Phillip Morris back then) was the best performing stock between 1957 - 2003, was because it grew earnings and dividends while shares were always cheap, and thus shareholders were able to consistently reinvest dividends at low valuations. This turbocharges dividend income and capital growth.

4) While the growth prospects for mature dividend paying stocks are not as high as the prospects for a hot new IPO, they are more dependable. Many of these mature companies tend to deliver a small but consistent growth, which makes them clear winners over time. Many of these stodgy dividend champions tend to sell a similar type of a branded product or service that your parents or grandparents have used and which you and your children would likely use for decades to come. The consistent growth translates into consistent profitability, which coupled with the relative undervaluation when compared to the stock market makes investment a very good idea.

5) The dividends that these companies pay to shareholders represent a return on investment which is always positive. A company can see its stock price rise quickly to new highs or fall precipitously to all-time-lows, leaving investors with rapidly fluctuating capital gains or losses. At the same time however, income investors receiving a dividend would be essentially paid to hold on to the stock of their choice, and would be less likely to panic and sell at the worst time possible. The dividend payment, if sustainable, would thus be a factor that could keep the stock price from losing too much, since value oriented investors would step up and provide support behind the stock by purchasing it at attractive valuations.

6) The dividend payment provides a regular stream of income, which investors could use to either spend or invest in stocks that fit their entry criteria. Dividend reinvestment allows investors to compound their capital over time, through the systematic accumulation of undervalued assets over time using dividend income. This strategy has helped famous value investor Warren Buffett to accumulate a fortune worth over $60 billion. By focusing Berkshire Hathaway’s capital on income producing investments, and then reinvesting excess capital into other income producing assets, Buffett has transformed the sleepy textile company into a diversified conglomerate with a market capitalization of over $200 billion.

The article discusses dividend paying stocks and non-dividend paying stocks in general. While there could be dividend paying stocks which have failed, as well as non-dividend paying stocks which have been wildly successful, this does not change the overall conclusion that dividend paying stocks have historically done better than non-paying ones. The probability that your average blue chip dividend stock provides better returns is much higher than the probability of good returns by your average non-dividend paying stock. In order to further increase your chances of achieving your goals, one also needs to further screen out investments and evaluate the final list of candidates for inclusion one by one.

Full Disclosure: Long KO, PG, MO, PM,

Relevant Articles:

Another reason for companies to pay dividends
Why Dividend Growth Stocks Rock?
What is Dividend Growth Investing?
Should dividend investors hold non-dividend paying stocks?
The predictive value of rising dividends

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