Wednesday, December 10, 2014

The Pareto Principle in dividend investing

The Pareto Principle is an economic term invented by an Italian economist Vilfredo Pareto in the 20th century. It is also called the 80-20 principle, meaning that 80% of effects come from 20% of the causes. Vilfredo observed that 80% of the land in Italy is owned by 20% of the people. The ideas behind this principle are wide ranging in multiple fields, including investing. I am a firm believer that a small minority of the investments I make today will end up becoming so successful, that they will produce 80% of my investment gains over the next 40 - 50 years. This is why I am really careful about selling, even if a stock I own is up by 1,000%.

For example, in the book “The Tao of Warren Buffet “ written by Mary Buffett, I read that 90% of Warren Buffett’s returns came from just 10 stocks. I did some research, but unfortunately I was unable to find any detailed data behind this exercise.

For purposes of simplicity, Berkshire Hathaway (BRK.A) has accounted for over 99% of Buffett’s wealth. Before 1970, the Buffett Partnership accounted for majority of his wealth. This statement  is overly simplistic, as Buffeet had to make hundreds if not thousands of stock and business decisions, that compounded partners and shareholders net worths for decades. But the quote from above, discussed the investments that made Berkshire Hathaway what it is today.


Buffett has consistently delivered outstanding results from the mid 1950s, whether for Buffett Partners or Berkshire Hathaway shareholders. So while Coca-Cola (KO) has delivered over $15 billion in capital gains and dividends, this should not be viewed in isolation. In order to come up with the $1.3 billion to purchase Coca-Cola between 1988 & 1994, Buffett had to spend a lifetime making money in a lot of stocks and businesses. His first investments in Sanborn Maps and Demster Manufacturing netted him a few million in the 1960s. His concentrated investment in American Express (AXP) in the early 1960s resulted in some great returns within a few short years. But these and other investments helped him make the sufficient amounts of cash to buy Berkshire Hathaway as well in the early to late 1960s. The business problems at Berkshire made him buy insurance companies such as National Idemnity, which provided him with tens of millions to be invested in the likes of Washington Post (WPO) and See’s Candies. So the point is that his investment results followed a natural progression of things.

If you looked at his Buffet Partners Limited partnership, chances are that the largest contributors to performance could have been Sanborn Maps, Dempster, American Express and Berkshire, in addition to the 300 – 400 special situations he uncovered and made money on during the 13 years he did the partnership. The profits from each and every one of those investments were used to invest in the next big wave of investments.

If you looked at Berkshire’s operations prior to the 1990s, the largest additions were Insurance Operations, Cap Cities, Washington Post, Buffallo News and See’s Candies. The profits from each and every one of those investments were used to invest in the next big wave of investments.

In the 1990s, insurance operations, Coca-Cola, Gillette, American Express have contributed mostly to performance. But because each of these investments has been possible, because of the wit, wisdom and capital, accumulated from the previous cohort of hundreds of investments from the preceding 30 – 40 years. In addition, his knowledge helped focus much more on acquiring whole businesses, rather than partial ownership interests.

In his speeches, Buffett talks how people should be investing as if they could only make 20 investments in their lifetimes. The reality is that he has done a whole variety of things, including purchasing cigar butts, participating in arbitrage situations, actively buying and selling stocks, derivatives, as well as acquisitions of businesses. He has been able to evolve as an investor over time, and select the best opportunities at the time, while also having adequate margin of safety. For ordinary investors like you and me however, his advise on selecting investments as if we have a limited number of slots in our lifetime is relevant.

I believe that in a typical investors career, out of the 50 – 80 investments one does make, probably less than 20 or so would end up accounting for the majority of investment gains. Even if you purchased stakes in 100 dividend paying stocks today, chances are that less than one quarter of those would account for majority of the gains in 30 – 40 years. This is because things change, companies merge, get acquired, go bankrupt and only a few prosper. But those who stay riding a big trend and manage to expand their operations by steady reinvestment into the business, could deliver outstanding returns to their shareholders, which could lift up total portfolio returns substantially. If you look at the original dividend aristocrats from 1989, you can see that those companies that at least maintained dividends did much better as a whole relative to those who cut dividends. The companies that kept raising dividends throughout the period, provided exceptional returns. If an investor had sold those companies, their returns would have been substantially reduced. It would have been difficult to forecast in 1989 which company would remain an aristocrat, and which would drop off the list.

The important thing is to be able to focus and uncover quality dividend paying businesses with staying power. Those companies with staying power should have an above average chance of continuing to earn more and pay more for the next 20 - 30 years. Purchasing those great businesses at attractive prices is as important as identifying them in the first place. Overpaying for them is a bad idea. The reality is that an investor does not to be right all the time to make money in dividend investing.

A few investments you make will do the heavy lifting for the whole portfolio for 20 - 30 years, while others will be average, and a few will fail outright. The nice thing about dividend stock investments is that the downside is zero, while the upside is unlimited. This is why it is also very important to hold on to the companies in a portfolio for as long as possible. In my case, I have learned that it is best to simply hold on to companies once I have acquired them, and ignore any short term noise. The main reason why I would consider selling is either after a dividend cut or extreme overvaluation such as a stock selling for 30 - 40 times earnings. Actually, the downside is less than zero, because a company that fails can end up providing a stream of dividends for several years, which could end up exceeding the price paid for the business in the first place, thus acting as a rebate on the purchase price of the stock. This is why diversification also helps, in case the investor made a poor choice or things change for the worse.

It is also interesting to think about the returns of Ben Graham, who is the father of value investing, and who ran his Graham-Newman partnership between 1936 - 1956. Incidentally, his largest gains came from GEICO, which he simply bought and held on for decades. Actually, the amount of profits from GEICO exceeded profits made from his active value investing. The reason I am using this example is that despite all our analytic models for identifying promising investments, a large part of the outcome could be the result of luck. Therefore, a dividend investor should be very patient with a company, and patiently hold it for decades. My study of a few spin-offs from a few weeks ago also showed me that long-term returns could materialize after years of holding on to a good investment that noone appreciates.

After thinking about the Paretto Principle for my dividend investing I think twice before selling a company, even if it is temporary overvalued, freezes dividends, or if there are other comparatively cheaper securities available. Since noone can predict the future accurately, I believe that simply staying the course is the way to go, rather than jump in and out of companies like a trader, and making my broker and Uncle Sam rich with my hard earned money.

Full Disclosure: Long KO, BRK.B,

Relevant Articles:

Warren Buffett Investing Resource Page
Should Dividend Investors own Non-Dividend Paying Stocks?
Dividend Investing Is Not As Risky As It Is Portrayed
Dividends Offer an Instant Rebate on Your Purchase Price.
Should you sell after yield drops below minimum yield requirement?

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