Thursday, February 18, 2016

Business Change is bad for dividend investors

Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago… a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.”  

-Warren Buffett, 1992 Shareholder Letter

Recently, I have been fascinated by the concept of intergenerational wealth. That is, wealth in the form of productive assets that is passed along from a generation to generation for at least say 100 years. Thinking of myself, it would have been nice if I didn’t have to start from scratch to build my nest egg, but be born with a trust fund. Since I cannot count on much of an inheritance, I am in the process of building my own dividend trust fund, and live off those dividends for decades (hopefully). In the process of my research on families and entities that have lived off assets for decades however, I uncovered a few interesting observations.

1) Productive assets generate income to live off, which means you spend the income and keep the asset that produces more income for you again. This includes stocks, bonds, real estate, business interests etc.

2) You want to train the next generation to be astute businesspeople, but also try to place the assets in protective trusts, just in case. This is done in an effort to reduce death taxes, and ensure that money is not squandered by some offspring with questionable habits.

3) You want to invest in productive assets where change occurs slowly. This means that obsolescence or changes in consumer tastes are very slow, which makes it easy to maintain an entrenched dominant position in an industry.

I think that this is the most important observation, that is relevant to dividend investors - you want to invest in companies offering a product or service that doesn’t change much overall at its core. If that product or service covers a basic need, and is easily distinguishable from that of competitors, you have the competitive advantages to maintain that business essentially forever. In addition, that product or service does not change, meaning that demand is not going to fall off over time but is fairly constant. Those consistent revenues and earnings tend to quietly compound over time, making reliable dividend payments to trust fund shareholders very easy. Let that sink in: Those stable companies have managed to send dividends for generations to families and charities that controlled the ownership interests for decades. Companies with recurring revenue streams, selling everyday essentials can do really well over time. What I got from this for my own situation is that no matter who gets my money after I am gone ( family or charity or a mixture of both), I need to invest in companies offering a product or service that won’t change much over time, which is somewhat unique however, which has lasting power, and which is in an industry that my investment can continue to dominate for a few more decades. It would be nice to collect a stream of dividend payments on the work that your ancestors did decades ago. This is why passive dividend investing is so appealing to me.

Some notable charitable trust funds, which have benefitted from decades of dividend include those with Hershey (HSY) and Kellogg's (K).

Approximately one-third of Hershey (HSY) shares are held by the Milton Hershey School Trust, which has 80% of the voting power. The trust needs income every year that grows above the rate of inflation, which is a sufficient incentive for the company to keep growing the dividend over time. This is a powerful testament to the power of dividend growth over time, which makes it really easy for anyone to live off of for many decades. The trust holds 12,703,921 ordinary shares of Hershey. This foundation also holds 60,612,012 Hershey Class B shares that have have a preferential voting power to ordinary shares you or I could purchase - however they earn a dividend which is lower than the dividend on regular shares. Currently, the regular dividend is 58.30 cents/share and 53 cents/share for the B shares. It earns over $158 million in annual dividend income.

The Kellogg WK Foundation Trust owns approximately 20% of shares outstanding. This is a great example of a trust fund, which has been “living off dividends” for several decades. In fact, the trust is projected to earn over $140 million in annual dividend income from their ownership of 70 million Kellogg shares.

Below are a few examples I found, after looking at fortunes of richest US families. It is interesting to note how the generations after the original founder keep earning millions in dividends from the companies started decades ago. The common denominator behind each of those families is that the money is coming from an industry that derive a product or service that hasn't changed much over time, and where the company in question has strong brand name and strong competitive advantages.

Mars Family - Forbes Overview
Brown Forman (BF.A) and (BF.B) - Forbes Overview on Brown Family 
SC Johnson Family - Forbes Overview on SC Johnson Family
Rollins Family - Rollins (ROL) - Forbes Overview on SC Johnson Family
Dorrance Family – Campbell Soup (CPB) - Forbes Overview on the Dorrance Family
Johnson Family – Johnson & Johnson (JNJ) - Forbes Overview on the Johnson Family

You also have Media families like Hearst and Cox as well. Newspapers and magazines used to be the type of product with strong competitive positions, strong brands, pricing power and low change. However, we live in an information revolution which is shifting things around. Some have adapted to new technologies, while others have not.

All of those fortunes were built slowly, which is what you and I are probably facing. These are all established companies where the business sells a product or service that has withstood the test of time. Chances are that you will not inherit a fortune, that is passed down from your parents or grandparents. However, you can potentially identify and profit from such businesses, if purchased at a good entry price. For us ordinary investors, once a great business is identified, and purchased at an attractive price, the goal is to sit patiently on it. Dividends will be either reinvested into more income producing investments, or spent if one is in the distribution phase of their live. The importance of thinking long-term cannot be overemphasized. If you are able to patiently sit on an investment for 20 – 30 years, which is paying you rising dividends every year in the process, you will likely do well no matter what the economy, unemployment, taxes, politics will be.

Full Disclosure: Long HSY, K, JNJ, BF.B

Relevant Articles:

Living off dividends in retirement
Four Percent Rule for Dividend Investing in Retirement
Multi-Generational Dividend investing
How to invest like a Dividend Billionaire

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