Wednesday, February 26, 2014

Do not focus only on income for retirement planning

Over the past 85 years US stocks have delivered a total return of 9% - 10%/year. Dividends have contributed approximately 35% - 40% of average annual returns per year during the period. The remainder has come from capital gains. As dividend stocks are equities after all, investors who focus only on the dividend might be missing out on total returns over time. In my investing I focus on companies that have a balance between dividend payments and growing the business. I prefer when the companies I own reinvest a portion of profits in the business in order to maintain and expand the enterprise. This hopefully leads to higher earnings per share over time, which provides the cash to pay higher dividends. The combination of higher earnings per share and dividends leads to higher share prices over time. This is of course an overgeneralization, but in most of the situations companies that exhibit these traits and manage to effectively deploy earnings per share into more earnings per share growth which will increase shareholders’ wealth over time.

Investors should also mostly ignore companies that pay high dividends and do so because of an asset depletion strategy. Certain trusts in the US, like oil and gas pay high distributions, but a large portion of these distributions is a return of capital. Your claim to the company’s assets decreases with each dividend check. To maintain level of dividend income, one needs to reinvest a portion of distributions. If you have to reinvest 62.50% of distributions from a company yielding 8% simply to maintain the stability of dividend income, you might be better off in a 3% dividend achiever or a dividend champion. The dividend achiever might not pay a high yield today, but future distributions would more than likely rise above the rate of inflation. With oil and gas royalty trusts, the distributions are expected to decrease over time, until the wells run dry. Thus, the high yield stock of today has a double whammy, as it will provide a decreasing stream of income that losses purchasing power every year and would likely lead to a stock price that is close to zero eventually.

Other investors tend to focus on option strategies such as covered calls in order to augment their returns. Unfortunately the generous premiums come from the fact that these strategies and the funds that employ them tend to limit their upside. Unfortunately there is no free lunch on Wall Street.

The types of companies I focus on include those with proven track records of growing distributions which also have the capability to grow earnings over time. For example, a few companies such as Coca-Cola (KO), McDonald’s (MCD) and Chevron (CVX) come to mind as great examples of companies to hold for the long-term.

With the rise in the middle-class population in the world over the next few decades, I expect that more people will drink Coke products. For example, consumers in China only have approximately 38 servings of Coca-Cola products per year, whereas the typical US consumer has approximately 400 annually. Check my analysis of Coca-Cola for more information about the company.

I also expect the rising middle-class consumer to be as time-starved as their developed country peers. Therefore, I would not be surprised if the convenience of fast-food companies such as McDonald’s (MCD) becomes a daily treat for these consumers. Check my analysis of McDonald's for more information about the company.

The rise in the middle class will also increase demand for natural resources such as oil and gas, as more people would need to drive to their places of work on congested highways. With improvement of technologies, companies like Chevron (CVX) would be able to recover a higher percentage of carbons from their wells. In addition, they would be able to leverage new technologies in order to increase success rate in their exploration wells, even if these projects take place in inhospitable environments such as the deep seas or arctic circles. Check my analysis of Chevron for more information about the company.

Full Disclosure: Long KO, MCD, CVX

Relevant Articles:

The number one reason why i don't chase high-yield stocks
Dividend Investors – Do not forget about capital gains
Dividend Champions - The Best List for Dividend Investors
Dividend income is more stable than capital gains
Dividend Growth Investing is a Perfect Strategy for Young Investors

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