This is a guest contribution written by Ben Reynolds at Sure Dividend. Sure Dividend uses The 8 Rules of Dividend Investing to build high quality dividend growth portfolios.
The financial community likes to segregate investments into different styles.
You have ‘value’ investments, ‘growth’ investments, ‘income or high yield’ investments, etcetera.
In my view, this is much ado about nothing. It is true that different investors have different needs. An investor in their early 20’s isn’t going to need the same level of current income as a retired 70 year old investor.
At the end of the day, all investors are looking for the same thing: The maximum amount of total return for a given level of risk and income.
Whether that return comes from the price-to-earnings ratio rising from 10 to 20 or from the company growing its earnings-per-share by 100% shouldn’t matter.
This article gives an overview of value, growth, and dividend investing and shows how they culminate in dividend growth investing.
Value investing traces its roots back to Benjamin Graham. Graham is often called the ‘father of value investing’.
Graham’s approach was to look for ‘cigar butt stocks’ – stocks that had been discarded by the investing community but still had one ‘puff’ of value left in them.
An example would be a company whose assets less liabilities were worth more than its stock price. Graham devised a number of more in-depth strategies beyond the scope of this article, but the basic idea is to spend less than $1.00 on $1.00 worth of value.
So if a stock was trading for $10.00 per share, but had a value of $15.00 per share, it would be a good value. The quote below is from Benjamin Graham’s mentee, Warren Buffett:
“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
Finding the true value – the ‘intrinsic value’ of a business is imprecise. You can never say exactly what the fair value of a business is, but you can come up with a reasonable estimate.
Some things are easy to quantify. A stock trading for less than its liquidation value is almost certainly undervalued.
Other items are more difficult to quantify. What is the value of the Coca-Cola (KO) brand, for instance? It’s a lot, but how much?
What is the value of quality? A company with a strong competitive advantage should trade at a premium to a marginal commoditized business, but how much?
The appeal to value investing is how tidy it looks – everything has a number. The downside is that just because something is given a number, it doesn’t mean it’s accurate.
Finding the intrinsic value of businesses worth significantly more than liquidation value is difficult and imprecise.
Next, we will cover growth investing.
The core idea behind growth investing is to invest in businesses that are likely to exhibit rapid growth.
It follows the idea that fast growing businesses will create tremendous wealth for investors. A growth portfolio will likely include names such as:
- Facebook (FB)
- Amazon (AMZN)
- Google (GOOG)
These are businesses that are likely to exhibit growth significantly in excess of the market. On the surface, growth investing is very logical. Businesses that grow faster will provide better returns.
The first downside to growth investing is that growth is not attractive at any price. The second downside to growth is that rapid growth is typically fleeting.
Rapidly growing stocks are typically found in relatively young industries. If the business model is replicable, competition will erode growth.
If the business model is not replicable due to a strong and durable competitive advantage (think Google, Facebook, and Amazon), rapid growth becomes its own downfall. At some point, Amazon’s growth will slow simply because it get so large.
No business can grow at 30% a year forever – otherwise it would consume the entire global economy. Wal-Mart (WMT) is an excellent example of a business which historically grew at a tremendous speed, but saw growth slow as it saturated its core market in the United States.
Markets are fairly efficient. You are not the only investor that knows Amazon is growing quickly. Because of this, it’s valuation is bid up – discounting future growth. This makes investors pay an ever higher premium for growth, which ends up drastically reducing total returns even if the business does exhibit rapid growth over long periods of time.
The traditional dividend investor is focused on income. Dividend investors are typically people in need of current income, or people who really enjoy seeing their investments pay them actual cash.
“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”
– John D. Rockefeller
But focusing exclusively on current income is not a terribly good idea. The higher a company’s payout ratio, the less money the company has to reinvest into future growth.
All other things being equal (and they are most certainly not in the real world), the higher a company’s payout ratio, the lower its growth rate will be due to having less money to reinvest in the business.
On top of that, dividends are usually not the most tax efficient form of returning capital to shareholders. That’s because dividends are taxed when paid (depending on your taxation status). Share buybacks are not. Dividend taxes make share repurchases a more tax efficient way to return capital to shareholders
Note: Share repurchases done when a stock is overvalued destroy shareholder value and are much less efficient than dividends.
A high payout ratio makes a dividend cut more likely in the future. Too many individual investors fall into the trap of investing in very high yielding securities for current income – only to see that income fall as the company reduces (or even eliminates) its dividend.
As with growth investing, markets are fairly efficient. Other investors look for yield and will bid up the price on safe, high yielding securities. This brings down their yield.
Dividend Growth Investing for the Long-Run
What would happen if you combined value, growth, and dividend investing? I believe dividend growth investing is the culmination of these 3 separate investing styles.
Dividend growth investors look for yield (as the name suggests). All things being equal, a dividend growth investor prefers higher yields to lower yields. In this way a dividend growth investor is similar to a traditional dividend investor.
Dividend growth investors look for growth (again, as the name suggests). That’s because dividend growth investors want growing dividends through time. Having an above-average yield today is not enough. The dividend needs to grow through time to counteract inflation (and hopefully grow far faster than just inflation).
Dividend growth investors indirectly care about value. For one, lower valuation implies higher dividend yields. A typical dividend growth investor will look for a combination of a high yield (for current income) and a low payout ratio (for dividend safety in case earnings drop temporarily). Interestingly, the payout ratio divided by the dividend yield equals the price-to-earnings ratio. High yield, low payout ratio stocks are by definition low price-to-earnings ratio stocks. Depressed valuations are appealing to dividend growth investors.
The downside to dividend growth investing is that it never hits the extremes of the 3 methods outlined above. A typical ‘good’ dividend growth investment will:
- Have an above average dividend yield, but not an extremely high yield
- Have a lower than average price-to-earnings ratio, but not extremely so
- Have average or better than average expected growth, but not massive growth
The strategy looks to be ‘good’ in the factors that matter, not amazing in one factor at the exclusion of other factors.
Want to learn more about dividend growth investing? Don’t miss these dividend growth investing concepts on Passive Income Earner. Here’s a how-to guide to building your dividend growth portfolio as well.
Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
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