At Urbem, we have observed the increasing popularity of high-yield stocks and so-called "income" funds among investors, particularly among the retail sector. For various reasons, it is our belief that these yield chasers, who focus only on dividends and stock price appreciation, are missing the whole point of investing in stocks.
Unique advantage of stocks
Unlike other asset classes, stocks can compound in value "internally." To achieve this, companies retain a portion of profits to reinvest in the business at a reasonable rate of return, assuming that such a secular growth opportunity (e.g. regional expansion, new products, etc.) exists. By contrast, bonds and real estate lack such a feature of automatically retaining their coupon payments or rental income for capital deployment to drive up future income.
To illustrate the compounding effect, let's say you own shares of the S&P 500 Index fund (SPY), where the 500 businesses, on average, can earn a mediocre return on equity of 10% and retain (reinvest) 50% of their annual earnings. Then the retained 50 cents from the one dollar of this year's profit would become 55 cents, or one dollar and five cents in total earnings - a 5% increase, which is not thrilling but also no too shabby.
However, what if you own a company with a superior 20% return on equity, protection through a competitive moat and attractive reinvestment opportunities so that it can consistently deliver superior returns for the foreseeable future? You would want to pray for zero dividend payout so that the business can retain all its earnings to compound its growth of shareholder value going forward. This resonates with Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (BRK.A) (BRK.B), which has not paid a dividend for the past half-century for this very reason.
Disadvantage of dividend reinvestment
By this point in the article, you are probably wondering about the question of dividend reinvestment. It is important to note that there is always a cost to such reinvestment; dividends reinvested pay the market value of the share, while retained earnings get reinvested at the book value. According to Morningstar, investors currently pay $3.20 for one dollar of the book value of the S&P 500 Index. This represents a vast premium, even without considering the cost of income tax upon the distribution of dividends.
Most high-quality businesses cost far more than 3.2 times book value, including Monster Beverage (MNST) at 8.4 times, Intuitive Surgical (ISRG) at 8.8 times and even Lululemon (LULU) at 18.2 times. Shareholders of these companies should be more than happy not to receive any income from the stock, as the fully-retained earnings attributable to them are being put into good use and generate high returns at a much lower cost vs. dividend reinvestment.
We believe that equity investors should seek to maximize their total return instead of chasing dividend income. Meanwhile, in the case of unmet spending/liquidity needs, one can redeem share capital (who said that income has to come from dividends?).
Of course, some readers may argue that identifying high-return reinvestment opportunities also involves risks. Rather than chasing the highest yield, we recommend becoming a passive investor and buying the whole index, which is more promising than a basket of high-yield stocks (refer to the consistent underperformance of the MSCI World High Dividend Yield Index over the last decade versus the S&P 500).
Disclosure: The mention of any stock in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Berkshire Hathaway, Monster Beverage, and Intuitive Surgical.
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Read more here:
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This article first appeared on GuruFocus.