Show me the money (dividends)

‘Show me the money!’

Yes, most of us would know that line from the Tom Cruise movie.

When it comes to investing we think dividends are the equivalent of ‘showing us the money’.

Those doing our coaching programs know that we are devotees of what we call the risk hierarchy.

In short we normally prefer to buy market indexes from both developed and developing markets, from sectors (such as e.g. energy, or consumer discretionary), or regions, such as emerging markets.

We don’t have an aversion to buying individual stocks, but we believe that for most investors using the risk hierarchy (as one of our 8 timeless principles) is a prudent way to manage risk.

Now we also know that some folks just can’t resist a bit of a dabble in individual companies. 

We get that!

It’s clearly not going to be that cool when you hit the dinner party and say, ‘I just bought Russia!’.

We know that’s not exactly a great opening line to a conversation and, yes, it’s usually better to say that you’ve just bought Woolies or BHP…or indeed any other big-name company.

Now if you look at the following diagram it shows a distribution of returns from US companies.

That long column way out there on the right represents the big winners of the market such as the Apples, Amazons etc.

Unfortunately, by definition most of us end up with companies that are nowhere near as successful as Apple or Amazon. 

For our Australian readers here’s some information about the success or otherwise of Australian publicly listed companies.

I don’t think you need us to tell you that a large portion fail over time (around 70%).

Many others don’t fail outright, but lose 75% or more of their value (meaning you’d subsequently need to hope for a 400% return to be ‘made whole’).

Roughly 60% of companies never beat the index.

And finally there’s a small batch of winners – approximately 20% of the total – which succeed and pay dividends. 

To summarise, then, for the would-be stock pickers out there:

Still not convinced?

We also notice that many folks (and much of the finance industry) spend an inordinate amount of time talking about and searching for the next Amazon or Google or Apple.

Of course the trick is to buy them when they small or micro cap stocks with prices under a dollar.

However the big problem here is that you must pick be able to pick them early!

Pick one of these babies early in the piece and it’s easy street. Cool! 

You often see this type of line:

‘If only you’d invested $10,000 in Berkshire Hathaway/Apple/Amazon back then you’d be a billionaire today!’

This may well be true!

Alas, firstly $10,000 ‘back then’ may well be the equivalent of a huge sum today, so you’d have had to be wealthy to slip a lazy $10,000 of spare cash into Apple or Berkshire.

Secondly, you must’ve been able to hold through Amazon’s 95% decline (no, that’s not a typo) in the dotcom crash.

Or when Apple nearly went bust, but thanks to Bill Gates stayed alive.

Or held any of them through the subprime crash or the 2000 dotcom crash where the overall market fell 50% or the tech-heavy NASDAQ fell approximately 80%. 

OK, but still…

Let’s say you are 30 years of age and you’re still keen to invest in individual companies for the next 30 years.

Let’s also assume you pick 5 to 10 companies each year and hold that as a portfolio (the reality is that most folks and fund managers have more than 10 companies in their portfolio).

Now that may mean picking as many as 200-300 stocks over your 30-year horizon.

In order to be successful, you’ll first need to pick more than 50% as winners, and then have these 50% outperform so well that they cover for your inevitable losers.

If you glance again at the capitalist distribution diagram above you should be starting to think that picking stocks might prove to be a mug’s game… 

The dividend component of returns

Right, I get it, but I still want to pick individual company stocks.

OK, so let’s see what has worked for us most of the time. 

We prefer to invest in large, long-established, profitable, and systemic companies that pay dividends.

Why?

Because they’re a far more reliable source of income, and they’re much easier to select than trying to pick the next 100-bagger.

And dividends are a very important component of overall returns.

Market prices of individual stocks fluctuate with the short-term rises and falls of the market, but the dividends in the long run may become the bulk of your returns.

The reinvestment of dividends (or good, solid compounding) is often neglected because investors focus on trying to buy growth companies (a subject for a later post) for the short term, rather than focusing on sustainable long-term results.

Notice how many pundits talk about the price of stocks or the market rather than the earnings yield or dividend yield. 

Studies show that dividends are a very valuable source of returns for investors (and largely account for the fact that overall returns are strong).

Capturing these returns will most likely come from investing in reliable dividend payers, being incumbents that have established themselves in their market or sector, and thus have a strong level of security and continuity.  

Therefore if you want to start investing in companies when markets are low, look for the large, mature, dividend payers, with a stable market share and not too much debt.

As a rule, you will do better with these types of stocks over time than with trying to pick the next Apple. 

Finally, check out some simple strategies such as the ‘Dogs of the Dow’ concept.

No, these don’t outperform every year, and even Buffett doesn’t beat the market every year.

But having a systematic approach (one of our 8 timeless principles) will increase your probability of investing success.   

Remember, show me the money dividends!

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To find out more about our coaching programs see here.