Why Investing Solely For “Income” Is A Mistake

I don’t think you should ever invest for income. It is a mistake…….. You shouldn’t just invest for dividends, you should invest in businesses that reinvest their profits to achieve a future growth rate…..However, I realise that for many investors, the idea of realising part of their capital to provide income is anathema.

– Terry Smith, CIO of Fundsmith.

I’m a proponent of total return investing, not “income” investing. Dividend paying stocks can serve as a useful heuristic of where to look for good companies, but nothing more. The goal shouldn’t be to grow “income”. To invest solely for “income” you have to consider this:

  1. A dividend is not an income. It’s a capital distribution from the company to the owners, from one pocket to the other (less taxes).
  2. You need to spend time to reinvest (if you don’t consume or spend the dividend).
  3. You reinvest at multiples to book while being paid from book value. Thus, marginal rate of return diminishes. Over many decades it’s the earnings/reinvestment that is the main contributor to wealth. You better understand how to reinvest within a proper framework.
  4. A company that can retain and redeploy earnings are far more preferable than being paid a dividend and subsequently reinvest at multiples to book.
  5. You can always sell shares to create “income”.

Please read my previous articles about dividend investing:

Stocks are unique because you can reinvest internally:

The unique feature of stocks is that they allow you to reinvest the earnings internally, ie, redeploy it back into the business without distributing it. To keep all or a great majority of the earnings for redeployment, is a feature no other assets have. This allows for growth. Real estate, for example, don’t offer this opportunity. You receive taxable rental income but none of it will be reinvested until you have enough for next purchase.

As mentioned, over the long-term the wealth comes from the reinvestments, not the initial capital. The compound interest works like magic for the ones who are patient! Unfortunately, this advantage is understood by very few investors.

I believe the payout ratio is around 50% among the S&P 500 companies. Assuming the average S&P 500 company earns 12% on the equity, 50% of the earnings are redeployed back into the business at that rate (or close). If you reinvest the dividend at today’s P/B of 3 you reinvest at 4% (you pay three times book value for the same equity). The higher the payout ratio, the more difficult it is to compound. Furthermore, because S&P 500 trades at 3x times book value, every retained dollar translates into a valuation of 3x.

Many investors refrained from investing in Berkshire Hathaway because it didn’t/doesn’t pay a dividend. But Berkshire Hathaway has been a great investment exactly because it didn’t pay a dividend but managed to redeploy earnings at high incremental returns. A very simple principle, yet many ignore it.

Being paid a dividend gives a feeling of receiving something for “nothing”. But a dividend always has an alternative use!

Lesson learned:

To achieve above average return it pays to look for companies that have high returns on capital but additionally are able to redeploy most of the earnings. You can pay high multiples today and still beat the market handsomely over 10-20 years, as I have explained in this article.

 

(This article was published 27th of July 2020.)

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