Thursday, August 20, 2009

Investing for Capital Appreciation or Dividend Income?

I am very sure that every dividend investors would have received this question. While dividend investors can ignore responding to folks with trading philosophy, sometimes it does become difficult to argue with value investors. Value investors who in general are looking to invest below book value sometime have an argument that focusing on dividend is not that critical. Business should be applauded for reinvesting profits back into business to grow. In essence, either create additional value or continuously increase value for their shareholder. That is a good argument. However, the key here is “creating value for the shareholders”.

Each individual will look at this differently. For me, “creating value for shareholder” is how much I am getting back in return. In simplistic terms, what is in there for me? From purely business standpoint, typically, value creation means increasing value of its business (and hence increasing stock value). Managements use combination of funding sources (debt, equity, leverage, etc.) to continuously increase the value of its business.

Let us consider that an individual is interested in harvesting profits based on buying undervalued stocks and cashing out after it is has reached its value. In this context, focusing solely on capital appreciation makes sense. Dividends can be considered as misnomer. Here the investor wants to focus on value itself, and given an opportunity, he/she will cash out that value. The objective is not to stick with the business or company. In this case, the buy-and-hold is based on certain criteria (i.e. value)

In my investment approach of buy-and-hold, I am also looking for management to continuously increase the value of its business (and hence my stocks value). I do not plan to cash out my profits (if any). In that context, I only have paper value creation. Unless I cash out, that increased value has no meaning for me. Who knows some nutjob manager will screw things and value is vanished. While I am waiting and continue to trust management, I need management to share some profits with me. That’s rational argument and prudent money management which shows to me company cares for its shareholders. I don’t want 100% profits. I want management to give back 25%-30% of profits as dividends.

Furthermore, if management is confident and company pays increasing dividends, it will be because of increased earnings (and hence P/E ratio). Indirectly, my stocks price valuation will also increase.

Let us take an example:
I start a corner store. I am owner (or shareholder). I want to grow my business. I agree for first few years (say three years) I need to put every penny back into growth. But after three years, I still want to continuously grow it. And I also want to make a decent above average living. It cannot be a one way street forever. I would take some percentage (say 20-30% profits) and remaining plow back into business. That’s what I call prudent management. I am getting something back to wait and continue to do my business.

Other options could be I keep plowing back for few years, say 5 or 6 years, and then sell it completely at higher value. Here my focus would be solely to go after increased value and cash out. I am not worried about whether my business stays to goes.

To summarize…
There has to be balance based on individual’s buy and hold objectives.

  • Going after buy and hold approach solely for capital appreciation is a high risk strategy, even when buying at deep value. My view is, until you exit, this value creation has no meaning. And hence, one needs dividends to keep the total returns increasing year after year.
  • Individuals wanting to use value investing for capital appreciation alone should always have an exit strategy (it cannot be buy and hold on continued basis). This paper value can vanish at any point in time.

This article was written by Dividend Tree. If you enjoyed this article, please vote for it by clicking the Buzz Up! button below.

1 comment:

  1. It doesn't matter what style of investor you are, there is always a risk of idiot management messing everything up. The issue I have with dividend growth investors is that they seem to care about NOTHING but the dividend. Value? Growth? Who cares as long as the dividend gets increased!

    I realize it's more complicated that that. But when you make comments that an increase in a share price means nothing, that's it's only paper wealth? That irritates other investors. Tell that to Barel Karsan.


Recent Posts From DIV-Net Members