This is a sequel to How to Avoid Getting Hurt: Don’t Chase Yields Blindly. Apart from investing in instruments and companies that are unable to sustainably pay out interest and dividends based on their operating cash flow, investors are committing a mistake by solely focusing on investing for income.
Income investing means building a portfolio of interest or dividend-paying common stocks, preferred stocks, and bonds in an effort to generate sufficient income to maintain their desired lifestyle.
Investors should not be fixated on chasing yields. Rather, they should focus on the maximum total return they can derive from their investments. Total return includes both income and capital gains.
“The best way to approach this is to invest for the highest total return you can achieve and sell whatever shares or units you need to provide cash. However, I realise that for many investors, the idea of realising part of their capital to provide income is anathema.”
Terry Smith, CEO of Fundsmith
When investors focus on income-producing stocks, most are focused on stocks that have a high dividend yield. Generally, this would be limited to companies that pay out most of its earnings as dividends such as REITs or mature companies such as Singtel and ComfortDelGro.
These companies do not retain most of their earnings for reinvestment, largely because they are unable to reinvest at high returns. Cash generated by the business will have to be deployed in other places (e.g. acquisitions) or returned to owners (e.g. via dividends or share buybacks).
Investors focusing on dividend yield alone would miss out on the great compounders—companies that are able to reinvest at a high rate of returns. Instead of paying out a dividend, they would retain most of their earnings for reinvestment, growing the intrinsic value of their businesses in the process.
Let’s look at an example comparing two businesses and understand which yields a higher total return. The first company, Compounding Corporation. It has the ability to reinvest all of its retained earnings at high returns due to its strong reinvestment moat. As a company that grows at a high ROIC, the market assigns it a higher multiple, at 20x earnings.
The second company, Dividend Corporation. It is a mature and steady business that pays out good dividend yield and trades at 10x earnings.
Assume that, over time, both companies will be valued approximately in line with the market, at 15x earnings. In this case, Compounding Corporation will suffer a multiple derating, while Dividend Corporation will enjoy a multiple expansion.
Let’s observe which company would provide shareholders with higher total returns:
By focusing on companies that provide a high dividend yield, investors would miss out on companies like Compounding Corporation. Although income investing would provide a decent result, the opportunity cost of doing so is huge (total returns of ~700% against ~300%).
The desperate search for yield has led to a number of people choosing to invest in income funds, or in mature companies providing a high dividend yield. On the surface, it might sound sensible, but it is erroneous. It may lead to investors underestimating the risk of investing in high yield instruments. Moreover, what is less obvious is the opportunity cost of focusing on yield only, as opposed to the total returns of a company that is able to compound at a high clip.
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