Investing to win dividends and income has grown to staggering levels of popularity. Perhaps at the cost of what investors should really be concerned with: total return.
Dividend investing is currently very popular. It involves buying businesses that pay large and regular dividends. The idea for some is simple: “I get growth AND yield - that’s two things! What a great deal!”
But I would like to propose a new version of this theme, which I believe is just as good. Rather than invest in companies that pay large regular dividends, we buy companies that retain their profits rather than distribute them. Let’s call it Retained Earnings Investing.
“Hey, wait a minute” – you say. “This is the opposite of dividend investing - I want yield!” But bear with me. Currently almost all investment managers sponsor dividend funds of some description - perhaps after reading this article they will see as much sense in offering “retained earnings” funds.
Retained Earnings Investing will target companies that have good earnings and retain a high proportion of those earnings in their business. “Why should they do that?” – you ask. Distributing profits to the owners (dividends) has the effect of devaluing owner wealth by the amount paid out. So a company trading for $100/share will trade at almost exactly $99/share after setting a $1 dividend.
On the other hand, a company that is a strong Earnings Retainer looks to grow their business. Retained Earnings Investing should focus on successful businesses who invest in themselves. How else can a company grow? With their retained earnings they can use profits to do far more than provide a onetime payout. For example, they could:
- Open new locations
- Develop new products
- Increase their efficiency
- Buy new machinery
- Research new ideas
- Hire people
This approach means your investment doesn’t have to be on the rat wheel of dollars in and dollars out. Or worse, borrow money to pay you the owner a dividend. Or even worse (if your investment is a fund that allows return of capital) your “yield” may be nothing more than a return of your own money.
Retaining earnings is an engine for genuine growth. Want examples? The three largest businesses in the world: Apple, Exxon Mobil, and Wal-Mart. All used their retained earnings to become who they are today. Apple recently paid their first dividend since 1995.
Some have argued that large dividend requirements impose much needed discipline on managers, and that this discipline leads to better investment results. Perhaps, but this is a much different argument than the “yield plus growth” story many are buying. Retained Earnings Investing is mathematically better than Dividend Investing from a tax perspective. The best way for a taxable investor to receive returns is not by a profit yield (dividend), it’s by growth (capital gains). Return of capital is great for advanced tax planning - but let’s never confuse it with yield.
Will this article usher in a landslide of new investment management mandates? Probably not, but I hope I’ve done my part to temper the yield frenzy. A dividend is nothing more than money flowing from your left pocket to your right – sometimes it’s fine for it to stay in your left pocket. Long live Retained Earnings Investing.
Written by Ian Collings