Easily Understood, Totally Overlooked
There are some things in investing that are difficult to understand. How you use a complex options strategy as a hedging overlay for example. Or how you calculate the waterfall payments on CLO tranches.
Most concepts in investing are simple. One of the simplest is the concept that companies generate profits, some of the profits are used by the company management to grow the business and some of the profits are paid out to the shareholders of the company in the form of dividends.
When analysing a business, there are two things that matter. 1) The price at which you buy and sell the business and 2) the cash flows that the business generates while you own it.
Human nature leads us to focus solely on the former and totally overlook the latter, certainly when it comes to public companies – the sort that you buy and sell on a stock exchange, and the sort that we are interested in here.
We know that the price of companies (remember: stocks or equities are companies) fluctuates all over the place. In his 1987 shareholder letter, Warren Buffett used Mr Market to explain the movement of stock prices.
Mr Market is a crazy person who is your partner in a private business. Every single day, without fail, Mr Market will give you a price at which he will sell his portion of the business to you.
“The poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions, he will name a very low price, since he is terrified that you will unload your interest on him.”
Mr Market’s severe psychological problems means that he views his company to be worth something completely different every day despite the business itself being very stable.
You can all read that and realise how silly it is. But it perfectly explains the short-term movement of stock prices.
Now let’s look at the other part of the business – the cash flows generated and paid out to the partners and shareholders of the business.
Below is a chart of the total dividend payouts of the S&P 500 over the past 10 years, broken down by quarter.
It’s a beautiful chart.
There are two things to notice, internalise and remember for ever.
One, annual cash dividend – the actual cash you received as a shareholder of the biggest 500 companies in the US – has increased over this period by 90%.
Let me say that a different way.
Your income, as a shareholder in the biggest 500 companies in the US, has increased by 90% over the past ten years.
When it comes to generating a passive income (income coming from something other that your work) and being free to walk away from full-time employment, you need your income to grow at least as quickly, preferably quicker, than the rate at which the price of the things you are buying is increasing. That is, you need your income to grow faster than inflation. If it doesn’t, you are going backwards.
I wonder what inflation did over this period.
IT GREW 20%.
The second thing to note about this chart is the resilience of dividend payments. Mr Market’s crazy brain doesn’t, for some reason, impact the cash that he pays out to his shareholders anything like as much as it impacts the price at which he is willing to sell his business.
Dividends fall, but only occasionally. Companies HATE cutting dividend payments because of the signal it sends out to shareholders. Dividends fall a lot less than the price of the underlying companies and they bounce back a lot quicker.
For reference, going back to 1960, CPI (a measure of inflation in the US) compounded at approximately 3% per year. The cash dividend paid by the S&P 500 Index compounded at an annual rate of 5.8% per year (figures from Nick Murray).
Right there is the power, the beauty and the magic of owning companies to generate an income to sustain you for the rest of your life.
Now, quickly, what are the alternatives. One is property. People love to rely on property to generate an income.
Please, if anyone can send me a property investment that has the cash profile (once you have paid the costs of owning the property) that is shown in the chart above, I will eat my hat. In front of you all.
In general, residential property in Cayman (commercial may be different) has fixed rents. People generally increase their rent as and when they can, perhaps when they get a new tenant. Meanwhile, the cost of owning the property is going up year on year. Your cash flow is getting squeezed. It certainly isn’t rising consistently year on year. It just isn’t.
That is a huge problem if you are living on that income, and a vitally important point to remember if you are buying a property as ‘an investment’.
The second option is fixed income or bonds (same thing). Well, without getting deep into the weeds here, the name sort of gives that one away. FIXED income.
So, there you have it. Dividend payouts – the most easily understood but most routinely overlooked part of equity investing.