Dividends Are Weighing Down Your Portfolio
Editor's note: Forget everything you thought you knew about dividends.
Investing expert Chris Mayer says they're hurting your portfolio.
In today's Masters Series essay – originally published in the January 12 edition of Bill Bonner's Diary – Chris explains why companies that don't pay a dividend can vastly outperform dividend-paying stocks over the long run...
Dividends Are Weighing Down Your Portfolio
By Chris Mayer, editor, Chris Mayer's Focus
"Dividends are an expensive luxury."
You've heard me say that before. It's a quote from Thomas Phelps in 100 to 1 in the Stock Market (1972).
Phelps found that if you're hunting for stocks that return 100-to-1 (what I call "100 baggers"), you should look for companies that reinvest the cash they generate rather than pay out dividends.
It's a powerful idea... if you follow the important caveat I'll explain to you today.
Say you have two companies, with $1,000 invested in each. And both earn a 20% return on that money invested.
Now, say Company A pays all of its profits in dividends. But Company B reinvests all the profits.
After five years, Company A is still worth $1,000. But you have $1,000 in your pocket in dividends (leaving out taxes for the moment). Not bad.
Company B, however, is now worth $2,488. You've got almost 25% more.
Over longer periods of time, the accumulated results are staggering. After 25 years, for example, Company A is still worth $1,000, and you have $5,000 in dividends. But Company B is worth $95,396.
That's theoretically true... but often doesn't work out in practice.
A new paper by Newfound Research called "Is Dividend Investing Dangerous?" shows that companies with higher reinvestment rates lag behind those that reinvest less (and pay out more in dividends).
The reason for this, the authors conclude, is that "companies are generally not good at reinvesting free cash flow."
But wait... Doesn't this go against what I just said about reinvesting profits?
Yes and no.
It's theoretically true that reinvesting will compound your gains faster, assuming the company can earn returns higher than you can earn with a dividend. Yet it also seems undeniably true that most (or at least many) companies are poor investors of their own capital.
The bridge here is that "most" does not mean "all."
And this gets to something critically important about how my team and I pick stocks: management.
Most management teams are corporate types. They got there for a lot of reasons – charm, political savvy, leadership skills, whatever – but not because they were great investors.
This is why we spend so much time thinking about how the management team will invest the cash the business generates. One of my favorite Warren Buffett quotes makes this point...
The lack of skill that many CEOs have at capital allocation is no small matter: After 10 years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.
And that's just reinvesting 10% of annual earnings. Most firms retain more than 10%. (Buffett also said, "If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.")
To guard against unwise investment of earnings, then, we want to see that the company has ample opportunities to reinvest cash and earn high rates. We don't want management teams having to find new ways to invest in cash because that means they'll likely squander it – often on an acquisition.
In my newest advisory, Chris Mayer's Focus, we invest only in companies that have ready opportunities to deploy capital... and skilled leadership that knows how to deploy it.
The bottom line: If you want to shoot for 100 baggers, the most important thing is to look for companies with the ability to reinvest profits and earn a high return on equity – again and again and again...
Otherwise, for the typical firm, you're probably better off taking the dividend.
Sincerely,
Chris Mayer
Editor's note: Chris has one of the most impressive track records in our industry. And this afternoon, he's hosting a free, live online training session to walk viewers through how to identify the next 100-bagger investment opportunity. You'll also receive the name of six stocks on Chris' watch list – for FREE – just for tuning in. Click here to reserve your spot.