It is close of five year now that I have been a long term buy and hold, and dividend growth focused investor. When I meet friends, acquaintances, or colleagues, on many occasions the discussion starts from what’s market doing today and steers towards trading/investing is nothing but a poker game. I get a sense that many of these folks think that buying (and selling) stocks is just a gamble of some kind. Irrespective of this, I believe both, trading and investing, have their own set of pros and cons depending upon what context an individual is looking at it. In the end, both trading and investing is done to make money. Some use approach of capital appreciation, some use dividend income, some do trades to generate income. The key is to have a plan and execute it with consistent results.

When it comes to dividend investing, many individuals think of high yields (perhaps Cramerica syndrome!). It shows lack of patience and tendency to read too much into the business media. They do not understand dividend growth and sustainability.

There are two very significant aspects that investors need to understand about dividend growth investing and sustainability. These are (a) quality of dividends; and (b) potential for capital appreciation.

• Quality of dividends is related to how and from where the company is paying dividends. Good quality of dividends from companies that consistently generates cash from selling products or services, manages dividend with payout ratio, prudent uses capital for growth, and remains focused on its core competency. It is ideal to have everything in a company, but ideal situations and scenarios are either in short supply or not practical. Occasionally, companies will have issues and stumble, but those should be short lived. As long as quality of dividends are good, I believe the dividends are sustainable. These dividends add to the total return.
• Potential of capital appreciation is related to individual’s cost basis and future growth in value. Buying a stock at fair value builds-in a level of safety margin. Furthermore, I believe as the company grows and expands, it will grow its earnings and hence the dividends will grow. This growth in the company is bound to result in value over a period of time (and hence capital appreciation).

Thus, the key is to invest in companies which can grow its operating cash flow with consistency and can sustain it. A company that consistently generates cash is likely have to less downside risk. Even if they do get affected by market downturns, such companies experience less downward pressure. In addition, the continued dividends keep adding to the total returns. Examples of such companies are Proctor and Gamble (PG), Johnson and Johnson (JNJ), Becton, Dickinson and Company (BDX), T. Rowe Price Group (TROW), Sysco Corporation (SYS), Emerson Electric Company (EMR), Dover Corporation (DOV), and Jonn Wiley Sons (JW.A).

Dividend investing does not mean focus on high yield only. It is about consistency and sustainability which inherently focuses on total returns.

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.