When I first contemplated investing, there were two concerns that I had to immediately address: Should I be a short-term investor or a long-term investor? And once I make that determination, how should I proceed?
It didn't take me long to realize that I had no ability to predict the short-term movements of stock prices. Probably the most vivid example of this would be my history of guessing the price movements of Colgate-Palmolive's (CL) stock, which have been absolutely abysmal. I remember when the stock crossed $95 per share, I thought "It will come back down to $90." Then it hit $100. I thought, "It will come down to $95." Now it has hit $115 per share, and well, you get the idea. On a year-to-year basis, I had no ability; in fact, I might be something of a negative indicator when it comes to predicting stock prices. I wouldn't be successful making money trying to time the market like that.
But although I couldn't predict stock prices in the short term with any degree of reliability, I did realize that there was something I could predict with more accuracy: earnings and dividends. I could review the company's history and see that there had only been two years since 1996 when Colgate's earnings did not grow relative to the previous year, while the dividend had grown every year over that period (in fact, the company has raised its dividend every single year without fail since 1964. That is what I call a money machine). I could review the company's balance sheet and see that cash flow per share has tripled since 1999, and the company has consistently maintained net profit margins of 12-15% over the past twenty years. And of course, I could use my own judgment to determine that the underlying business is strong and the core business is not going to go anywhere soon: I feel comfortable betting on Colgate toothpaste, Irish Spring soap, Speed Stick deodorant, and dozens of other cleaning products to continue growing profits and returning them to shareholders in the form of a larger payout that rises with time.
This struck me as a much more "doable" way of creating wealth than trying to make stock market predictions in the short-term. I simply don't have the skill set to guess what other people will be willing to pay for an ownership stake in Colgate-Palmolive six months, one year, or two years from now. Instead, I decided to forge forward with a path that would make it much easier to reach my goals: If I own excellent businesses instead of just "renting" them for a year or two, all I have to do is sit back and make sure the company is still making profits, protecting its competitive position, and maintaining adequate balance sheet strength (i.e. not taking on too much debt). Because most of the large, excellent businesses in the United States maintain a tradition of raising the dividend every year, I can passively sit back and collect checks in the mail every three months just for staying alive. Once the initial investment in an excellent business is made, a growing stream of cash will often come my way with no additional effort on my part.
If you identified Coca-Cola (KO) as an excellent business in 2000 and bought shares, the only thing you had to do over the past thirteen years is take a few hours each year to make sure the underlying business is still strong, the balance sheet is still strong, and that the earnings and dividends are growing at a rate in accordance with your expectations. Even though you would have had to tolerate 15-35% fluctuations in the price that other people would be willing to pay for your shares, you would have watched your ownership share of the Coca-Cola pie grow from a share that paid out $0.34 per share in dividends and generated $0.74 in earnings to a share that paid out $1.02 in dividends and generated $2.20 in earnings (2013 estimates).Through a period of time that has witnessed spiraling debt, rising unemployment, and a few across-the-globe wars, you have managed to roughly triple your earnings and dividends over a thirteen-year period just by owning an excellent business. And all you had to do was make a one-time capital outlay in an excellent company and spend a few hours of your life monitoring the company for signs of deterioration.
The terms of being a dividend investor are very appealing. You don't have to be phenomenally clever and make frequent guesses about the market. You just have to find an excellent company, determine a reasonable price to pay for it, and then sit back and continue to own the company as long as it grows earnings and shares them with the owners in the form of cash dividends. Not only is it a reliable way to build wealth, but the path is more certain. You don't have to follow the market day-to-day and have a manic focus on the stock prices, but rather, you focus on the business fundamentals instead of the stock price fundamentals once you have acquired your ownership from there. Once that initial outlay of investment capital gets devoted to an excellent business, you just have to sit back and watch the earnings and dividends rise at a rate greater than inflation with time. That's a much better alternative than worrying about whether we're due for a correction or if the bull market will keep on raging.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.