I currently own 49 equity positions in high-quality businesses across multiple industries and geographies. These are little, tiny slivers of ownership in real businesses out there making real money by selling real products and/or services to people and/or other businesses.
These aren’t just pieces of stock paper. Or, translated for modern times, digital stock tickers that show up in a brokerage account with a number next to them, indicating how many shares you own.
These are real businesses that I own a real piece of. And the same goes for you readers – every share you own is a small piece of a real business. As such, I always think like an owner. When analyzing a potential investment, I look at the entire business as if I’m buying the whole company. After all, why would I want to own a slice of a business if I wouldn’t want to own the whole thing?
A Holistic Approach
When you buy stock in a company, you’re buying more than just the future stream of rising dividends that will (hopefully) come your way on the back of rising profitability. You’re buying a piece of that company’s stores, factories, plants, distribution centers, goodwill, trademarks, products, services, reputation, history, technology, etc.
I take this into account with every investment I make. If I don’t comfortably and reasonably understand the totality of the business, how they make money, and how I’ll receive rising dividends for the remainder of my ownership experience, then I’m likely to take a pass.
And the reason for this is risk. My main objective as an investor is to limit risk whenever and wherever possible, while seeking attractive risk-adjusted returns and growing dividend income. I’m not out to beat the market or swing for the fences. I want to get on first and eventually round the bases in due time, collecting rising income all along the way. Reducing risk means I’m reducing the chance of permanent capital destruction. I work hard for every dime that comes into my possession, so I’m not interested in seeing my hard-earned capital evaporate because I didn’t know what I was investing in.
And I say that because permanent capital destruction therefore means I have less capital, which I can use to generate rising dividend income. I always remember a 20% price drop requires a 25% appreciation just to break even. Now, we have no control over the stock market. Furthermore, a price drop is something I look forward to so as to average down and buy more stock for a cheaper price.
However, it’s difficult to be excited about a stock’s depreciation when you don’t really know what you own. After all, how can you get excited about buying more of something when it’s cheaper when you’re unsure as to what you’re buying?
Know What You Own
I remember getting a lot of flak back when I first started blogging because I was avoiding mortgage real estate investment trusts (mREITs), like Annaly Capital Management, Inc. (NYSE:NLY), that invest in mortgage-backed securities. These were fairly popular stocks when I first started blogging back in early 2011, but I didn’t really get how exactly they made money and how I could be assured they’d not only be paying dividends 10 or 20 years from now, but be paying more than they were at the time.
For instance, this is an excerpt of NLY’s business description, per Google Finance:
Annaly Capital Management, Inc. (Annaly) owns, manage, and finance a portfolio of real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations (CMOs), Agency callable debentures, and other securities representing interests in or obligations backed by pools of mortgage loans.
Now, I understand most of that. But some I don’t. And after taking a look at NLY, among other mREITs, I just didn’t really get how they create value and can pay out those big dividends. They seemed to be shuffling money and assets around, and worse – using leverage to do so. This seemed to reek of some of the issues that led to the financial crisis in the first place.
I’m not saying NLY is a bad investment today, or won’t make you a ton of money. But I will say this: NLY was paying a $0.65 quarterly dividend per share in the middle part of 2011, when I first started hearing how crazy I was to avoid these investments. They are now paying $0.30 quarterly per share. The dividend is seemingly cut every few months, and the share price has been decimated with the dividend. High yield typically equates with high risk, which is important to remember.
Owning an mREIT like NLY appears to be a bet on interest rates and mortgages, which is something I’ve never felt comfortable with.
I’d rather make a bet on more people being alive in 20 or 30 years from now, consuming more products from companies like The Coca-Cola Company (NYSE:KO). I’d also feel comfortable betting that energy will continue to be in high demand as middle classes around the globe spring up on the back of economic growth, meaning companies like Chevron Corporation (NYSE:CVX) or BP Plc (NYSE:BP) should continue to profit and pay me rising dividends. I also think healthcare is a great area to be in, and businesses like Johnson & Johnson (NYSE:JNJ) will continue to sell more products in this space, meaning I’ll continue to collect more and more dividend income.
But bet on which way interest rates are going? Nah, I’ll pass.
While it’s not necessarily realistic to know and understand every iota of a business, you should have a basic grip on what they do and how they do it. Know what you own. Know why you own it. If you can’t explain in a short paragraph what the company does, how it makes money, and why you think you’ll be collecting more income 10 or 20 years from now, then you may want to consider whether you should own a piece of the company at all.
Collect A “Paycheck”
Imagine you own a local pizza shop. You work 40 or 50 hours down at the shop, making sure the ingredients get delivered, the dough is fresh, pizzas get made and delivered, and customers remain happy.
You love your job. You feel like you’re part of the community, and you’re providing a quality product at an attractive price point. Plus, who doesn’t love pizza?
But would you do all of this if you weren’t making any money? Would you want to spend the next 20 or 30 years of your life turning out great-tasting pizza if you didn’t make a dime doing it?
If the business isn’t profitable, then how do you expect to make any money? And if a business is profitable, shouldn’t you be collecting a portion of that?
This concept is exactly why I invest only in companies that regularly and reliably pay and raise dividends to shareholders. I would expect to receive some income if I wholly owned and operated a business, so why should I think any differently as a shareholder?
There are plenty of stocks out there that don’t pay any dividends. And you can buy these anytime you’d like. But that would be like working at the pizza shop for free, hoping that someone will come down the line and offer you more for your business than you paid for it. If I would expect to run a profitable enterprise that can afford to pay me as an owner, then I expect the same as a shareholder. Because as a shareholder, I’m a part-owner in a business.
I don’t know everything about every business I’m invested in. But I know enough information about each of the businesses I’m a part-owner of to where I’m comfortable putting hard-earned capital to work. I look to reduce risk while maximizing the opportunities to collect more dividend income for the next two or three decades of my life, and beyond.
If I don’t have a pretty good idea what it is I’m investing in then I’m likely to pass. It would be just the same as owning a business. If I’m in the corner office but can’t explain to visitors exactly what we do and how we make money, then why am I even in the corner office? Higher-yielding securities may look attractive now, but stocks typically have a higher yield for a reason: risk. And risk can surely create opportunity, but it can also lead to permanent destruction of wealth. I aim to limit it where and when possible.
And a dividend is “proof in the pudding.” Profitable? Show me. Pay me a dividend. The business is more profitable today than it was 10 years ago? Well, then I should be collecting even more dividend income. If a business is profitable, I expect to collect a portion of the profits as a shareholder because I own a part of the business. It’s no different than if I owned the entire business. I don’t work for free, and I don’t put my capital to work as such either. Whether I’m working or my money is working, there should be a paycheck waiting.
Do you think like an owner? Understand your investments? Expect to get paid?
Full Disclosure: Long KO, CVX, BP, and JNJ.