Is Total Return A Useful Metric For Income Investors?

by: Robert Allan Schwartz

Is total return a useful metric for income investors?

Barron's front cover on the 11/5/2012 issue proclaimed, "Best 25 Dividend Funds," followed by: "With investors eager for income, we rank mutual funds that focus on dividend stocks. Topping the list: JPMorgan, Vanguard, and Columbia, up 15% a year over the past three years."

My first reaction was: "Barron's clearly does not understand investing for income; they're telling me the prices went up, but I want to know how much the dividends went up."

My second reaction was: "I don't want to buy something after the price has gone up 15% a year over the past three years."

The article contains a chart titled "Ranking the Top Dividend Funds". The columns are headed: "Assets (MIL); 12-Mo Yield; Total Return (1-yr, 3-yr, 10-yr)."

I wondered why Barron's thought I would be interested in the "total return" of an income investment.

Investopedia.com says: "Total return accounts for two categories of return: income and capital appreciation. Income includes interest paid by fixed-income investments, distributions or dividends. Capital appreciation represents the change in the market price of an asset."

I understand the value to me of the income portion of "total return". I intend to retire on the dividends produced by my dividend growth companies.

What I don't understand is the value to me of the "capital appreciation" portion of "total return".

For example: I own my home. I watch the market price of my home go up and down every day (well, I don't watch it every day, but it goes up and down every day). I can tell by going to Zillow.com, Trulia.com, etc. Both sites can show me the market price of my home for the past several years. It has definitely gone up and down.

If the market price of my home goes up, will I sell it? No.

If the market price of my home goes down, will I sell it? No.

As long as I choose to continue to live in my home, the market price's ups and downs make no difference to me. They don't change my life or my decisions.

I may enjoy comparing the market price against what I paid for the house, and I may enjoy believing that I have in some way benefited from this "change in the market price of an asset," but any "capital appreciation" is only a paper gain, unless and until I sell, at which point it becomes a realized gain. The bad news about paper gains is that they don't pay the mortgage.

Back to dividend growth companies.

I watch the market price of my dividend growth companies go up and down every day. I can tell by going to finance.yahoo.com, finance.google.com, etc. Both sites can show me the market price of my dividend growth companies for the past several years. They have definitely gone up and down.

If the market price of a dividend growth company goes up, will I sell it? Possibly. I have sold overvalued dividend growth companies. I reinvested the realized capital gain into other dividend growth companies, in such a way that my overall portfolio income went up.

If the market price of a dividend growth company goes down, will I sell it? Possibly. Not solely because the price went down; if there is no material change to the business, then I might view the price decline as the company "going on sale," and I might buy more! If I determine that there is a material change to the business, such that earnings will likely decrease, which might lead to a dividend freeze or cut, then I would sell, and reinvest the proceeds into other dividend growth companies.

This might entail a capital loss. Folks who held on too long to many financial companies in 2008 suffered a capital loss. Seeking Alpha member Chowder holds approximately 50 positions, so that even if one completely tanks, he won't lose more than 2% of his total wealth, and he will make back that capital loss very quickly, given that his entire portfolio is growing at more than 4% per year. Many income investors diversify by holding a larger number of positions, precisely to reduce the risk to invested capital. I currently hold 32 positions, and I am not averse to holding more, should I find more dividend growth companies that pass my tests.

If I wouldn't sell solely because the price went down, what would lead me to sell a dividend growth company? A material change to the business; insufficient dividend growth (dividend growth is needed to counteract the erosion of purchasing power caused by inflation); a dividend freeze; a dividend cut.

If a dividend growth company continues to pay (and raise) its dividends, and its price does not go up to the point where it is overvalued, then I have no reason to sell. It is doing precisely what I bought it to do.

As long as I choose to continue to own my dividend growth companies, the market price's ups and downs make no difference to me. They don't change my life or my decisions.

I may enjoy comparing the market price against what I paid for the dividend growth companies, and I may enjoy believing that I have in some way benefited from this "change in the market price of an asset", but any "capital appreciation" is only a paper gain, unless and until I sell, at which point it becomes a realized gain. The bad news about paper gains is that they don't pay the mortgage.

Conclusion

Total return might be a useful metric to other investors, but I do not see it to be of value to me, an income investor.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.