Dividends Vs. Capital Appreciation: Wrong Question

Includes: DIS, JACK, JNJ, KO, MCD, WMT
by: Mike Serebrennik


Investing is a process, a direction and not a destination.

Dividends and capital appreciation are but "side effects" of the underlying business performance.

Evaluate businesses in addition to merely valuing stocks.

A case study of how NOT to invest.

Investing is a process

"If you can't describe what you are doing as a process, you don't know what you're doing." - W. Edwards Deming

In my opinion, investors could do better by not setting either dividends or capital appreciation as a goal. Investors run the risk of shaping their mindset by describing themselves as "income" or "growth" investors, thus limiting their options. Dividends and capital appreciation are merely the means through which stock ownership rewards its owners. Instead of focusing on the rewards, investors could follow a sensible investing process.

Investing is a direction, not a destination. Instead of reaching for dividends or capital appreciation, investors could simply acquire good businesses. Specifically, good businesses should have attractive economics and competitive advantages. Dividends and/or stock price appreciation will most likely follow if an underlying business does well. Even if the stock price of a good business is range-bound and the dividend is meager, it is important not to lose patience, for profits have a way of reaching shareholders.

Both dividends and capital appreciation create wealth. These are different kinds of wealth: dividends create cash flow while capital gains increase net worth. While regular income is nice to have, most rapid and significant wealth increases have been obtained through capital gains (one can see a stock triple but not 300% dividend yields). Therefore, even an income-minded investor should not ignore the price appreciation potential of securities.

Key metric: performance of the underlying business

"I'm lucky I have enough money to be really independent, but it doesn't drive just to count money, thinking about money. It's only a side effect of what I'm doing in business." - Mikhail Prokhorov

Mr. Prokhorov has got it right. The owner of an operating business creates wealth commensurate with his or her performance. Likewise, stockholders of a public company will likely receive dividends and/or capital gains earned by an underlying business. This may not happen right away, or to the desired extent, but over time, that's the way to bet.

Stock market downturns may keep the price of a well-performing business down, but only temporarily. Transient setbacks that happen to a good business may move its stock out of favor, but again not permanently. If a business continues to earn more than its cost of capital, the cash will eventually begin to build up on the balance sheet. At that point, the company will likely experience share price growth and may initiate a dividend.

Evaluate businesses in addition to merely valuing stocks

"Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result." - Charlie Munger

An often-cited example of overvaluation is the "Nifty Fifty" stocks. Often described as "one-decision," they were viewed as rock-solid investments regardless of price. Given their solid earnings growth, these stocks commanded extraordinary high price-earnings ratios, 50 being not uncommon. The vicious bear market of the mid-1970s brought stock prices back to Earth, and the Nifty Fifties corrected with the overall market.

The Walt Disney Company (NYSE:DIS) is a classic example of a Nifty Fifty stock. As great as the company's business was, its stock lost about 80% of its peak value as the bull market unwound towards the mid-70s. That's a devastating near-term loss for someone who bought at the top.

Disney, however, did not cease to be a great company. Let's have a look at the bigger picture:

Stock market peak marked by the green arrow

The stock market peak of 1972 (green arrow) is, in the big scheme of things, a tiny blip on the chart.

Investors who overpaid for the stock but held on still made a killing over time. By 1990, they quadrupled their money. In 1996, they had 8 times their money. In 2000, they had 16 times their original investment (10.4% CAGR for this period). At the time of this writing in 2014, they have more than 32 times their money, not counting the dividends.

By the way, do you think Disney investors are any less wealthy because the dividend history was somewhat sporadic?

From the peak of the early 70s bull market to present

The above chart starts at the 1972 stock market peak. Even if bought at the peak, Disney subsequently outperformed the major indices.

Similar statements can be made about Wal-Mart (NYSE:WMT), Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), McDonald's (NYSE:MCD), etc. Not all of the components of the Nifty Fifty are with us today, at least not in their then-current form, but overall, a Nifty Fifty investor did very well, even having bought in at the top of the bull market and lofty valuations.

Again, we see that good underlying business performance can trump even rich valuation, given enough time.

Just to be clear: I am not saying that one should go out and buy a bunch of overvalued stocks. Buying great businesses cheap is much better than buying them dear, but such opportunities do not always exist.

A case study of how NOT to invest

I first had a meal at Qdoba in 2010, but did not then think of it as an investment. In 2011, when I noticed that the restaurant had been expanding, I did consider it for purchase. It turned out that the Qdoba franchise was owned by Jack In The Box (NASDAQ:JACK). The stock seemed a bit expensive to earnings at about $20, did not pay a dividend and was not a pure play on Qdoba -- JACK included a large fraction of what I considered an uninspiring namesake business. I set the stock aside. Then, in 2012, Ryan Fusaro won a Value Investing Congress challenge with his JACK thesis. I read his research, but still did not acquire the stock, which had by then increased in price to just above $25. Well, Qdoba did well operationally (It had to -- I ate there 3 times a week) and grew as a percentage of the overall business. Today the stock is above $60. Earlier this year, JACK initiated a dividend, which would have given me a yield on cost of 4% had I bought it when it first came to my attention. JACK's having not been statistically cheap to earnings or a dividend payer should perhaps not have deterred me -- the underlying business performed well, performance caught up with the price, the stock went up and the company began paying a dividend.


"Nothing can have value without being an object of utility." - Karl Marx

To paraphrase Mr. Marx, a stock (with exceptions, such as asset plays) cannot have value without good performance of the business which underlies it. With business success, price appreciation will eventually follow, and so could the dividends. By focusing on the process of evaluating businesses in addition to valuing stocks, one may increase his or her chances of better performance.

Disclosure: The author is long WMT, JNJ, KO, MCD.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.