This article originally appeared in InvestmentTalkk’s newsletter. He is a professional securities analyst and I highly recommend following him on twitter and getting a copy of his book on financial statement analysis. I am an affiliate because his analysis is sound and he’s a Liverpool supporter. We are bound by blood to suffer a delayed first ever Premier League title. Additionally, there are referral links to finbox which is my tool of choice for getting pre-built financial models. It’s a huge time saver!
Today, as I sit down writing this article, bourbon next to laptop, I’m going to tell you something that I shouldn’t:
Dividend paying stocks are not the best investment.
Dead simple. They are not. Never will be. Do not let people tell you otherwise.
There is a book that will tell you that they are the best investment, aptly named “The Single Best Investment”. And while the book is excellent, and the logic is sound, it is straight up BS meant to gain clients for their investment firm. If you are good enough at googling, you will find a free copy on their marketing website.
Everyone has to make money somehow in the financial industry. Including InvestmentTalkk and myself. InvestmentTalkk creates excellent financial analysis and market commentary. I write books and research dividend paying stocks. I should be talking my book here and tell you that Dividend Growth Stocks are the best thing ever next to sliced bread because that is the biggest financial incentive I have when featured in such an article. But I won’t.
Instead, I will say this: Dividend Growth Stocks, with a bent toward higher yield are in my opinion the best way to generate current income from your stockpile of assets. People young and old can benefit from increasing their current income through dividends whether through an ETF or single issues. That’s hard to say of many illiquid and non-cash generating assets. That current income is why I believe it makes the most sense to use a taxable account if you are going to pursue some sort of dividend growth strategy. Especially if you are a sophisticated capital allocator.
So that begs the question: What is the best investment?
To be short: Innovation.
Creative destruction and disruption nearly always topples big companies who let their guard down for just a moment. I am not a registered investment advisor so don’t take this as actionable financial advice and I will most certainly receive a ton of flak from asset allocators and statisticians. However, as a financial strategy, I believe that the best thing for a young person to do is invest nearly 100% of their retirement account contributions into small cap growth equities, ideallly in disruption, and never alter it until they need current income. In taxable accounts, I believe it is best to pursue a Dividend Growth strategy of some sort and use current income generated to improve one’s standing in life.
Here’s the reasoning.
Disruption grows. $XSW, one of the closest proxies of a disruptive industry, software, has exhibited a nearly 19% compounded annual growth rate since inception even with the recent drawdowns in price. If you compare that with the financial industry standard, the S&P 500, at 12% in the same period, you start to see a stark difference in ending asset values.
Of course there is no guarantee that past performance continues into the future, but the theme of disruption has nearly always upended industries and toppled stalwarts. Once-huge titans like IBM, Kodak, and Sears have been replaced by companies like Google / Alphabet, Apple, Microsoft, and Amazon. Even Jeff Bezos himself admitted that Amazon will likely not be around in 100 years because it will be disrupted. As long as he is the CEO he will fight to prevent that from happening, but as soon as cofounder leadership leaves, there is often a decline in emphasis on innovation and more emphasis on protecting the moat. And that act of protecting a moat is what leads to a company starting to be complacent to threats against its business.
We’re seeing this in Google, Microsoft, and Apple now. The founders are no longer in place, and while their moats are wide at the moment, their cash war chests will need to be spent acquiring software startups for many millions or billions of dollars. Consumers will change their habits. Businesses will need flexibility. These are traits that corporate giants are terrible at adapting to.
This leaves room for the Shopifys, Appfolios, Atlassians, and Twilios of the world to step in quickly, fill gaps, and win corporate minds.
I’ll do what I always hate reading, but let’s create a retirement model with the following assumptions.
Let’s take 3% discounts on each of the priorly stated numbers to bring them more into the realm of sensibility.
Assuming a CAGR of 9% on the S&P leads to a $3M nest egg.
Assuming a CAGR of 15% on XSW leads to a $25M nest egg.
It would take an over 80% drawdown in $XSW to match the S&P, a highly unlikely scenario unless we were to repeat the Great Depression. Even in that case, you will still likely be ahead as the S&P will drawdown as well, maybe to a lesser degree because of its smaller beta.
Of course, this is perfectly clear in hindsight that “software would eat the world” as Paul Graham said, but hasn’t it been at least somewhat clear that this has been the case for anyone even mildly interested in markets?
In any case, this shows me that a simple model is possible to generate a significant nest egg with relatively low contribution. An 8.3% savings rate, inclusive of employer matches, could theoretically generate a ridiculously large retirement nest egg. While $500/month is still a significant amount of money, it is definitely achievable for anyone financially minded. This also tells me that it makes little sense to invest any more than that amount in a tax advantaged account.
Instead it makes sense to improve your life through current income. And that’s where we come full circle and I get to pitch you on the benefits of investing in dividend growth stocks for current income.
Current income generates possibilities and increases your money velocity. Money velocity in retirement accounts is zero. You can do nothing with them until you’re at retirement age unless you pay a penalty. If you even make it to retirement. If the government hasn’t enacted a wealth tax on the account. There are a plethora of assumptions that we make in the name of the “Retirement”. However, if you can start to divert that money into improving your current life, then dividends indeed pay dividends on your current situation.
At 38, I’ve amassed a significant enough chunk of change in my taxable account to provide a nearly passive wage equal to the poverty level. Without working another day, I may be able to potentially survive. That’s without tapping my retirement accounts, which are invested in, guess what, disruptive technology companies, including a position in $XSW. I do not intend to make significant contributions to my retirement accounts anymore. Instead, I will be improving my income through dividend growth investing.
A note on capital allocation. I believe that it is possible to be an efficient capital allocator with good discipline. Having a set of models in place and the discipline to not overpay can make you an overachieving investor. This is why I advise against dividend reinvestment plans. These plans assume that you are too stupid to make a good investment decision. I believe that it is always important to scrutinize exactly where your investment dollars are going and make the best purchase that you possibly can to optimize returns over time. The best investors I have met reinvest based on conditions rather than blindly reinvest.
I talk about this in a good degree of length in my book, Too Much Money, linked below. I hope you give it a read because it is the exact plan that I use to find, analyze, and purchase stocks for current income. For blog readers I offer 25% off of the normal price, which at the time of publishing will likely be close to $19. If you don’t follow me on twitter yet, please do as I try to make dry financial and investment commentary somewhat interesting.