At extremes in the fnancial markets, investors and their advisors loose track of how to truly achieve long-term wealth. It is not as easy or as difficult as some think. It entails available cash, a sound investment philosophy, and compound interest over the years.
I grew up with an elderly immigrant father who came to this country in 1900. He had to raise a young family on his career savings with no established corporate retirement account (retirement funds only began in the late 1960s), so I learned first hand the value of wise investing for the long term. My father’s savings were mostly invested in common stocks and the dividends on those stocks paid for our education. My father was a big fan of American enterprise and was always doing extensive reading and due diligence on companies with favorable growth and earnings as well as attractive and growing dividends.
The beauty of compounding good assets over time — including income from those assets — is the key to success. Assets that are able to grow at a 7% rate per year will double in ten years time. If inflation is modest during your investment time period and you are able to invest in a tax-free account, all the better.
Valuations, however, are very important. If you purchase, for example, GE at a price-to-earnings ratio (or valuation) of 10, and the company can grow at a 10% rate, you will theoretically earn an approximate 10% compound annual growth of the share price over a market cycle. If during that time the price-to-earnings ratio doubles, then you will receive the 10% price increase to match the earnings growth plus a stock price that approximately doubles from the doubling of the stock multiple.
I call this the double whammy! (But please be mindful that the reverse can also happen, as was evident when inflated stock multiples collapsed over the past three-plus years.) Not only is the security held during this period, but the dividend yield on the book value of your GE purchase goes from the modest single-digits to the high teens or higher as the dividend is increased each year in line with earnings growth.
This yield component of stocks is approximately one-half of the total return of a major stock index such as the S&P 500. The yield on individual stocks and annual dividend increases are the only ways to assure greater stability of total returns on equities over the years. Under such an investment strategy, an investor will have maximized his equity return while minimizing his risk. Approximately one-half of his expected equity return will have been realized as income, and the other half (+/-) will be a function of the market’s price direction. If he is able to reinvest the income and the net capital gains over the years (no withdrawals) in a diversified portfolio made up largely of growth securities bought at reasonable prices, wealth will be created. Add to this strategy a balanced portfolio with some fixed-income exposure to offset equity bear markets, and he will do well throughout various market cycles.
Most investors today are being taught to save as much of their career earnings as possible, after expenses, to invest for their retirement needs. Most retirement plans offer a monthly opening for these contributions. Therefore, assets tend to be dollar averaged into the markets over time. Investors are buying at the average price that the individual securities trade in over time. They neither buy all their shares at the high price nor at the low price. This strategy provides asset contribution discipline along with long-term investment focus. Such plans should be promoted and liberalized as much as possible.
So the question are: What is a good investment philosophy that has been proven to create wealth over time (with the help of dividends and annual dividend growth)? What should be the expected return on such a philosophy?
For the twenty-five years ending June 1995 (before the Internet bubble) the pension fund I was managing had cumulative returns of 11.8 % versus 10.4% for our peer benchmark and 5.2% for inflation (GDP deflator). Even with our more conservative investment philosophy during the Internet-bubble period, the twenty-year return of the equity portfolio through December 1999 was 17.1% versus the S&P 500’s 17.9% return. On a risk-adjusted basis the equity portfolio’s return was 18.0% versus 17.9% for the S&P 500. The latter figure means the stocks owned in the fund have less risk, or less volatility, than the market while incorporating the risk-free T-bill return. Corporations with good products, a competitive edge, and financial strength should achieve reasonable earnings and comparable dividend growth. And their stock should be a less risky investment. (Risk-adjusted returns are important to know especially if one’s securities are not primarily high quality and do not possess ample trading liquidity to lessen volatility.)
These numbers show that decent returns can and should flow from a sound investment philosophy — one that features good implementation along with low management and transaction costs. Dividends and dividend growth are vital components of total return — that’s why President Bush’s plan to tax dividends only once is so important today.
Our retirement plans — be they self-administered, defined benefit, 401(k), 403(b), IRA, etc. — are dependent on the existing and future savings of wage earners as well as good corporate management and boards (whose interests are tied to the beneficiaries — both employees and pensioners). Total returns on assets are a function of thoughtful asset-allocation strategies, companies that are capable of growing internally with positive cash flow, and securities that are bought by investors at reasonable prices. If done well, and if employee benefit levels (for defined pension plans) are held in check, current and future retirement needs will be met.
The challenge is to stay on course, creating wealth to meet your growing retirement needs.
— Patricia A. Small is a partner with KCM Investment Advisors, and is the former Treasurer, University of California.