EVGGF - Accumulation Vs. Distribution: Which Strategy Is Better?

2024-01-08 08:00:00 ET

Summary

• Accumulation strategy maximizes compound interest and has the potential to radically change one's economic condition over the long term.
• Distribution strategy provides short-term cash flows through dividends, offering psychological satisfaction and immediate benefits.
• Both strategies have advantages and disadvantages, and the best choice depends on individual goals and preferences as an investor.

Within the vast world of financial markets, an investor will always face a choice: to invest in an accumulation or distribution asset. In the former case, we find ETFs that automatically reinvest dividends or companies that reinvest profits instead of distributing them externally; in the latter case, there are ETFs or companies that distribute dividends. If desired, we can include bonds in this latter group but in this article, I will primarily refer to common stocks and ETFs.

As we will see, from a purely mathematical standpoint, it is always advantageous to invest in companies that focus on an accumulation strategy to make the most of compound interest. However, financial markets are driven by humans, not machines (machines are set up by humans), so it is crucial to consider the psychological component.

We all know that by investing $300-$400 per month for 30-40 years in an accumulation ETF that tracks the performance of the S&P 500 we can become wealthy, but how many actually do it? How many are truly willing to have such a long-time horizon? Life often proves unpredictable.

In this article, I will highlight the main advantages and disadvantages of these two strategies, and in the end, I will express my personal preference regarding them.

Accumulation: the main advantages

The accumulation strategy is to maximize the power of compound interest, often called by Einstein the eighth wonder of the world. All it takes is a small amount invested, a good average annual return, and a very long-time horizon to make your investment grow exponentially. Here are some examples:

• $300 invested for 10 years at 10% annually becomes approximately $778. Invested for 20 years, it's $2,018; invested for 30 years, it's $5,234.
• $1,000 invested for 10 years at 10% annually becomes approximately $2,593. Invested for 20 years, it's $6,727; invested for 30 years, it's $17,449.

As you can observe, the investment return is not linear over time but exponential. This means that for the more patient individuals, compound interest can indeed change their economic-social position. The S&P 500 from 1957 to 2022 has generated an average annualized return of 10.13% ; based on this historical data, if a 20-year-old today invested $1,000, at age 70 he would have about $124,532 in his account.

By investing in individual companies the underlying mechanism is the same, but the outcome will probably diverge significantly from investing in the S&P500. Finding a company that maintains a high ROIC for 50 years will probably make you rich, but the risk is significantly higher. In addition, it is much easier to keep an ETF on the S&P 500 ( SPY ) in your portfolio for that long than an individual company.

In light of these considerations, it is clear that the greatest advantage of an accumulation strategy is to radically change your economic condition by making a series of reasoned investments over the long term. Since dividends are reinvested, you will pay taxes only when the position is closed: the tax savings will be reinvested. In other words, accumulation is the only strategy that can really enrich you if you do not have a huge amount of capital at your disposal. In the previous examples I considered investing small amounts: try to think what would happen if a 20-year-old invested much more money in the S&P500.

So, since time is the key to compound interest, the accumulation strategy is more suitable for young people but could also make sense for those who are 40-45 years old.

Accumulation: the main disadvantages

Based on the above, it would seem that getting rich is not that difficult. After all, just invest as a young person each month in an accumulation ETF that replicates the performance of the S&P 500 ( SP500 ) and you're done. Technically it is as simple as it appears, but there are several important considerations to be made.

The first aspect to evaluate is the question of age. As mentioned, to take full advantage of compound interest, it is essential to be young and have a long-term view but this is by no means a given. To begin with, it is not necessarily the case that a young person has money available to invest since the age of 20 to 40 is where his or her future is decided. Some may still be paying off student loans, others are paying off a mortgage, and still others incur various unexpected expenses. In addition, building a family comes at a significant cost, so the money set aside as a young person is likely to be used to meet new daily needs. In short, to take advantage of compound interest we need to be young, but we probably only have the money to invest when we are old: this is the paradox of the accumulation strategy. By the time we are in the prime of our careers and have a more stable financial situation, it may already be too late. In compound interest, time is often more important than the amount invested, so no time will be better than your 20 years to invest. Let me give you a practical example of two people who want to have a retirement supplement when they are 65 years old:

• Warren invests $1,000 when he is 20 years old, at an annual rate of 10% for 45 years. At age 65 he will have $72,890.
• Charlie invests $7,000 when he is 40 years old, at an annual rate of 10% for 25 years. At age 65 he will have $75,842, almost the same as Warren but investing 7 times more.

Moreover, assuming a young person has the financial means, it is not guaranteed that he or she has the will to take such a path. After all, at the age of 20-30, we are in our prime, and that $1000-2000 set aside can be spent on a nice trip rather than immobilizing it until we retire.

The second aspect to consider is the age at which we will presumably become rich by investing our first savings at a young age. Maybe we will not wait 50 years to sell the position, but at least 20-30 years are required to take full advantage of compound interest. Most likely we will be 60-70 years old, and by that time the energy and desire to take advantage of the enormous fortune we have accumulated may have gradually faded (the unlucky ones may never see it). Traveling around the world at age 70 may not be as good as we imagined at age 30. So, while from an economic point of view, it makes sense to hold on to the position as much as possible to make our wealth grow exponentially, there is also the risk of accumulating a fortune that we will not be able to make full use of. After all, what is the point of being the richest in the graveyard?

The third aspect to be evaluated lies in the return. In this article, I am referring to the average annual return from 1957 to 2022 of the S&P500, and I am assuming that it will be the same in the coming years. This is only an assumption, so the return could be either higher or lower. Over a very long time frame, even a 2% change in the yield has a big impact on the final capital we will get. Here I show you some examples:

• $1,000 invested at 10% per year for 40 years becomes $45,259.
• $1,000 invested at 8% per year for 40 years becomes $21,724.
• $1,000 invested at 12% per year for 40 years becomes $93,050.

As you can see, it takes very little to change the final result considerably. Also, the return taken into account is the average return, so it is possible that when we plan to sell the position, the return on the investment will be different. The figures calculated so far discount a scenario in which the S&P500 each year grows by about 10%, but the reality is quite different. There are years when it can yield 25% (such as 2023) and others where it can collapse by 18%-20% (such as 2022).

Let's say I started my accumulation plan in 1959 and the much-discussed 50 years have passed. In 2009, I was ready to become rich after a lifetime of savings and sacrifice and I was faced with one of the worst financial crises ever. I could still sell my entire position with a huge capital gain, but the end result would be halved since the S&P 500 lost 50% during that recession. At that point, a choice has to be made:

Sell everything and enjoy the accumulated capital even if the gain is totally different from the previous year. This entails not inconsiderable psychological damage: we are talking about millions of dollars less for those who have saved a lot and invested from a young age.

Postpone selling the position with the knowledge that it may take years to recoup the losses. For those who are young, they have time to do so, but for those who have been accumulating for 50 years, they really risk not materializing their life's sacrifices.

In short, the timing of position closure is a crucial aspect and one that could radically change the return on your investment. Finally, staying on topic, the yield calculated above is nominal. So, the money you get 50 years from now will be worth much less than it is today. If today a $1,000,000 house is for the few, in 50 years it may be the norm.

The inflation-adjusted return of the S&P500 from 1957 to 2022 is 6.29% per year, thus much lower than the nominal 10.13%.

Some companies that follow this strategy

The companies that tend to take the most advantage of an accumulation strategy are mainly those that have a high ROIC and reinvest a large part of their profits. After all, the incentive to issue dividends is very low if the company is able to earn 15-20% on invested capital. Among other things, various studies point out that there is an important correlation between a company's long-term return and its ROIC: the higher and more constant the latter, the greater the likelihood that the company in question has proven to be a good investment.

Typically, companies that take advantage of this strategy with high ROICs and no dividends are tech companies, especially in the middle phase of their life cycle. A practical example would be in my opinion Meta ( META ):

• Return on Capital of 24.30%.
• A very high CapEx because the company is reinvesting profits to improve advertising efficiency and create the Metaverse infrastructure.
• No dividend has ever been issued and none is expected in the short term.
• The company's vision is long-term.

In short, Meta seems to reflect the conditions for an investment with an accumulation strategy. In any case, there is nothing to prohibit Meta from issuing a small dividend in the future, something already seen for Apple (AAPL) and Microsoft ( MSFT ). The important thing is that the ROIC remains high and that the company's vision is geared toward long-term prosperity rather than in distributing much of the profits to shareholders.

Then there are rare cases where a company follows this approach without necessarily reinvesting much of the profits: this is the case with VeriSign ( VRSN ). This company is able to earn increasing profits while keeping CapEx low due to its dominant position in its target market. Its ROIC is high, but since demand is sluggish, it is not possible to reinvest a significant portion of its profits within the company. As a result, management uses a large amount of the profits each year to buy back its own shares, thereby increasing EPS. This solution is much more tax efficient than dividends and allows shareholders to enjoy a good capital gain over time. After all, the price per share over the long term follows the trend of EPS.

Finally, how can we not mention Berkshire Hathaway ( BRK.A ). Warren Buffett's legendary company has never issued a dividend but has always made buybacks to remunerate shareholders. Here again, the approach was the same: better to reinvest within the company and accumulate wealth than to distribute it externally. How can we disagree with him after the results he achieved?

Distribution: the main advantages

The distribution strategy is to receive steady, short-term cash flows issued by companies in the form of dividends. The goal is to get the first benefits from our investment but sacrifice some of the capital gain. In practice, we are giving up having much more tomorrow in order to have a little more today.

From a purely mathematical point of view, the distribution strategy appears less advantageous than the accumulation strategy. After all, given the same ROIC, initial earning capacity, and price, the company that issues more dividends and reinvests less is the one that will deliver a lower total return: taxation on each individual dividend will weigh heavily in the long run. Yet despite this important premise, the accumulation strategy is not always the better of the two. Paradoxically, earning more is not always the better option.

At first glance, this last statement may seem silly, but it actually makes sense. As mentioned earlier, although on paper it pays to reinvest profits, there is too much uncertainty over our lifetimes to consistently stick to our plan over a decades-long time frame. Few have the steadiness to save in their best years to have a huge amount of money to spend in their old age. Some don't see the point at all, since no one can guarantee that the timing in which we will sell will be correct and especially that health will still be good after 30-40 years. In other words, rather than be rich at 60-70 years old, many prefer to have a salary supplement in the short term knowing that they will probably never become rich.

This is an agreeable choice and one that in my opinion cannot be criticized even if it does not have the numbers on its side. It makes no sense to opt for an accumulation strategy if it does not make you feel good and you believe you are depriving yourself too much in your best years. Investing should make you feel better and not worse: everyone has their own personal needs and we are not all the same.

In light of these considerations, it is clear that the main advantage of the distribution strategy lies in the psychological component. Seeing our account experiencing continuous small increases thanks to dividends is a psychological factor that makes the long-term investment process less stressful. When savings start to pay off something is very satisfying and makes the act of investing more enjoyable. This strategy does not make you rich, since to live off dividends you probably already have a huge amount of capital at your disposal. However, from a psychological point of view, it helps the average investor a lot. After all, investing today to get something back in 20-30-40 years is demotivating for many: at best we will be old and rich, at worst we will make the heirs celebrate.

Distribution: the main disadvantages

The main disadvantages are all related to the lower long-term return compared to an accumulation strategy. Each dividend represents a cash outflow from the company and must necessarily be taxed (in some cases even twice), so receiving small amounts in the short term greatly reduces potential future ones. The buyback turns out to be a more tax-efficient shareholder compensation methodology.

The distribution strategy will not make you rich since you must already be rich to live off dividends. Suffice it to say that to receive $1,000 per month gross in dividends, you must own a portfolio worth $240,000 with a dividend yield of 5%; to receive $3000 gross per month with the same dividend yield, your portfolio must be worth $720,000. In short, a goal that is not for everyone and still takes a lot to achieve.

At the same time, assuming you have enough money, it is not certain that you will choose the right companies to invest in. The dividend is never guaranteed, and if you invest in the wrong companies you could end up losing money rather than gaining it. Opting for an ETF can reduce the risk of this happening, but it will make the road to receiving a good monthly dividend payout even longer.

In other words, for those who do not have large amounts of capital on hand, they cannot set their sights too high if they want to follow the distribution strategy. There are no shortcuts, and companies with double-digit dividend yields are often cheap for a reason. In short, while it is complicated to apply the accumulation strategy consistently, the same is true for the distribution strategy: the risk is that the average investor may take an overly speculative attitude in order to earn more and see his or her goal come closer. Be wary of those who propose early retirement companies . There are no free meals in finance.

Some companies that follow this strategy

Typically, companies that prefer to issue dividends are those that have a stable business model and have been operating for decades in their market. Sometimes, they are companies that do not need to innovate much because the products they offer do not require it. Some of the most famous companies are Coca-Cola ( KO ) and Procter & Gamble ( PG ), with dividend yields of 3.12% and 2.57%, respectively. Then there are other companies with a much higher dividend yield, but they are likely to have much higher risks. For example, British American Tobacco ( BTI ) has a dividend yield of 9.81% and is sustainable on paper, but the industry in which it operates is often subject to unfavorable new regulations. In general, from a dividend company, you can expect your account to register small increases every three months, but the capital gain associated with the investment is underwhelming compared to a solid growth company.

Personally, since I am only 25 years old, when I invest in a dividend company I mainly look at its sustainability and growth rate rather than dividend yield. There are companies with high ROICs that pay high growth dividends every year; Visa ( V ) and Evolution ( EVVTY ) are among my most favorite companies:

• The former has a ROIC of 33.70% and a 10-year dividend growth rate of 18.33%.
• The second has an ROIC of 28% and a 5-year dividend growth rate of 85.95%. Obviously, this growth is not sustainable over the long term, but it highlights management's willingness to grow the dividend in a major way over the next few years. Cash flows have the potential to support this move.

Investing in Visa and Evolution will perceive a rather low dividend yield in the immediate term, but if dividends continue to grow fast, in 10-15 years the dividend yield on cost could be excellent. Basically, if you want to achieve significant and sustainable returns, even the distribution strategy takes time, albeit much less time than the accumulation one. And in the meantime, you will still perceive the fruits of your labor, but they will not change your life.

So, if you want to achieve outstanding results in your distribution strategy, time is again the key element: Warren Buffett waited 35 years to achieve an on-cost dividend yield of 54% on Coca-Cola.

Conclusion

In light of all the above considerations, it is clear that neither strategy prevails over the other. Each has its own advantages and disadvantages: the best choice is the one that most closely coincides with your goals as an investor.

If you care little about the financial markets and just want to have a supplement to your retirement, then it will probably suffice to invest a small amount each month in an accumulation ETF on the S&P500; if, on the other hand, you are not willing to wait too long and want to see small results in the immediate term, then the distribution strategy is the most suitable. There is no right or wrong answer regardless.

In my opinion, the only wrong approach is to focus entirely on only one of the two strategies: it is probably better to do a mix than to be extreme.

Saving as much as possible and investing in order to become very rich in old age could raise quite a few regrets about how the best years of our lives were lived. At the same time, taking a short-sighted approach and investing only in companies with a high dividend yield without caring for sustainability and long-term growth can jeopardize the entire portfolio. After all, dividends are uncertain, and history is full of major companies that have been forced to cut them. Better to focus on dividend growth companies rather than high-yield companies, but even here a fairly long time frame is required.

Finally, to avoid misunderstanding, I would like to specify that the accumulation strategy does not necessarily guarantee becoming extremely rich in old age. As seen above, the impediments are many and only a few can perfectly follow a 30-40 year plan. Sometimes it also takes a lot of luck so perhaps it is best to invest moderately over such long time frames: we are not all Warren Buffett.

When it comes to accumulation, the Oracle of Omaha is the most striking example: many envy him but few understand what the path was to owning a net worth of $118.60 billion : a mix of intelligence, luck, and predisposition.

• He became interested in the stock market very early, at only 11 years old. Today he is 93 years old, so he has had an enormous amount of time to take advantage of compound interest. Very few people have the predisposition to take an interest in such matters from a young age (his father's job probably influenced this) and very few live as long as he did.
• As a child, Warren Buffett lived in poverty due to the Great Depression of 1929. This experience taught him the value of every penny and the importance of not squandering money from a young age. Despite economic hardships, Buffett had the opportunity to study as a teenager, which was not a given in those times.
• Warren Buffett is known for his humble lifestyle. He has lived in the same house since 1958, drives a 2014 Cadillac XTS, and has never led a lavish lifestyle. His patience is one of his distinctive traits, and he is capable of holding onto an investment position for decades to leverage the power of compound interest.
• In his early thirties, Buffett's net worth was $1 million, at 44 it had grown to $19 million, at 53 it reached $620 million, at 72 it was $35.70 billion, and today it is estimated to be $118.90 billion. Many individuals might have squandered everything, even if they were the world's best investors, but Buffett has demonstrated prudent financial management throughout his life.

Warren Buffet is an example of accumulation to the nth power, in fact, much of his wealth has been generated since age 60. Of course, he was already rich before, but if he had spent those millions to buy himself luxury cars and multi-million houses, he would not have achieved the same results as he has today. Probably some readers of this article live a more luxurious life than Warren Buffet and do not even envy him. It's all a matter of predisposition, and if you want to achieve huge sums through accumulation you must pay a high price.

In conclusion, it is fine to have a very long-term time horizon, but relying on it too much may limit daily life too much, making the investment process too stressful given the uncertainty involved. Dividends give important psychological support that can fuel curiosity about the investment world as well as improve the financial situation. So, as usual, the truth lies in the middle in my opinion: it is better to invest by following both approaches. I find it reasonable to prefer accumulation when one is young and then gradually shift toward distribution as the years go by.

I would appreciate your views on this in the comments. How do you handle the dualism between accumulation and distribution?

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