WE - Growth Vs. Income: What Are We Betting On And Why?

2023-08-15 07:33:02 ET

Summary

• Earning that average but still often elusive "equity return" over the long term is the goal for most investors.
• But "total return" is "total return" and there are lots of ways to achieve it.
• "Growth" can also be attained in various ways, not all of them requiring "growth stocks".
• That was a radical statement on Seeking Alpha a decade or so ago.
• Now it's gone mainstream.

[This article is adapted from an upcoming lecture.]

Asset Classes: What Are We Betting On, And Why ?

People first starting out as investors often ask: What should I invest in? By that they usually mean "What asset classes" should I invest in; meaning, should I invest in stocks, bonds, real estate, gold, silver, bitcoin and other "crypto currencies"? Also "collectibles" of one sort or another: paintings, jewelry, stamps…?

The answer depends on addressing an even more basic question: Why am I investing?

For some people, investing is sort of like gambling. They buy assets and hope they'll go up in value and they'll make a profit. Most collectibles fall into that category, as do many more traditional asset classes like gold and silver, as well as many newer asset classes like crypto-currencies, where relatively few purchasers probably even understand what it is they are buying or what its "fundamental value" is.

Many people even buy stocks on that basis, tending to buy whatever is considered "hot" at the moment, and just hoping that it will stay hot and keep going up long enough for them to make a profit and get out.

Ancient History (The Roaring 20s)

Prior to the 1930s, most investing was of that type and the average investor during the "Roaring 20s" before the crash of 1929 and subsequent depression thought of the New York Stock Exchange and other stock trading markets as essentially Las Vegas-style gambling and not "investing" as most of us think of it today.

That began to change in the 1930s when Benjamin Graham and his co-author David Dodd published their ground-breaking book Security Analysis , in 1934. It introduced the idea of "fundamental value investing" which was - at the time - a radical idea that emphasized using basic analytical methods, of the kind we routinely use today, to determine what a company's future earnings and cashflows were likely to be.

At about the same time, an economist named John Burr Williams wrote a book called The Theory of Investment Value that explained, mathematically, how an efficient market would value the future earnings and cashflow that Graham and Dodd's analytical methods would enable us to determine.

John Burr Williams explained how the current economic value of a stock, bond or other asset (i.e. its market price today ) should (in a rational world) equal the discounted present value of all its future cash flows. That means its market price would reflect the total of all the asset's future dividend or interest payments, plus the final residual value you would receive when you sell the asset or wind up the business, discounted back to their present value today .

Straight-forward and intuitively obvious as this concept is, there are a lot of moving parts and analytical choices to make in applying it, especially determining the appropriate discount rate to use in determining that "present value." That discount rate would have to reflect both the current interest rate level, as well as the degree of risk in the investment. Obviously the higher the interest rate level, as well as the higher the risk, the lower would be the present value of that stream of future cashflows.

Complicated as all this may seem, putting the work of these three men together was a huge leap forward for investing, a fundamental change from the 1920's when investing in stocks was considered to be more like buying lottery tickets and hoping for the best.

Graham and Dodd showed us how we can use analytical tools to evaluate the past record of a company and to predict its future performance. Then Williams showed us how to evaluate that future performance - the stream of future profits and cashflows - and express it in a market price. At least a theoretical market price. But since markets aren't always "rational" or predictable, the discounted present value we come up with may NOT be the actual market price. But at least it is a good starting point for valuing a security, and once we have a starting point or a value we think is rational, then we have a basis for judging whether the real market price on a given day looks attractive or not, and whether the stock looks like a bargain or appears overpriced.

Now, almost a century later, their work still explains and underpins the whole idea that stock markets are not casinos, but are vehicles - albeit imperfect ones - for pricing and trading investments that have rational, determinable economic value .

Our Own Investing

That's the theory on which our modern investment industry is based, and it makes as much sense today as it did back in the 1930s. While nothing is a sure thing, based on historical experience as well as our own logic and common sense, I believe there are asset classes we can invest in with reasonable confidence that if we are patient and take a long-term view, the economic worth of the investment will grow at some fairly predictable rate over the next several decades. That's the level of confidence we need if we are to embark on investment programs with a reasonable assurance that if we follow them for 20, 30, 40 years or more, they will result in an outcome that meets our personal retirement or other financial goals.

For many investors, that "fairly predictable rate" that we target is an average return of about 9 or 10% per year. We pick that target because 9-10% is approximately what average returns on stocks have actually been over the past century. Some equity investors do better than that, others do worse, but if someone can match that average or even come close to it over a lifetime of investing, they (and their dependents as well) should be pretty happy later on when they reach and surpass retirement age.

To put 9-10% returns into perspective, we should note that if we earned an average return of 9% over the long-term, we would double and redouble our portfolio value every 8 years. So after 8 years we'd have twice what we started with, after 16 years we'd have 4 times as much, after 24 years 8 times as much, after 32 years 16 times what we started with, and so on. The point is, many active investors might think 9% per annum is unexciting, but in reality it would be a powerful earnings rate over the long term.

If an investor were fortunate enough to achieve the higher end of that 9-10% historical range, and averaged 10% returns for the long-term, they'd double and redouble their portfolio value about every 7.2 years. So they would hit 16 times what they started with after only 29 years and would be up to 32 times what they started with after about 36 years.

Bottom line, an investment strategy that merely meets the historical average equity return , can be a powerful lifetime wealth builder, due to the power of reinvesting and compounding over the long term.

The big question: "How to achieve that 9-10% return?"

Return, or "total return" as it is often called, has two components:

• Cash received (dividends or distributions paid by your securities)
• Plus market price appreciation or depreciation.

Growth Stocks vs. Income Stocks

For many years, most investors tended to think that price increase (or decrease) was practically all that mattered. Our media - CNBC and others - have encouraged this idea, that price increases and decreases deserve almost all of our attention, and they tend to downplay the role of "cash income." It makes sense that they would do that, since price swings up and down, which they cover on TV all day long almost like it's a football game, are easy to report on and catch people's attention. Reports that "the Dow Industrials is up by 200 points… or down by 150 points, etc." easily catch viewers' attention and attract an audience that then becomes hooked on the minute-by-minute drama of market movements. Notice sometime how the media covers stock price movements much the way ESPN covers sports. (For more detail on this theme, check this out. )

Growth stocks, which pay very little in the way of dividends, often 1% at most, are almost totally dependent on market growth of 8-9% per year in order to make up the difference and achieve a long-term equity total return of 9-10%, since they get so little of it in the form of cash dividends.

A good example of a growth stock would be Amazon ( AMZN ). It pays no dividend so its yield is 0%, which means shareholders are totally dependent on price appreciation for their entire return. Anyone who bought Amazon ten years ago would be very happy, as its price has gone up by almost 10 times over that period. But someone who bought it 3 years ago has actually seen their investment drop by 10% over that period. Or if they bought it a year ago, they would have essentially just broken even on their investment. The point is that with most growth stocks, we sort of "live or die" based on the market price swings of the stock, and we just have to have faith that if the underlying company does well over time, that eventually the market - being rational in the longer term, if not always in the shorter term - will reflect that in the price.

Another growth stock example is Apple ( AAPL ). Unlike Amazon, it pays a dividend, although it's a very small one; its yield is about one-half of 1%. So the dividend is a very small part of its overall total return. Apple has done even better than Amazon over the past 10 years, growing its price by about 11 times, and during the past 3 years while Amazon lost 10%, Apple actually earned a positive 60%; and if buyers bought it a year ago, they would have earned 9%, versus Amazon's breaking even.

Both Amazon and Apple have been great stocks for investors smart or fortunate enough to buy and hold them over long periods. But it is worth noting that even for good long-term performing growth stocks, there are occasional "white-knuckle" periods where investors are sitting there worrying because the stocks are not growing, or may even be dropping, and you have the choice of either "keeping the faith" and holding on for the eventual recovery, or cutting your losses and reducing your position or hedging in some way. These "defensive actions," while well intentioned and understandable, almost invariably end up costing investors money or reducing their upside opportunity.

Many investors find the volatility - the ups and downs - of holding growth stocks a bit too stressful. That is particularly true when we realize that for every highly successful growth stock story, like Amazon or Apple, that we hear about, there are dozens of other companies whose stocks have not done nearly so well, or have even failed to stay in business. Like WeWork ( WE ), a recent start-up that had an estimated valuation of $47 billion less than 4 years ago, but last week appeared to be on the verge of bankruptcy.

Given the volatility and minuscule yields of most growth stocks, many investors, in their quest to achieve that historical equity average return of 9-10%, choose to invest in index funds, where they buy a diversified "basket" of hundreds of stocks that reflect the entire stock market or a major segment of it. Best examples are the SPDR S&P 500 ETF ( SPY ), or the SPDR Dow Jones Industrial ETF ( DIA ). But even indices like SPY and DIA only yield about 1.5 to 2%, which means patient investors still have to suffer through bear markets and downturns with very little cash flow to reinvest and comfort themselves that they are still growing their asset base, albeit at a very slow rate. While numerous economists and even a Nobel Prize winner or two have demonstrated conclusively that a long-term buy-and-hold indexing strategy is the most cost-effective and sure way of achieving an equity return over the long term, it still can require an iron will and nerves of steel to stick with the program during bear markets and other downturns.

Enter "Dividend Growth" Strategies

That's why so many investors have turned to more income-based strategies, focusing on the stocks of well established companies, like utilities or other familiar, well-known "blue chip" companies that pay higher dividend yields. Unlike growth stocks like Amazon or Apple that have to depend almost exclusively on market price growth for their total return, older, more established companies are more likely to give their shareholders a balanced total return, one that is a combination of cash dividend yield and market price growth.

Exxon ( XOM ), for example, is about as "blue chip" a company as you'll find. Unlike Amazon or Apple, Exxon pays a serious dividend, and it has increased it every year for the past 41 years. Its yield has averaged 4.6% over the past three years, although recently XOM's stock has risen to where the yield is down to 3.25%. So any investor seeking that 9%+ equity return is getting a third to a half of it in cash every year from Exxon, and only needs to rely on capital appreciation for the remainder. So if some years they only get a third to a half of their target return, and have to wait for an upturn for the rest, they can sleep better at night while waiting for it, than if they were only holding "growth sticks" that paid 1% or so.

There are lots of other "dividend growth" candidates out there. Dominion Energy, a major utility company, recently paid a dividend yield of 5.4%. Duke Energy pays out 4.6% and has raised its dividend every year for the past 19 years. Real Estate companies, like Simon Property ( SPG ) or cell tower owner Crown Castle ( CCI ), both offer cash dividend yields over 6%.

Stocks like these offer investors the opportunity to collect a major portion of their target return in cash, rather than having all their eggs in the "capital appreciation" basket. As we said earlier, "total return" is the sum of the cash dividends we collect plus whatever capital appreciation (or depreciation) we experience. So a 10% cash yield and 0% capital appreciation gives us the same return as a 0% cash yield and 10% capital appreciation, or 5% cash yield and 5% capital appreciation. It's all the same to us, as investors, especially if we are investing in an IRA where there are no tax issues to worry about.

But while it makes no financial difference whether we earn our total return in cash or in price growth or some blend of both, it can make a big psychological or emotional difference to many investors. If we are totally dependent on growth for our total return, and are collecting no cash or very little cash in the form of dividends, it can be very stressful to wait through the down market periods, like we had in 2022, where your portfolio is racking up "paper losses" and you're just sitting there waiting for a turn-around that may come any day - or a year or so later. That's when many investors get nervous and go out and do things, like going to cash or switching to other assets (like bonds) with lower earnings prospects. Things that they regret later when the market finally picks up and they find themselves standing on the sidelines watching it take off without them.

It is during down market periods like that when many investors really enjoy collecting a steady stream of cash dividends, which makes it emotionally easier to wait for the eventual recovery. In fact, investors who are still in an "accumulative mode" and not yet having to live on their dividends, find they can grow their long-term wealth faster than ever during downturns because they get to reinvest and compound their cash dividends in additional stock at bargain prices.

Some investors, like me, actually focus primarily on high-dividend paying stocks and funds, and are happy to achieve virtually ALL of our long-term growth through reinvesting and compounding our high cash distributions, so we don't even have to worry much about stock price growth.

In summary, when we buy equity, i.e. stocks in companies (or mutual funds that hold equity), we are essentially "betting" on those companies continuing to provide us with an equity return that will be some combination of (1) organic growth in the company's earnings that the market will recognize and grow the company's stock price over time at a similar rate, and (2) a cash dividend yield sufficient that when you add the two together your overall rate of return will be somewhere in that 9-10% range of historical average equity returns.

The choice of what types of stocks or funds to buy - "growth stocks", dividend or income stocks, or something in between - depends mostly on each individual investor's risk/reward comfort level, as just described.

Mixing It Up A Bit

There are all sorts of other asset types and strategies that can be mixed into this blend. Bonds, which are an investment in a company's debt, as opposed to its equity, have a whole different set of risks and rewards. With bonds you are betting on whether the company that issues them will survive and pay its debts; not on whether it will grow and increase its profits. The win/lose threshold with bonds is much lower. Either the company pays you back , or it doesn't.

For companies that are well established and have very high credit ratings, bonds represent very little risk… but also little reward as well. Especially long-term fixed-rate bonds, where the issuers are so highly rated that there is very little real credit risk, and your "bet" represents more of a bet on interest rate levels than on whether the companies issuing the debt will repay it or not.

However, there is a more interesting segment of the corporate debt market, which involves the loans and bonds of less highly rated companies, where credit risk is a real factor, and where you also get paid well for taking the credit risk. This is a market where many investors decide they would prefer to make their 9-10% "equity" return by buying high-yield corporate loans and bonds and taking credit risk, rather than taking conventional equity risks.

As we said earlier, as investors we should be indifferent about whether we earn our 9-10% "equity return" in the form of cash interest or in a combination of cash dividends and capital gains. The one caveat to that is taxes. Interest is taxed at regular income tax rates, whereas most dividends and long-term capital gains are taxed at qualified tax rates, which can be 0%, 15% or 20%, depending on a taxpayer's overall income level (15% for most taxpayers). So most of the attractiveness of high yield bonds as an "equity substitute" is for IRA and other deferred-tax investors.

A big advantage of high yield income strategies comes when investors reach retirement age and need to begin taking a portion of their portfolio total return to live on, rather than re-investing it. If we invest in stocks, whether growth stocks or higher yielding dividend stocks, our cash dividends often do not cover all of our income needs. That means we have to sell a portion of our portfolio each year to generate the income we need to live on or for other retirement needs. That's fine if the market has been rising and we are just taking some of our capital appreciation but not reducing the capital we started that period with. But if we are in a bear market or downturn, having to sell out some of our capital to create income, at what may be a market trough or bottom, may be like "eating our seed corn" by forcing us to turn "paper losses" into permanent ones.

Here's where a credit-based portfolio, that generates the same high interest income regardless of whether the principal goes up or down, can prevent our having to sell off principal at a loss in order to have the 5, 6, 7 or 8% income we need.

Wait, Are You Telling Me To Buy Junk?

Guilty as charged. Whenever I tell equity investors they can make the same long-term returns in the high-yield debt market as in the equity markets, but typically with less volatility, the first objection I hear is: You want me to buy "junk" bonds. But aren't they so risky?

This is one of the most misunderstood topics within the financial community. Despite the unfortunate nickname - "junk" - given to non-investment grade credits back in the 1980s, companies rated BB+ and below actually comprise the majority of all corporations, including many we deal with every day. More important and relevant to investors is the fact that the debt of these companies that we invest in, including both the secured loans and the unsecured bonds, are all higher on the balance sheet than the companies' equity. That means the so-called junk bonds and other debt have to be paid in full, or the equity below them is worthless. The mid-cap and small-cap equity funds that so many investors buy contain mostly the stock of companies that are non-investment grade (i.e. junk). So when an investor buys a small-cap or mid-cap stock, or a fund that buys stocks in those sectors, they are buying stock that is much riskier than buying the debt of those same companies; the "junk" debt that many of those same investors swear they'd never buy.

Bottom Line

There are lots of ways for investors to earn that long-term 9-10% equity return that most of us seek. We can do it through growth stocks that generate little cash income but produce capital gains sufficient to meet our target. We can take a middle-of-the-road approach and invest in unexciting but predictable blue-chip dividend-payers that split the difference between cash dividends and modest (but hopefully steady) growth. Or we can utilize an even higher yield strategy where we "create our own growth" over time through reinvesting and compounding, without having to worry much about growth and market volatility. The key is to pick a strategy that makes sense to each of us, both financially and emotionally, so we can stick to it through thick and thin over the long term.

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