Total Return

[earthtodan]

(05-24-2015, 08:20 AM)KenBob Wrote: The key problem is that capital gains are unknowable. You can not plan for capital gains.

Planning for capital gains isn't much different than planning for dividend growth. Capital gains over the long term is a structural consequence of growing earnings and dividends in a functional market. I think a better question would be, why would you want to ignore it?

I would agree with the argument that, in the context of long term compounding and reinvesting, people who have trained themselves to look at investments only from an income perspective and ignore capital gains are taking an overly puristic approach.

Dividends are just one form of capital allocation. A dollar paid out as a dividend is not subject to market valuation, i.e. at risk of being worth less than a dollar, or at risk of being wasted. However, a dollar reinvested in the business, while put at risk, has the potential to return more. Money reinvested in business growth is necessary for economic growth and dividend growth. In fact, cash paid out as dividends arguably destroys shareholder value due to opportunity cost if there are alternative uses that could have high internal returns.

I consider myself a recovering dividend growth investor. DGI is a great way to learn about investing and is a perfectly good strategy, and still forms the basis of my approach, but it can also be a narrow strategy. A holistic approach is to consider the value of all forms of capital allocation (dividends, buybacks, growth spending, acquisitions, and deleveraging). True, this type of growth is subject to market valuations, economic cycles, and your ability to sell higher. But in a functional economy and a functional market, business growth will be valued appropriately because institutional investors won't leave money lying around in the street.

A good example of a total return investment that I own is UNFI. United Natural Foods is a distributor of natural and organic foods and other supermarket items, with Whole Foods as its largest customer. The company has been expanding at about a 15% annualized rate for at least a decade. UNFI doesn't return anything to shareholders via dividends or buybacks, because all their money is better spent building more distribution centers, hiring employees, leasing trucks and expanding their service territory, as well as making small acquisitions. If they hadn't spent their money on growth, they would have missed a 15% internal return so far, and shareholders would have paid the opportunity cost. If they had stayed small and paid dividends instead, and you had reinvested those dividends, you would have surely made a lower return. You would also own a less stable business today.

When the growth runway slows, UNFI will start returning cash to shareholders. They mentioned in a recent conference call that they see about two more years of reinvestment in the business before they start diversifying their capital allocation strategy. If and when they start returning money to shareholders, it will be a lot more money than if they had remained a small business. The intrinsic value of the shares has gone up over the last 10 years because of their growing underlying cash generation.

The stock market could correct and UNFI shares could crash, and I would have nothing to show for it. This would be a buying opportunity because ultimately, the company makes money and therefore has intrinsic value to owners.

The portion of the earnings not paid out as dividends should compound internally at the rate of RoE or RoI (this is still a bit fuzzy to me) in a way that only management has the ability to do. The part of earnings paid out as dividends will not earn those returns; that is now your money and your responsibility.

A growing dividend is a sign of a strong business, real earnings, an anchor on the price, and an important part of total return, but it is not always the best form of total return, and not the only way I want my money spent.


Edit: I should add that in 30 years or so I plan to start rotating out of total return and into yield, hopefully during years when I can tuck my capital gains into the lowest tax bracket.