James Gruber explains why he doesn’t invest in dividend stocks. He believes that if you need income then buying dividend stocks makes perfect sense. If you don’t, it makes little sense because it’s likely to limit building real wealth. He runs through the numbers and speaks about what you should do instead to build real wealth.

In an article originally published on Firstlinks, a reader suggested a debate with Mark LaMonica, a well-known proponent of income investing strategies for those whose goals align. Mark lays out the case for income investing.

This episode wasn’t a call for investors to follow either strategy, but it is a call for investors to understand how different investment strategies support different financial goals. One approach isn’t always the answer.

Looking for more on investment strategies?

You can start with James’ article on why he doesn’t like dividend stocks.

Mark went through the process of connecting his Investment Policy Statement (IPS) to how he purchased an investment that aligns with the goals of his portfolio.

Shani runs through a financial advisers’ favourite strategy – Core/Satellite, and an alternative way to use it.

Is your goal passive income? Mark talks about how to generate $100,000 of passive income a year. Reaching six-figures in passive income is not easy but don’t underestimate the benefit of time in the market.

Shani outlines her investment strategy.

Mark runs through why he is an income investor. He believes the critiques of dividend investing don’t hold up to scrutiny.

Shani runs through growth investing so investors can understand whether it is the strategy for them.

Understand whether you are an investor focused on outcome maximisation or a speculator focusing on wealth maximisation.

We are strong advocates for creating an Investment Policy Statement (IPS). Regardless of the investment strategy and style you follow, it will anchor you to your goals and act as a north star during all market conditions. When forming an IPS, it is worth understanding the factors that contribute and detract from a return, that will help your total return outcomes.

Strategies through life stages

Mark has written a series about approaches to investing throughout life stages.

You can find them for your 20s, 30s and 40s.

You can find the transcript for the episode below:

Shani Jayamanne: So, today we have a guest episode and he takes the gong for the most guest episodes on Investing Compass.

Mark LaMonica: With two.

Jayamanne: Yes. Another one in the works.

LaMonica: There we go. So, not a big number, but the most. And that is James Gruber. So, James is the editor of FirstLinks. Prior to that, he covered Asia at a leading fund manager as a stock broking analyst and as a journalist. And most recently, he was a portfolio manager for Asian equities at AMP Capital, managing investments in Asia and China.

Jayamanne: And during his time there, the China fund was ranked number one globally over one and two years during this time. And to top this all off, he was also a television and radio news journalist at ABC and founded Asia Confidential in 2012.

LaMonica: Now before we started recording, I made a joke about Asia Confidential, but Shani was not paying attention. And it’s probably not something I should repeat on here, but just illustrates how you don’t listen to me at all. But FirstLinks is a Morningstar publication. And go to FirstLinks, get on their email list. James writes some really insightful articles on markets, on different products, on investments.

Jayamanne: And James wrote an article about why he isn’t a fan of dividends, hugely controversial, especially with particular members of the Investing Compass team. But he believes that if you need income, then buying dividend stocks makes perfect sense. But if you don’t need them, then it makes little sense because it’s likely to limit building real wealth. And he talks about what you should do instead to build it real wealth.

LaMonica: And when he posted this on FirstLinks, somebody suggested that we have a debate about dividends. So that’s what this episode is going to be today. So James will talk about why he doesn’t focus on dividends as part of his investment strategy. And I’ll talk about why I do.

Jayamanne: And this isn’t a call for investors to follow either strategy. There is no winner. It’s about understanding how different investment strategies support different goals. And one approach isn’t always the answer.

LaMonica: OK, so you’re just trying to soften the blow here by saying that there’s not going to be a winner in this debate.

Jayamanne: Exactly. And I think you’re both very thoughtful investors, Mark.

LaMonica: Well, that’s very nice of you. A little known fact about Shani is she was on the debate team in high school. So maybe you should take part in the debate.

Jayamanne: I was a debating captain, actually.

LaMonica: Well, there you go. All right. Well, enough about Shani. We will get into the debate with James.

James, you recently wrote an article titled Why I Dislike Dividend Stocks. And there was a comment on FirstLinks and somebody said that the two of us should debate them. So we’re here now. We’re going to talk about dividend shares. Now, Shani was very enthusiastic about this and wanted to get us boxing gloves. But we’re going to try to keep this civil. So why don’t you start out and just go over your article? What was the argument you were making in the article? Why do you dislike dividend shares?

James Gruber: I do feel like I’m walking into the boxing ring right now, given you’re Mr. Dividend. Look, the article for some context was about, was inspired by a podcast. David Gardner was on it, who’s the co-founder of the Motley Fool Investor Newsletter. He’s run it for, I think, about three decades now. He detailed his investment philosophies and what he’s done, and he’s been highly successful with them. He mentioned that he’d had seven 100-bagger stocks. Now, for those that don’t know 100-baggers, that means he’s made 100 times or more on his investment. So $1 invested is equal to $100 or more. Now, I don’t know about you, Mark, but there aren’t a lot of people that get one in their lifetime of 100-baggers. Getting seven is pretty incredible.

So that got my attention. He’d invested in NVIDIA and Amazon at a cost-adjusted price of $0.16. They’ve gone on to make him, I think it’s 1,100 times and 1,300 times his money. Pretty incredible stuff, but there are other stocks also. And he got talking about how he’d done it and the rules he’d applied to do it. And he obviously looks for market leaders in emerging growth industries is one key aspect. But he’s also got some other odd criteria like investing in expensive stocks only. He doesn’t want cheap stuff. He wants that which is expensive. He also likes it when stocks have run up a lot. Now, that sounds pretty counter-intuitive and it goes against what I invest in a lot. But if you look at his investing framework, it’s about a venture capital style of investing. He’s happy to have some losers amongst the stocks in his portfolio and he details many failures. But if he can invest in one or two big winners out of 10, he’s happy.

They’ll make up for a lot of the losses. And portfolio that he’s run has average 21% returns over a couple of decades he has done very well. It got me thinking about my own investing. I’m a growth investor as well, but do it very differently. I don’t invest in high-multiple stocks in emerging growth industries. I prefer lower growth industries, but different types. For instance, ones I like where they’re quite fragmented industries and you have a couple of companies that consolidate that industry. It can be really profitable from a revenue and cost synergy perspective. And they’re generally sort of lower growth industries and that’s nice because it doesn’t attract a lot of competition too. And there have been many industries like that, both in Australia and overseas, that where companies have done that and done it quite successfully in those industries.

But it also made me think about what my ideal type of company was. And ideally I want to invest in a growth company that has a return on equity that’s quite high, maybe 15%, 20% per annum over a long period of time. That doesn’t pay any dividends, that is on reasonable multiples as a purchase price, and that has a competitive edge in an industry that has barriers to entry so they can maintain that return on equity, that high return on equity over time. Now this gets to why I don’t like dividends as part of that. Well number one, if you think about dividend stocks, a lot of them that many investors invest in don’t have high returns on equity. They have lower returns on equity, a lot of them. But also even if they do have high returns on equity and they make a lot of money, paying that out to me as a shareholder can attract tax.

It also certainly attracts transaction costs. So it can detract from a total return perspective, even if you reinvest all of those dividends. And keep in mind that studies have shown that most people don’t reinvest their dividends at all. Well a lot of them keep it. Now there’s nothing wrong with dividend stocks, I want to make that clear. If you need income right now or over the course of the journey, then dividend stocks make sense. And they also make sense, can make sense as part of an overall portfolio where you have a mix of different stocks. Some are income stocks, some are growth stocks, some are other stocks. But from my own personal perspective, if I’m an investor over a 10 year plus period and I want total returns and to build my wealth, I think I can do that better and more profitably via growth stocks than dividend stocks. And that was the point of the article.

LaMonica: Okay, I was hoping that we could keep this debate civil, but you started by saying you’re listening to other podcasts. So Shani and I are obviously very offended with that. So maybe a question just to clarify for people listening that may not understand what you were saying. Can you talk a little bit about return on equity and why that is a good thing for a company, why that’s something you look for as an investor? Just people may not be familiar with the term or exactly why that’s important.

Gruber: To clarify on return on equity, equity is what shareholders put money into a company. So if I put $100 into a company and I own the company 100%, that’s $100 equity in that company. What the company subsequently earns as a profit on that is generally your return on equity. So say they make $16 on that $100, the return on equity would be 16% in a particular year. That can change obviously over years depending on what they earn and what their equity is. And what I like about companies is that they take that $16 and reinvest it back into their company rather than paying it out as a dividend. If they reinvest it in their company and they grow that equity and compound it over a long period of time, that can lead to a very valuable company. If they pay it out, it’s up to the investor to reinvest that in the company if they have that choice. And for then the company to potentially grow that over time. But some investors obviously don’t reinvest that so that equity is withdrawn from that company for good.

LaMonica: And you did use a couple examples and you were talking a little bit about the types of industries and companies you gravitate to. You were looking at the insurance brokerage market in both the US and Australia. And you did use a couple specific companies and you were showing differences. Obviously Australia companies tend to pay out a lot more dividends. We can get into that in a second. But do you want to explain that example and what you were looking at?

Gruber: The example of insurance broking was an example of a fragmented industry that has consolidated over time both in Australia and the US. And US top insurance brokers have been immensely successful in consolidating that industry and earning high returns on equity and therefore having spectacular shareholder returns over a two or three decade period. It’s less so in Australia but there have also been insurance brokers that have had success in consolidating that industry. And what I mean by that is that there are -- in a fragmented industry there are lots of little players. There might be a thousand small insurance brokers. Over time five of them may end up owning 70% of the industry. And that can be very profitable from a cost synergy and revenue perspective in grabbing that share over time. And that’s what’s happened in the US.

What’s happened in Australia is likely to keep on happening. And I’ve kept my eye on the US operators as a company called Brown & Brown. I think it’s the fifth largest insurance broker in the US. And it’s had a bit of a dip in share price and I looked at whether I should get in. It’s on around 20 times PE. It has an ROE that’s dipped from 14, 15% down to 11 over the past year. And that’s part of the reason why the share price has gone down. It pays little in dividends about 16% of their earnings. It pays out as a dividend. Then I looked at Australia. I looked at AUB, which has been a very successful insurance broker here. And its return on equity is 11% also the same as Brown & Brown in the US. But it pays a much higher dividend payout ratio of 56%, I believe it is, versus 16% for Brown & Brown.

Now, I did my calculations about what future returns might look like for these insurance brokers. And I think Brown & Brown can get back to that sort of 14% to 15% return on equity over time. Its dividend payout ratio is likely to remain low. And current multiples, and I don’t expect them to dip a lot over time. So I think your returns are going to be close to 14% to 15% over the next 10 years on Brown & Brown. On AUB, if you did the same calculations, with the dividend payout ratio and paying that out, that reduces your returns over time. So that 11% return on equity, if you extrapolate that, which I know is an extrapolation and is not a proper forecast.

But if you extrapolate that, and I don’t think that’s too far from the ballpark of what it might be. Your returns are going to be a bit lower than that over time, likely at these levels. Now, the valuations are slightly richer for Brown & Brown at 20 times PE versus 17 for AUB. Their returns on equity is similar right now, but I expect half for Brown & Brown. The dividend payout ratios are dissimilar. But what it makes you realize is that even if, let’s hypothetically say that Brown & Brown and AUB had the exact same characteristics. They had the same valuations, the same return on equity, the same industry prospects. But their dividend yields were different, and they were 56% for AUB versus 16% for Brown & Brown. I want to own Brown & Brown, all things being equal. For the sole purpose that their dividend yield is lower, it’ll attract less tax, although you have to take into account tax differences between the US and Australia. And that’ll be different for individuals. But in an ideal world, I would rather own the low dividend payout company versus the high dividend payout company.

LaMonica: And do you think, I mean, obviously dividends, in this case, both companies pay dividends? You said you’d obviously prefer. to find companies that do not pay dividends. But I think one thing is there are different buckets we can put dividend paying shares in. So in Australia is strange in a lot of ways around dividends, but I think there’s companies where they clearly have no opportunity. So companies that are not growing quickly, so they might be, and I think your example is different because clearly you think there are opportunities to go out there and continue to consolidate the industry, but then there are companies that are just not growing. And so in that case, you don’t have a lot of choices. There’s management, right? Like you could obviously buy back shares, you could pay down debt, you could give it out in dividends, but I think one of the things that I worry is that companies without dividends, management can make stupid decisions.

So obviously you’re relying on management to make smart capital allocation decisions. How is that something that you evaluate as an investor? Because that’s really important, right? That they can’t go out there and buy insurance brokerage for too much money so that there’s no returns when they’re consolidating. So how do you evaluate management? You’re putting a lot of trust obviously in management to make good decisions there.

Gruber: You make a good point. If a company isn’t growing and it earns below its cost of capital, which I know you would have discussed on the podcast, then it makes sense to pay out dividends rather than reinvesting it back in the company. And what often happens is that companies do make silly decisions. They make acquisitions that make no sense just to try and grow when they should be paying out that money to shareholders in dividends. You’re right. With growth companies, you need a certain trust in management. And I look a lot at the track record and what they’ve done. And I don’t mean a track record of two years or five years. I’m looking for through the cycle as in they’ve been through cycles of ups and downs in their businesses. And they’ve made sensible decisions over a very long period of time. Gives me some assurance of what can happen going forwards.

But you’ve also got to have a bit of a handle on industry dynamics. I actually, I invest as much in industries as I do companies. I often look at attractive industries and then look at companies within those. And insurance-broken is an attractive industry because it does have barriers to entry. I own a small business and small businesses and customers of these insurance brokers and small business needs are quite complex. They’re not easy to handle. And these insurance brokers do it quite well. I actually use an insurance broker for that reason. And yes, price does matter, but what also matters is that you need customized services part of that. And they do that. So there are barriers to entry. The complexity of the needs is a barrier to entry too. So I look at the industry, I look at management. I look at a lot of things when I invest in growth companies to try to minimize some of the risks involved in investing in that growth and that they won’t make silly decisions, that the industry won’t change and make it more competitive and less profitable for these businesses.

LaMonica: And then I guess that’s obviously one end of this dividend spectrum, but also, I would say that I am a dividend growth investor as in I want that dividend to grow. And so I think once again, looking at track records, and I’d say once again, this is differences between Australia and the US. So in Australia, dividends tend to just follow earnings. It’s a set percentage that’s paid out. There isn’t a lot of stigma if you cut your dividends in Australia, whereas the US is different. There’s a lot of stigma if you cut your dividends. That’s kind of a sign to investors you’re in trouble. And that’s why those dividend aristocrats in the US that have raised dividends for such a long period of time generally don’t have that high of a yield if you look at most of them, but they do have that history of growth. I think that’s more where I’m leaning as an investor.

So I don’t think we’re that far apart as much as this will disappoint, Shani. I just make the distinction that I would only buy a share if they have a dividend. And this did not work out well so far, but I’ve talked about CSL and how I bought CSL as a dividend investor. A lot of people think that that’s crazy because the yield is so low, but they’ve been growing their dividends steadily over time. And that’s where I’m trying to line up what I want in life, which is growing passive income versus investments. I mean, how do you think about that, sort of your goals as an investor and how at some point in your life you will have to fund those goals and the mechanism you’ll use to do that?

Gruber: You mentioned dividend growers, and they are not much different. If you’re a dividend grower, you are growing earnings as part of that. You can’t have growing dividends without growing earnings, which means you’re buying growth companies in many ways. You’re just buying dividends as part of that package. I look at it from a total return perspective in building wealth more so than a passive income perspective. And I believe that growth incomes are the better way to do it in my case. If you want passive income over time, then dividend growers makes perfect sense, and I own some Washington Soul Pattinson is a perfect example in...

LaMonica: The only dividend aristocrat in Australia?

Gruber: In Australia, yes. CSL is a curious one, though. I would say that what would put me off is recent management actions. I don’t think that they’ve been totally sensible. They’ve made some poor acquisitions, and financial engineering of late that is questionable, in my view. That would put me off, and I’ve said for some time that the trend in CSL’s return on equity and return on capital has been concerning for a long time. It’s been going down, I think, for almost a decade from its highs. It took a long time for investors to realize that, actually. But those acquisitions that have turned poor have really made that stark. And reigniting that growth, I’m not sure if they’re on the best path, but we agree to disagree.

LaMonica: There we go. So hopefully that gives Shani some of her violent disagreement that she’s looking for. I think just from a goal perspective, so obviously total return and then just trimming your portfolio when you’re going to start spending the money.

Gruber: Yes.

LaMonica: That’s your intention.

Gruber: Well, that’s right.

LaMonica: Yeah, so I think interestingly enough, we’re not that far apart. So I wrote about this in an article that there was this research done by Hartford Funds and Ned Davis Research in the US, and they were looking at returns between 1973 and 2022. They were looking at the S&P 500, and they basically divided up shares into dividend payers and non-dividend payers. But then they also divided them up into companies that grew their dividends, companies that cut their dividends, companies that kept their dividends steady. And actually the best returns were from companies that grew their dividends. But I think that is probably making both of our points. As you said, you do obviously have to grow earnings to grow your dividends. That is a long period of time, 1973 to 2022. If you’re able to grow your dividend the entire time, you’re doing pretty well as a company.

Gruber: Yes, I look at those studies, and I used to think that they were gospel, but now I don’t think they are as gospel as they once were. As in...

LaMonica: This is a very Trump-esque move. I give you a study and you say you don’t believe it.

Gruber: What is the use, truth, social or whatever is...

LaMonica: You can do that while you’re listening to other podcasts.

Gruber: Yeah, look, I’ll give you my handle on it soon. Those things that they measure can change over time. So I think that you’ve got to think through it more logically than rely on backtester studies. The reason I say that is that there are some backtester studies, and this goes off the topic slightly, but there used to be backtester studies that low price-to-book stocks were basically the best performers across time. And the very famous studies, that has changed a lot over the past couple of decades.

LaMonica: It’s a whole three-factor thing.

Gruber: The whole three-factor thing.

LaMonica: And then they all stop working.

Gruber: Yeah, factors change over time. And I would be -- not skeptical, but I do think that factors working change over time, and I think competition eats at those returns over time. As in if something works over a period of time, it may not work all the time, and you’ve got to apply your own common sense to that.

LaMonica: Now, one of my arguments for...

Gruber: Not that I disagree with dividend-growing stocks.

LaMonica: One of my arguments for income investing is it’s easier. So now, we obviously talked about your background during the introduction we did, but you used to be a portfolio manager. So you’re obviously very good at this. Most investors are not good at this, and this being investing. They tend to obviously chase things. They maybe take more of this Motley Fool approach, where they are trying to get these 100 baggers, but don’t actually do it. They’re chasing things. They get into late. All sorts of problems. Trade too much. And so I think one of the challenges is, to, try to find hundred baggers. You need to do a lot of research. You need to really understand these emerging industries where there is still not a stable competitive environment. So you are trying to pick winners in these emerging industries, and all of that’s very hard.

And so I guess I’ve always sat there and thought, okay, well, it is easier to find dividend-paying shares. They’re more mature companies. They are, as you said, you look for slower-growing industries. Well, they’re generally boring, slower-growing industries. There’s more established, a more established competitive environment so that things like moats are more obvious. So I guess my argument has always been that I’ve always thought that that is easier to do than trying to go out there and invest like the Motley Fool podcast you listened to. It kind of seems like you’re saying the same thing, that you, even though you were inspired to write this article off that podcast, that’s not the way that you actually invest.

Gruber: I agree. It’s a hard way to invest. And you’ve got to be able to take a lot of failure. You’re likely to fail eight times out of ten.

LaMonica: That’s an average day for me with everything that I do.

Gruber: No, I mean, if you’re investing in those growth companies, I think he mentioned he invested in the likes of Peloton and those kind of companies that have gone pear-shaped big time. You’ve got to be able to take that and stomach that. Not many investors can do that. Also, you’ve got to be able to identify those growth industries and really know them well. What I would say about any investing is that to try and niche it down as much as possible. As I said, I focus on particular industries, the ones that are fragmented and consolidating and lower growth industries. It’s a bit of a niche. There’s some of them out there, but there’s not a lot, and there’s enough to invest in and be attractive to me without being attractive to a whole lot of other investors. I think that investors try to spray bullets all over the place.

They try to invest in different ways. I would suggest be as niche as possible. I think Peter Lynch called it well, invest in what you know in many ways. Even if you don’t know something, but you find a particular niche and you focus in on that, it’s a better way to go than trying to do something big and bold that could come unstuck. It’s a high-risk, high-return strategy that David Gardner is employing. He’s done it well, but it certainly is not for everyone.

LaMonica: I think that’s probably a really good place to end this. It’s a really good message because I think a lot of investors get confused around what diversification is. I think it’s sold by the industry and industry trying to sell products in all these different places. That diversification means you need to do everything. You need your growth investing, your value investing, and emerging markets and frontier markets. That’s not really necessary, but good place to end it. I think the best message is everyone should find something they’re comfortable with that aligns with what they’re trying to accomplish and their strategy. I think we actually agree about more than I think Shani hoped before we recorded this. Thank you very much for joining us and thank you everyone for listening.

Gruber: Invest your way, right?

LaMonica: Invest your way.

Invest Your Way

A message from Mark and Shani

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