Focus on dividend-paying stocks not good strategy

I've used this space to talk about on the importance of knowing why we invest, in any instrument, be it equity, debt, real estate, etc.

And at one point of time even highlighted the current trends and changes in the way valuations are being done especially since the advent of tech giants like Amazon and the prevalence of sharing economy.

I discussed if it's time for different metrics to be followed to analyse a company.

But, in general, investing in stocks is for two reasons. One to have appreciation in the stock price and so the portfolio value of the investor.

Second is to earn income through dividends. The latter is out of profit generation, in most cases, and in some cases when the cash reserves increase and don't find much opportunities to deploy the higher cash reserves.

This is a concern, particularly if it continues for a prolonged period, which means the company is unable to find ways to make more money, expand and thus future growth prospects are a concern.

In the former, the appreciation of stock is based on superior growth performance, higher profitability and expansion of its products or services, etc.

The other possibility is also due to the stock buyback (by the promotors) which reduces the free float and liquidity in the system (markets) and thus the increase in the stock price.

This is a supply side issue. The primary reason for stock buyback, at least assumed at most cases, is the promotors confidence in the company and its future prospects that it would want to retain most of its profits within.

Of late, however, despite better profits, many companies are veering towards stock buybacks to enhance the stock price as most the executive compensation is linked to the stock performance also.

One needs to be aware of the free cashflows of the company and its logic behind the buyback before investing.

Warren Buffet, the oracle from Omaha, investing in stocks tantamount to investing in a business. Even reiterates that if one has to closely follow a company then one shouldn't own it.

His view of long term is much longer than majority of investors and runs into holding a stock for decades. He equals owing a stock with buying a farm.

Do you go up and look every couple of weeks to see how far the corn is up? Do you worry too much about whether somebody says this is gonna be a year of low price because its exports are being affected or anything like that?

No, you buy a farm and hold it, it doesn't grow faster if you go and stare at it. I know there's going to be some years when prices are gonna be good. Prices aren't gonna be good.

I know there's years when yields will be better than others. I don't care about economic predictions or anything of that sort.

I do care that over the years it's well tended to in terms of rotating crops and I hope the yields get better, which they generally have. In fact, that farm a hundred years ago probably produced 30 bushels, may be 35 of corn per acre. Now in a good year it would be 200 bushels.

It's long-term investment is what he claims. Companies are meant to stay forever, though the reality is different. According to a study by Hendrik Bessembider, a professor at Arizona State University, there were almost 26,000 publicly traded US companies during the last 90 years till December 2016.

They were listed for an average of just seven and a half years, where some companies were bought out (merger & acquisitions) and the rest were vanished as they struggled financially to their oblivion.

In face only 36 stocks were around for the full 90-year period of this study and that's a dismal 0.34 per cent of the entire listed stock universe.

This brings to the second reason I'd listed out for investing in stocks i.e. for income generation other than mere capital appreciation which is always notional.

In the last two decades, the corporate standings in America have changed drastically and big names like GM (General Motors) and Ford are replaced by Amazon, Apple, Berkshire Hathaway, etc.

But as Bessembinder writes, "GM common stock was one of the most successful stocks in terms of lifetime wealth creation for shareholders in aggregate, despite its ignoble ending".

GM was delisted in 2009 at 61 cents down from $93 less than a decade earlier when it filed for bankruptcy.

According to the study GM has paid out over $64 billion in dividends over the decades prior to the bankruptcy and stands eight among all the US corporations on creating wealth for shareholders.

But, imagine if one were to have invested in Amazon in almost its past two decades of listing. No buyout, no dividend, no stock buyback and of course, it has survived more than the average listed US corporation but hasn't yet made any cash to the investors except to those who traded for capital gains.

I'm not making a conclusion here that one has to look for dividend paying stocks only but a balance of growth and cash. Does this point to the changing metrics which I'd discussed earlier or is this how the stock market investment translates going forward?

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at [email protected])