on the New York Stock Exchange, didn't invest in the market looking to make a quick buck. He put money away for the long term, expecting the investment to generate a greater return than he would have been able to achieve elsewhere (and possibly some income).
He was willing to take risk, but not to the point where he was speculating on companies with such ludicrous business ideas that the only way to make money would be to find someone more foolish than he to buy his shares. This is an actual – and badly flawed theory used by some. Not surprisingly, it is called the Greater Fool Theory.
There were all kinds of companies, TheGlobe.com, Netcentives, and Quokka, to name just a few, whose CEOs declared we were in a new era: This time was different. When I asked them about revenue, they told me it was all about “eyeballs.” When I pressed them about profits, they told me I “didn't understand the new paradigm.”
Maybe I didn't (and still don't). But I know that a business has to eventually have revenue and profits. At least a successful one does.
I'm 100 % certain that if Grandpa had been an active investor in those days, he wouldn't have gone anywhere near TheGlobe.com.
One principle that I believe many investors have forgotten is that they are investing in a business. Whether that business is a retail store, a steel company, or a semiconductor equipment manufacturer, these are businesses run by managers, with employees, customers and equipment, and, one hopes, profits. They're not just three- or four-letter ticker symbols that you enter into Yahoo! Finance once in a while to check on the stock price.
And these real businesses can create a significant amount of wealth for shareholders, particularly if the dividend is reinvested.
According to Ed Clissold of Ned Davis Research, if you'd invested $100 in the S&P 500 at the end of 1929, it would've grown to $4,989 in 2010 based on the price appreciation alone. However, if you'd reinvested the dividends, your $100 would've grown to $117,774. Clissold says that 95.8 % of the return came from dividends.3 (See Figure 1.1.)
Figure 1.1 1929–2010: $100 Original Investment
Source: Chart: Marc Lichtenfeld; data: Ned Davis Research
Marc Lichtenfeld's Authentic Italian Trattoria
Years ago, my wife and I were in Ashland, Oregon. We loved the town and started talking about escaping the rat race, moving to Ashland, and opening a pizza place. We've repeated that conversation on trips to Banff in the Canadian Rockies; Asheville, North Carolina; and even Tel Aviv, Israel.
Considering that I know nothing about the restaurant business, would not be happy if not in close vicinity to a major American city, and am a lousy cook, the pizza joint remained a happy fantasy.
But for the purposes of this book, Marc Lichtenfeld's Authentic Italian Trattoria will serve as an example of a business with revenue and profits. We're also going to assume that I'm your brother-in-law (your sister was always a very good judge of character) and you've agreed to become my partner in the business.
One day I come to you, my favorite brother-/sister-in-law, with my plans for the restaurant. I have the space lined up. It's in a popular location with a lot of foot traffic. I've been talking with a wonderful young chef who is eager to make an impression on local diners and critics. All that's missing is start-up capital.
This is where you come in. In exchange for a $100,000 investment, you will receive a 10 % ownership stake. I show you my projections: The restaurant will break even the first year and make $100,000 in the second year and $200,000 in the third year.
One of the questions you may have is how will you get your money back. Do you have to wait for the restaurant to be sold, or will you receive some of the profit each year?
If I tell you that my goal is to build the business to $1.5 million in sales and then sell it for two times sales ($3 million), where you'll receive $300,000, your response might be very different from what it would be if I tell you that half the profits will be invested back in the business with the other half split up among the partners in a yearly payout (dividend).
Your decision on whether to give me the money will depend in part on your goals. Are you willing to speculate that you'll receive the big payoff in several years when the business is sold, or would you rather receive an income stream from your investment but no exit strategy (plan to sell the restaurant)?
When buying stocks, investors have to make similar decisions. Do they buy a stock with the sole purpose of selling it higher down the road, or do they buy one that provides an income stream and opportunities for income growth in addition to capital gains?
I don't know about you, but if I'm investing in someone's business, I want to see some money as soon as possible rather than wait for an exit strategy.
Here is another factor that might affect your decision to invest in my trattoria: Instead of offering to pay you your cut of the profits every year, I might offer to reinvest that money back into the restaurant and give you more equity. That way, your piece of the profits gets larger each year. Eventually, you can start collecting a significant cash payout annually, or receive a bigger slice of the pie when you sell your stake in the business because your equity has increased above your original 10 %.
This last scenario is the same as reinvesting dividends, a method that is the surest way I know of to create wealth.
And what I love about this strategy is that it works (and has worked) no matter who is President of the United States; what happens in Europe, Iran, or the Middle East; how high unemployment and inflation are; and so on. Sure, those things will affect your short-term results, but over the long haul, they mean nothing and in fact could help you accumulate more wealth, as I'll explain in the section on bear markets in Chapter 3.
The Numbers
Investing in dividend stocks is the best way to make money in the stock market over the long term.
But don't just take my word for it. Harvey Rubin and Carlos Spaht II, both of Louisiana State University in Shreveport, write, “For those investors who adopt ten and fifteen year time horizons, the dividend investment strategy will lead to financial independence for life. Regardless of the direction of the market, a constant and growing dividend is a never-ending income stream.”4
Just a few pages ago, I told you that dogma doesn't work, yet here I am sounding fairly dogmatic. The proof that dividend investing creates wealth is in the numbers.
First of all, investing in the stock market works. Since 1937, if you invested in the broad market index, you made money in 69 out of 76 rolling 10-year periods, for a 91 % win rate. That includes reinvesting dividends.
The seven 10-year periods that were losers ended in 1937, 1938, 1939, 1940, 1946, 2008, and 2009. The periods 1937 to 1940 and 1946 were tied to the Great Depression. The 10-year periods ending 1936 to 1940 were brutal with an average decline of 40 %. The decade ending in 1946 was much tamer with a loss of 11 %. The 2008 and 2009 10-year periods each lost 9 %.
Paul Asquith and David W. Mullins Jr. of Harvard University concluded that stocks that initiated a dividend and increased their dividends produced excess returns for shareholders. Additionally, the larger the first dividend payment and subsequent dividend raises, the larger the outperformance.
