Dividend growth investing and "double compounding"
Chapter 11 of "Getting a Better Class of Enemy", my investment book
I'm writing an investment book called "Getting a Better Class of Enemy - Money, Markets and Manias". As I write the chapters, they will be made available to paid subscribers to OfWealth. Previous chapters, along with the Preface and Chapter Plan, can be found by clicking on this link.
The reason for the title is that, as your wealth grows, there are a lot of potential "enemies" that will try to take it away from you. These are explained in Chapter 1.
"Money can't buy you friends, but you do get a better class of enemy."
Spike Milligan, Irish-English author and comedian (1918-2002)
In this latest chapter I look at a powerful investment strategy that should deliver growing income and capital over time, at least in the medium to long run. It's particularly worth considering for retirees that want to generate an income from their investments, potentially over several decades.
The year 2024 has now drawn to a close, and there is much to consider as we head into 2025. I'll provide some thoughts soon on what to look out for.
Last year saw the US stock market roar ahead again. The question is whether this price action is sustainable, with or without the potential new policies of the next US president.
One of my favourite benchmarks for taking the temperature of the market is the Cyclically-Adjusted Price-to-Earnings ratio, or CAPE. It's also known as the Shiller P/E, and sometimes the PE10.
Instead of using just one year of earnings to compare with a price, the CAPE uses the last ten years, increases each earnings figure by inflation since then, and takes an average. This inflation-adjusted average gives the "E" in the CAPE version of the P/E ratio. The idea is to get a feel for how stocks are priced relative to average earnings potential through an economic cycle or two.
Here is a chart of the CAPE for the S&P 500 index (or predecessors) going all the way back to 1871.
Source: multpl
The bottom line is that the US CAPE ratio has rarely been higher than it is today, and then only briefly. It's currently well above the level just before the Wall Street Crash of 1929. The current level was exceeded during the late 1990s market bubble and the early part of year 2000. That was followed by a major, multi-year stock market crash. And it briefly peaked at a higher level in late 2021, before the big price falls that occurred during 2022.
In other words, US stocks currently are baking in a huge amount of optimism. They look pricey, and thus there is a substantial risk of major price falls if there are any disappointments. Buyer beware!
Incidentally, the US stock market also has an extremely low dividend yield currently. It's a tough hunting ground for those seeking attractive dividend income, such as dividend growth investors.
Source: multpl
At 1.24% a year, the S&P 500's dividend yield is almost as low as it was in early 2000, just as the tech bubble reached its peak. (Another ominous sign, by the way.)
I hope you enjoy the latest book chapter below. Happy New Year, and thanks for reading OfWealth.
As always, feedback from readers is encouraged.
Please send emails to ofwealth@substack.com
Chapter 11:
Dividend growth investing and "double compounding"
What's the point of investing, and why do we do it?
Pretty obviously, investing requires deferred gratification. It's about finding places to park capital, with the intention of having more money in future. That's instead of spending it all now and worrying about the future later. And probably winding up broke and miserable as a result. Put another way, investing is within the arena of behaving like a responsible grown-up.
But having more money in future is pretty pointless unless there is an eventual aim to use it in one way or another. That could be to build a family fortune that generates an income for our descendants. Or it could be to fund charitable interests or other forms of patronage.
However, for most people, investing is about ensuring a comfortable and secure retirement, once we are no longer earning an income from work. For those that start investing early enough, apply the right investment strategy, and have the patience to see it through, this can mean an early release from the shackles of corporate drudgery.
In short, the ultimate aim of investors is to be able to draw money from their future funds and spend it on their needs or wants. The most sustainable way to do that is for the investments to generate a sufficient income to spend, but for the capital itself to remain untouched and invested.
In fact, the very best outcome is if both the annual income and the invested capital continue to grow over time, matching or beating the progressive loss of purchasing power of fiat currencies.
I believe that the most powerful way to achieve this is dividend growth investing, or "DGI" for short. This involves investing in dividend-paying stocks. The aim and expectation is that both the cash dividend income and the stock prices will increase over time, on average and in the medium to long term. That's as the underlying companies expand their profits and net assets.
Of course, there are other investments that generate an income. But they have some significant disadvantages when compared with a portfolio of dividend income stocks, especially over the long run. So let’s look at those first.
Income investments other than stocks, and why they're worse
The main financial alternative to stocks is investing in bonds, which represent loans made to governments or corporations in the form of tradeable securities. Most bonds pay coupon interest that is a fixed percentage of the face value of a bond, being the original loan amount that's repayable at maturity. Thus they are known as "fixed income" investments.
Most investment advisors, for various reasons, tend to recommend that retirees own a lot of bonds. I believe this is very poor advice, especially since retirement could last for several decades.