"The Single Best Investment: Creating Wealth with Dividend Growth" - Transcription
Lowell Miller Founder, President, CIO, Director of Research for Miller/Howard Investments
Audio Interview, January 27, 2007
JIM: The single best investment – what would that be? What we really want from an investment in the deep, traditional sense of the word is a way to benefit from the long term increase in equity values without having to play the market. We want a tangible, common-sense approach that will leave us mostly free of anxiety. To talk about that is the author of a new book, The Single Best Investment – Lowell Miller. He’s President of Miller Howard Investments.
And Lowell, we were talking just before we went on the air about where I had mentioned Bernanke’s testimony last week talking about Social Security, and there’s every bit of a hint that investors, or people that are going to retire, are going to have to depend more on what it is that they have saved and accumulated. And I wonder if we might relate that to your book, The Single Best Investment, because a lot of the things that are going on in Wall Street today, you were commenting hearing Bloomberg radio that this is going to be a hot market this year, you go to the store and look at the best investments for 2007 that this is a hot mutual fund, this is a hot stock. What’s wrong with that approach?
LOWELL MILLER: Well, it’s just so much noise. You can’t really keep up with it and very few people can be right consistently. By the time you realize somebody could be right consistently – or you could be right consistently – it’s too late to do anything about it because it takes 10 or 20 years to develop that level of confidence. You know, in a way it’s really fortune-telling.
And I think that people need to go back to basics and understand that an investor is not somebody who is betting on a horse, and you can read the price of that horse everyday in the paper or see it on the tape on CNBC, or see it on your computer – you’re actually an investor in a company. And what do you want that company to do for you? And what you’d really like that company to do for you is to build your assets over time, and also to pay you some income while that’s happening. And you’d like that income to go up over the years.
What people don’t understand is that the big driver of investment returns over time is not figuring which sector is going to be best, or which country is going to be best, or which style is going to be best over the next year or three – the big driver is income and the reinvestment of income. And the facts of it are that over a rolling, five-year period, 43% of your return is based on income; over a rolling 25-year period, 63% of your total return is based on income and the reinvestment of income; and over 80 years, which is perhaps a little longer than most of our investment horizons, more than 95% of the total return is based on income and the reinvestment of income. Because what happens is your income buys more shares and the additional shares that you buy generate more income, and that income buys more shares. So you can get kind of a virtuous circle of investment going, without worrying at all about what’s the next big thing or the next hot area.
In fact, according to Ibbotson (who’s sort of the leading expert in long term returns), if you started in 1926 (which is when he starts) with one dollar, in terms of price appreciation alone you’d have $87 by the end of…well, my data ends here at 2004, but it doesn’t really matter what year you end precisely…you’d have $87 by the end of 2004. Including income and the reinvestment of income you’d have $2,284. So that’s the kind of multiplier that you get as a stock market investor from stocks that pay income. Reinvest the income while you’re building your assets and then when you’re in retirement you have that income to spend.
What people don’t realize is if you start with a higher yielding stock (at our firm we specialize in higher yielding type stocks) and the dividend grows each year, then within somewhere between 7 and 12 years you can have a return on your original investment (that’s the original money you put up) of 10% of so – from income alone. That’s the level of expected return that most experts think is possible to get over the long term from stocks, including the ups and downs of pricing and appreciation and depreciation. You can get it from income alone, and that income is not going to be volatile, and it’s going to increase each year during your retirement [and] keep up with inflation.
So rather than seeing the market as sort of a devious and slippery beast that you have to keep outguessing, investors would really be better off seeing themselves as investors in enterprises that can produce income that they can use to buy more shares, and more shares, and more shares, as it produces more and more income. And then at a certain point, when they retire they will have a high income from this investment that they made long ago.
It’s not that different from income real estate which I think probably most of your readers have thought about if not participated in, where you have a property and the property produces rent and as the rent goes up the value of the property goes up because the rent has gone up, and over time the rents get much higher than the costs, and there’s a positive cash flow and it keeps going. And it keeps going indefinitely. The advantage of stocks of course is that you’re involved in large, broad-scale enterprises with professional management and you don’t have to repair the roof. [6:22]
JIM: Lowell, let me talk about a difficulty some investor have, and I think it’s because they don’t take a long term perspective because you talk about this in the introduction of your book, and you say:
In the realm of investing, the lesson is most people have difficulty taking losses, are more risk adverse than they realize or know. This is a very important aspect for each investor to recognize.
LOWELL: It’s extremely important. And in fact, in recent studies, neurologists who study investor behavior have been finding that the brain itself is wired in such a way as to make it really difficult to succeed as an investor. And, you know, what you really have to do I think to compensate for the character defects that we all have…Some of the behavioral finance professors like to say, well, we eat too much, we don’t exercise enough, we’re never as good as we’d like to be. And one of the things that we will do is, for example, sell a good company because it has a bad quarterly earnings report. When, in fact, you can envision that company being successful for 10, 20, 30, 50 years – and many of them have been. So in a way it’s therapy for all of our character flaws and our character defects, which are the most important thing in successful investing – and the therapy is to keep your eyes on the long term, and keep your eyes on the process of having income that rises. As the income rises it causes the price to rise. And as the income is reinvested in shares it also causes your total capital to appreciate. You know, to keep focused on that process (high income that rises, that provides you with the cash flow if you need it, that provides you with a reinvestment source if you need it, and that grows over time) it helps you to understand that it’s not going to happen every month, it’s not going to happen every quarter. But if you jump out of investment A into investment B, and then jump out of investment B to investment C, you never really give that process a chance to work. [8:31]
JIM: Let’s talk about another problem of investing and one I see as a major problem going forward for the batch of baby-boomers who are going to head into retirement, and it’s from your first chapter and it’s talking about saying goodbye to bonds – and the basic underlying context in which investments exists today, that context is inflation. Since World War II, there have been only two years in which inflation declined; and the average annual inflation rate for the past 60 years has been over 4%, and that inflation compounds. Relate that to dividend investing because if I go into a bond – let’s say I buy a 10-year Treasury note today, I get 4.8% – 10 years from now my cost-of-living is going to go up, I’m still getting that 4.8%. And let’s say my Treasury note comes due, it’s unlikely the $10,000 I put in that Treasury note is going to buy me the same purchase of goods 10 years later.
LOWELL: Well, that’s true. The amount that you put into the note is going to be less, and the amount of income that you’re receiving is going to be less in inflation-adjusted terms. And there’s no way around that in fixed-income. A lot of people like to set up ladders with various maturities and hope that their income is not going to change too much because one maturity will average out another maturity. But in doing that you take not only the inflation risk by being in fixed-income, but you also take what they call reinvestment risk.
And that is, let’s say you started this process in 1980, right? And you had a 10 year ladder – as one bond matured you bought the next 10 year bond; and as the next 10 year bond matured you bought the next 10 year bond. Pretty soon, you’ve gone from a 10% return on your bond to a 5% return on your bond. The principle of reinvestment risk is you don’t know what the interest rate is going to be when your bonds mature and it might be much less. So you might lose twice: you might lose from the inflation – depreciation of your purchasing power; and you might lose from reinvestment risk where rates might be even lower than where they are than when you invested in the first place.
So really the solution to this is to find some sort of an instrument where your income rises over the years and your income rises to meet inflation. I have a feeling that it’s going to sound like I’m repeating myself over and over again when you ask these questions because I sense what your understanding is of the problem – but it’s worth repeating, which is that if you have rising income not only are you going to defeat inflation with your rising income, but that’s going to cause over time the value of the stock that is producing that income to rise as well, so your principal is going to be inflation-protected as well. [11:30]
JIM: You know, the other thing that investors might want to look at (and this is sort of your concept of easy-to-hold and easy-to-buy declines) is the right long-term investment will be – ironically enough – one that becomes more attractive to you as it declines. And I wonder if you might relate that to…let’s say I own a good stock, it’s a dividend-paying stock, every year they increase the dividends and you know, like you say, they have one quarter where they miss their earnings and the stock goes down – but we know this is a long-term, viable investment. So why not buy more?
LOWELL: Yes. So the idea here is to look for quality companies and durable businesses. You want to look for businesses that are sizeable enough to survive, that have a business model that can enable them to survive. Generally, it’s businesses that provide the necessities of life – whether that be something like utilities that supply gas and electric, or banks that provide financial services, or food companies, or drug companies – insurance companies would be a good example. Generally, it’s the kind of companies where you use their products if not everyday at least once a month – and you pay for them regularly. It’s generally that type of company. And it’s a big company, a financially-strong company.
The newest technology stock – it may have been fun for people in 1998, 1999, but it’s really not going to do it for you in terms of building up assets that will serve you in retirement.
There’s another point I want to make about these assets in retirement is that as you build up your level of income over time, and you can spend just income, you don’t have this worry which is very high in the minds of investors today, which is will my money last as long as I do. If you only spend income your money will last for ever. So what you want to do is build the income that your money generates and so you don’t ever have to worry about spending down principal. [13:34]
JIM: Well, this is what you’re talking about which is building your own internal compounding machine. And you have a simple phrase that you use in the book – it is so simple and yet it is astounding how well it works. Let’s talk about that hidden key to compounding: dividend growth.
LOWELL: Uh-huh. Dividends come from earnings. And what you’re looking for is you’re looking for a company – we can even be more abstract about it and say you’re looking for a vehicle or an instrument – that can reliably produce earnings today and can reliably generate higher earnings in the future. And, you know, there are tons of these companies. They may not be the most exciting cocktail-party conversation. Nobody looks at you in awe because you bought Procter & Gamble 40 years ago. But they’re solid and they work.
You want companies that can generate sustainable – doesn’t have to be big – moderate earnings growth. And from that earnings growth they can then generate higher dividends over the years. And even earnings growth in the 5 to 10% range is fine. If you increase your earnings and your dividends at 5% a year – in 12 to 14 years you’ve doubled your yield on original investment. If you can increase 10% a year, in just over 7 years you’ve doubled your income yield on your original investment. So some of these stocks are today – say like a Bank America, Citicorp, or GE – they’re around 5% (more like 4%). Well, these are companies that have demonstrated that they can grow consistently 5, 10, 15 percent a year. So you might very well find yourself with an 8% investment ten years down the road. I don’t know where you’re going to find a bond that’s going to yield 8% ten years down the road – it’s just not going to happen. [15:35]
JIM: The other thing about dividends too – with all the noise that investors are bombarded with on a daily basis, Wall Street seems fixated on earnings: “their earnings are up this quarter,” or “they were down this quarter.” But if you really want to know how well a company is doing then the dividend, and what they do with that dividend, will tell you more about how well things are going with the business than one quarterly earnings report.
LOWELL: And it will tell you more than 10 Wall Street stock analysts as well. They’ve all got opinions but there’s one thing in this world that’s not an opinion and that is cold, hard cash. When a company pays its dividend, first of all, you know that it’s earned its dividend. We’ve had some problems with let’s say the credibility of statements from management and even financial reporting from management in the last 5 or 6 years. I wouldn’t say it’s universal but there have been such problems. When they pay the dividend they’ve earned the dividend. They have to pay it to you in cash. When management increases the dividend they’re sending you a signal about the future prospects of the company. And it is the best signal and the most reliable signal that you can have.
Many studies have shown that the companies with the most consistently rising dividends, and the most quickly rising dividends, outperform the market by far. It may not be spectacular; they may never be the stocks that you see at the head of the most active list, or even the most advanced list, but they slowly grind it out. And you get a level of credibility from management that you could never get from anybody’s opinion or from anybody who likes to make sound effects on TV at night while they talk about stocks, or anywhere else. [17:23]
JIM: Well, let’s talk about putting this single-best-investment strategy together. We’ve talked about obviously for safety you want something that is high quality; you want a high current dividend. In addition to that high current dividend, you also want high growth of dividend. But if you add it all up together that’s what makes high total returns.
LOWELL: That’s right. We have a little formula in our firm and it’s laid out I think pretty clearly in my book which is high financial strength, or high quality – however you want to put it – plus high yield, plus high dividend growth, equals high total return. It’s really that simple. And I’m afraid that the financial industry tries to make things a whole lot more complex, and tries to make it sort of a game of predicting the short-term future. And we don’t really need that. We need to understand what are the elements of life: we need a roof over our heads, we need electricity, we need heat, we need food, we need financial security; we have some things that we like – we like cars, we like to travel. You know, there are basics of life, and if you invest in the basics of life, in the long term, that’s where you’re going to get your return. [18:39]
JIM: Let’s talk about quality today. You list a couple of things in your book in terms of financial strength, low debt (which makes a lot of sense) – that way if the economy goes into a downturn the company doesn’t get into trouble; good cash flow – obviously you’re going to need strong cash flow for rising dividends. And what do you look for in terms of management quality? How do you assess that?
LOWELL: Well, it’s sometimes a little difficult I think for an individual investor who maybe doesn’t have access to all of the information that’s out there in the world (although there is tremendous access that people have now through the internet and the ability to listen to conference calls and form their own judgment about the credibility of management). In the end, this is a bottom-line business, and it really comes down to companies delivering not necessarily what analysts think they should deliver, but delivering steady, reliable earnings growth over long periods of time, and through many different kinds of economic circumstances.
And one key to that is to look at the history of the company, to see has it been able to do that in difficult circumstances and in easy circumstances. And then to see is it the same management? is it the same products? is it the same business model? So I would say the easiest way for individual investors to get a handle on management quality is to look and see the company has a high financial rating. It used to be you really couldn’t count on the bond ratings of say Dun & Bradstreet, or a Moody’s because they were just too slow and they didn’t keep up with corporate changes – but I think that has changed in recent years because of some of the problems with Enron, etc. So I think you can count on corporate bond ratings much more than you could. So you want to see the company – at least as far as bond analysts are concerned – is well able to pay its bills; and then see that they have delivered a pattern of steady, consistent earnings and dividend growth. [20:42]
JIM: What about in your book you talk about high current yield. But sometimes high current yield could be a warning that something is amiss with the company. What are the pitfalls of high current yields? What should investors be aware of?
LOWELL: Well, with a few exceptions investors should always look and see what percentage of earnings the dividends are. And for a normal company in the industrial world, or financial company, you really don’t want to see dividends that are much more than 50 or 60% of earnings, and you’d like it to be less – you’d like to have a margin of safety. When stocks have very high yields and their earnings are starting to shrink that’s when you go into a danger zone. And when the ratio of dividends to earnings starts to increase that’s when you go into a danger zone. There are some exceptions to this, and one exception is REITs, which are kind of a pass-through; and another exception is MLPs (maximum limited partnerships) which are also kind of a pass-through. But otherwise, for normal C corporations that pay taxes, the lower that you can be in terms of the ratio of dividends to earnings the better off you are. [21:59]
JIM: Now, in your book, in addition to analyzing dividends and management, you also go through some traditional valuation tools from price-sales ratios to PE ratios. And interpreting what it is that a PE tells you, book value etc – what are your favorite ratios and what are the keys to finding good dividend paying companies?
LOWELL: Well, I would say that dividend seekers tend to be in the value camp of investors. We prefer stocks that have low price-to-earnings ratios, low price-to-book ratios. Generally, because what you’re looking at here is – I made the analogy earlier of income property – assets that management manages in such a way as to be able to throw off cash flow which converts into earnings and dividends. And so I like to see the price to value of the assets be low. Today, that changes over time so it’s a little bit relative, but in today’s world if the price-to-book is 2 or less, that’s pretty attractive.
And what we find also is across many industries when there are private takeover deals, which have become more and more common as you know lately, they tend to go at two times book or more. So there’s a margin of safety if you try to keep yourself below two times book. And if you can buy an asset that produces earnings and dividends, and rising earnings and dividends – and you can buy it at more like one times book value, so much the better. Those don’t come up that often but so much the better. So I think book is a good comparison.
Professionals like to use the enterprise value to EBITDA – and just to even hear that I think probably is going to turn a lot of individual investors off. In a way, you could use these very sophisticated metrics and it doesn’t really come down to much more than PE or book-value ratios. Companies that are expensive on EV-to-EBITDA are going to be expensive on PE and expensive on price-to-book also. So because life is always changing going forward none of these things are ever going to be like absolute rules, or totally precise, but what you want is to know that you’re not paying too much for the level of earnings and dividends that you’re getting. And one way that you do that is by sticking to say the bottom-third of price-to-book and PE that’s available in the market. Generally, that will work.
There’s some cases where it doesn’t – such as the pharmaceutical companies today which are depressed. But even at depressed levels they have pretty high price-to-book value. You know, unfortunately there are going to be exceptions.
But the other thing is if the dividend is high, and the ratio of the dividend to earnings is low, the stock is likely to be a pretty good value. I mean that’s one of the things that a high dividend tells you is that the stock is not expensive. [25:09]
JIM: Let’s talk also about, unlike one of the things you talk about, is a simple strategy, but also a lot of the information that you’re talking about – cash-flow, dividend increases, PE ratios – a lot of this information is available in the public library, for example, in the Value Line publications. So you’re not talking about very complex research. A lot of this is available in the public forum.
LOWELL: To tell you the truth you could do it all with Value Line. You could go to the library or you could get a subscription; and you don’t need real-time quotes, you don’t need to watch CNBC, you could do it all with Value Line – and of course, listening to your show. [25:50]
JIM: Lowell, if an investor is getting ready to retire, let’s talk about asset allocation because one of the biggest mistakes I see people make is they retire and they go, “oh, I want safety,” so they put 70, 80 percent of their portfolio in fixed income. Let’s talk about asset allocation.
LOWELL: As you know, I feel that bonds are a bad investment, and anything fixed income is a bad investment.
JIM: I agree with you, by the way.
LOWELL: Yup, but that doesn’t mean that person can’t have savings which would be dedicated to a particular purpose. It might be for buying a house, it might be for sending kids or grandkids to college, it might be for medical emergencies or some other kind of emergency. That doesn’t mean that somebody can’t have savings, but that should not be considered an investment, and even the income from it should not be considered income that they live on it. So it’s like an isolated bucket.
When you are actually talking about investing (and that should be the major part of your assets because in today’s world, you know, lots of us are going to live to be 100 or more), you really have to avoid fixed income and you want a diversified portfolio of high yielding stocks where the dividend is going to grow. And to repeat myself – as I always do over and over again – the increasing dividends will prevent your purchasing power from being degraded by inflation, and the increasing income will also cause your principal to increase over time. [27:25]
JIM: You know, Lowell, you’ve been managing money, you manage over $½ billion…
LOWELL: We’re almost up to a billion now, I have to say.
JIM: Oh, okay, well, congratulations.
LOWELL: Thank you.
JIM: In terms of starting your investment career, how did you come upon this philosophy because I have found the principles of value investing (whether you’re buying low PE stocks, or looking at the dividend strategy) has been so consistent in delivering superior returns over a period of time and yet so widely ignored by Wall Street. What caused you to gravitate to this area?
LOWELL: Well, I’ve always been involved in research. I was never the type of person who wanted to argue about whether AIG was cheap or not cheap. I always wanted to understand what was true and not true. And nowhere, nowhere, is there more untruth, half-truths, false truth proposed as truth, and proposed as strong opinion, than there is on Wall Street. It’s astounding. And I don’t mean to say that people have a malicious intention, although sometimes they do want to manipulate people into buying or into transacting, but I would say the majority of people in finance don’t actually know the truth about what has happened statistically in history. And because of what has happened statistically in history what’s most likely to happen in the future. Of course, we never really know for certain what’s going to happen in the future.
And we, at a certain point in the early 80s, a number of clients and consultants were pushing us to have a management strategy for fixed income. So we spent quite a bit of time studying fixed income (studying fixed income means studying it on our own, and also studying the experts in large long-term asset class returns such as Ibbotson from Yale) and we came to the conclusion (as I think most people who study fixed income come to the conclusion) that it’s not a very good investment. It may be okay to dampen the volatility of a portfolio, or maybe okay for savings, but it’s not a very good investment because for long periods of time it actually gives you a negative return after you adjust for inflation. I think the real problem that most individuals have is they don’t count inflation because nobody sends them a bill in the mail for inflation. They don’t count it. It doesn’t seem to figure in. But if you think about what a car costs 20 years ago –a nice car would $8,000 to $10,000, right?
JIM: Yes, somewhere in there.
LOWELL: Maybe even less. And now you have to go and buy a car today, you probably you know more like 20 and higher. And so actually, what’s happened is that as people have gotten the bill for half their money to pay over half their money in 20 years but they never actually saw the bill. So they never wrote the check, and they didn’t realize it was happening.
So, anyway, we came to the conclusion that fixed income wasn’t good for investors because of the inflationary environment. And one of the things that we also saw was the statistic that I think I quoted to you (I don’t remember if it was off the air, or early on-air) is that since the 1926 a dollar grew to $87 based on price alone in the large company stock area – $1 grew to $87. But when you consider total return which includes dividends and the reinvestment of dividends $1 grew to $2,284. That’s an astronomical difference that indicates that price alone is responsible over very long periods of time for only 5 to 10% of the total return.
So we wanted to go and find what stocks were making the biggest contribution to this dividends and reinvestment of dividends. And we started out by studying utilities and we thought, because brokers are always selling utilities and analysts are saying you should buy this utility or buy that utility, we thought there should be some similar long term studies about utilities but there were none – no academics had done any, no Wall Street firms had done any. It turned out that they were busy selling utilities but they really didn’t know what the returns were like, what the long term performance of the asset class was. So we did a study ourselves and what we found was that utilities provided almost as much total return as the S&P 500 over long periods of time but with half the volatility and twice the income, and after adjusting for inflation provided 8 times the return of bonds over time. So this looked like a good avenue to pursue, and we began to look at other sectors in the market that were high yield and had consistent earnings and had consistent dividends and consistent dividend growth. And we found out that really these are the areas that have contributed to the long term growth of total returns in the markets – these companies with high and rising yields have been actually the leaders even though they never get the headlines. You know, it’s the technology stocks, or the biotechnology stocks, or the gambling stocks or whatever that get the headlines, but when the dust settles it’s the tortoise that wins the race. [33:07]
JIM: You know, Lowell, as we close one other point I wanted to reemphasize is we hear a lot of talk about deflation. You know, periodically, that comes out and sometimes that gives people the wrong impression where they might want to go into fixed income with deflation. But as you pointed out in your book, if you take inflation as measured by the CPI, I think there were only two years since 1950 where we actually had the CPI go down in any one year. But we’ve had inflation every single year. And I think that’s another investment constant that people just forget about.
LOWELL: It’s a good bet that we’ll have inflation because that’s what’s happened. And there are many reasons for inflation and not the least of them is you take a situation like today where the US government created a tremendous debt in just the last six years – an astronomical debt in the last six years – well, if there’s inflation, when they pay back that debt in the future they’re going to pay less money. So governments of all kinds have quite a lot of incentives to structure their financial system so that it’s cheaper to pay back debt in the future. And what that means to an investor is if you buy bonds, you actually are lending money to somebody. And so the whole system is geared to you getting back in real purchasing power less than you lent – which is what the governments would like. You’ve got another reason to kind of steer away from that area. [34:46]
JIM: Well, Lowell, I’ll tell you, you do investors a great service with the writing of your book and updating it. The name of the book is called The Single Best Investment: Creating Wealth with Dividend Growth by Lowell Miller. And Lowell, I want to thank you for joining us on the Financial Sense Newshour. All the best to you, Sir, a great, great book
LOWELL: Well, it was a pleasure talking to you and you also asked if I may say very good questions.
JIM: Well, thank you so much and all the best to you.
LOWELL: You too.
JIM: Once again, the name of the book is The Single Best Investment: Creating Wealth with Dividend Growth.
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