Which Is Best-Investing For Income Or Total Return: Part 2

There is a long running feud between investors who believe in investing for total return versus those who believe in investing for current income. Both camps are fervent advocates of their respective beliefs, and there seems to be no feasible middle ground or compromise. Unfortunately, I believe that the dogmatic positions of both groups create a roadblock to investing enlightenment. In truth, there are valid arguments supporting both sides of these hotly-debated subjects. On the other hand, there are also valid arguments supporting investing for income over total return, and vice versa.

But more importantly, with investments there are many other considerations besides returns. The amount of risk a person is willing or capable of taking is a major consideration. There’s also the size of an investor’s portfolio relative to their future or current needs. In conjunction with portfolio size, there is the issue of how much time an investor has before they will need to begin harvesting money from their portfolio. Speaking of time, there are also the considerations of how much time and effort the investor is willing or capable of putting into managing their portfolios. These represent just a few of the other important considerations.

At the end of the day, how a portfolio is managed is ultimately dependent upon the goals, objectives and risk tolerances of each unique individual investor. With investing, there is no one-size-fits-all, and there are numerous options to choose from.  The key is to pick the strategies and investment vehicles that are best aligned with your own unique situation and needs.  The portfolio that’s right for you may not be the portfolio that’s right for me. Consequently, we are all free to build, design and manage our own portfolios consistent with our individual circumstances. 

Therefore, I see no reason for arguing for or against one strategy over another. On the other hand, regardless of whether we are investing for total return or income, I would argue that it’s imperative that we understand the ins and outs of each respective strategy. Because in order to make the most appropriate decisions, it is imperative that we are fully cognizant of the advantages, disadvantages, benefits and pitfalls of each strategy.  This article is offered to cover a few of the major differences between investing for income versus investing for total return.

Act Accordingly Through Knowing and Understanding Your Options

In part 1 of this 2-part series found here, I presented the primary sources or drivers of long-term returns. 

I consider this critical information regarding choosing the strategy or strategies that are most appropriate for your own goals, objectives and needs.When you are aware of where and how returns are generated, as well as the risks associated with generating them, you are on your way to making rational decisions about how your portfolios can or should be run. Therefore, here in part 2, I will elaborate on why earnings growth (and/or cash flow growth) and valuation are the primary sources of total return.

Elaborating On Why Earnings and/or Cash Flow Growth Are a Primary Source of Total Returns

In the comment thread on part 1 of this series, my position that earnings growth (and/or cash flow), in conjunction with valuation as the primary sources of total return was challenged. Therefore, I want to take this opportunity to clarify what I was saying and validate the veracity of what I said. 

The principal reason why earnings and/or cash flow growth is a primary source of return is simply because these metrics are value creators. A business creates value for its shareholders in direct proportion to its operating success in the long run. The faster a business grows the more value it creates as it generates a higher level of earnings and/or cash flow - and does so faster.

Consequently, I submit that earnings and/or cash flow growth is a primary source of the returns you can expect to earn through investing in a business over the long run. These long-term returns can manifest as pure capital appreciation that will highly correlate to the company’s rate of change of earnings growth.Importantly, this will occur whether a company pays a dividend or not.

If a company pays a dividend, those dividends are paid out of earnings or cash flows, and as such, will contribute to total return via the income component. Total return is capital appreciation plus dividend income - if any. However, dividends are not the source; simply because they are paid out of the source and therefore only contribute when the total return calculation is made.

Elaborating on Valuation as a Primary Source of Total Return

I contend that you make your money on the buy side. Consequently, when you invest in a company at a fair or sound valuation, your long-term returns will be highly correlated to the company’s earnings and/or cash flow growth.  To clarify this, I am suggesting that if a company grows earnings at 10% per annum, you can expect to generate capital appreciation of 10% per annum when purchased at sound value.  If a company grows earnings at 5% per annum, your capital appreciation will be 5%, and so on.

Once again, this capital appreciation component will occur regardless of whether a dividend is paid or not. If the company does pay a dividend, your total return will be higher than the company’s earnings and/or cash flow growth in direct proportion to the amount of dividends received over time.

On the other hand, if you overpay when you originally invest, overvaluation will reduce your total return to a level less than the company’s earnings and/or cash flow growth rate. Of course, if you originally invest in a business at a low valuation, your long-term total return will exceed the company’s growth rate. Additionally, it’s important to understand that your total return will also be impacted by the valuation of your stock at the time performance is measured.

These valuation principles are why I also consider valuation a primary source of total return. In short, valuation will affect both the amount of capital appreciation and the amount of dividend income you will ultimately earn. Importantly, when valuation is in alignment at both the beginning of your investment as well as the ending period, your capital appreciation will be directly proportionate to the earnings growth rate your company achieved.

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Disclosure:Long LKQ,CTSH,OHI more

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