Introduction

I believe there is a critical piece of investment wisdom that all investors in common stocks should possess.Every common stock investor should have a clear understanding of where and how long-term common stock returns are generated or come from.When an investor does not possess this knowledge, they can be easily led towards drawing erroneous conclusions about their portfolios and/or the individual stocks that they own.Knowledge is power, and the knowledge of where and how long-term stock returns are generated is incredibly enlightening.

Importantly, every common stock investor should also understand that there are significant differences regarding how or where short-term stock returns come from or are generated.In the short run, common stock prices can go anywhere, often do, and often defy logic in the process.Therefore, when dealing with the short run, it’s critical to recognize anomalous price behavior when it is manifest.  This empowers the prudent and intelligent common stock investor in making sound long-term investment decisions.However, don’t confuse sound decisions with short-term market timing decisions.The first is prudence in action, and the latter is merely guessing.

The Primary Sources or Drivers of Long-Term Returns When Investing in Common Stocks

There are two primary sources or drivers of long-term returns when investing in common stocks.The first, and fundamentally the most important, is the rate of change of earnings growth (and/or cash flow growth) that the business behind the stock generates.Simply stated, the faster a business grows its earnings and cash flows, the greater the long-term returns it will generate for its stakeholders over the long run.Stated differently, all things being equal, a faster growing business will generate greater long-term returns than a slower growing business.Long-term investment returns are functionally related to how fast a company grows its business.

The second primary source is the valuation (not the price) you pay to buy a company’s earnings growth (and/or cash flow growth).Too high of a valuation will cause you to earn less than the company’s growth warrants, and a low valuation will cause you to earn more than the company’s growth warrants.And just like the porridge in the fairytale Goldilocks and the Three Bears, when you get valuation just right, your long-term returns will be highly correlated to the company’s earnings growth (and/or cash flow growth) rate achievements.

However, in addition to these primary sources or drivers of return, there are also contributors, or contributing factors.  The most common or obvious contributor to long-term returns are dividends, if a company pays one.The reason I suggest that dividends are a contributor rather than a source of long-term returns, is simply because dividends are paid out of earnings (or cash flows) which as stated above is the primary source.Moreover, the total amount of dividends (if any), as well as the long-term growth of dividends are also directly related to the growth of earnings (or cash flows).

The consistency of the company’s earnings growth (and/or cash flow growth) is another important contributor to long-term returns.The long-term returns produced by a cyclical company can vary greatly from one cycle to the next.In other words, if you are measuring long-term returns at the bottom of the cycle, they can be significantly less than they would be if you measure them at the top of the cycle.However, once again, the primary source remains the earnings (or cash flow) growth.At the bottom of the cycle earnings growth (and/or cash flow growth) will likely average low, while at the top of the cycle earnings growth (and/or cash flow growth) will average higher.

The Total Return VS Dividends Debate: A Classic Case of Erroneous Conclusions

My inspiration for writing this article came as a result of a recent article written by fellow Seeking Alpha contributor Psycho Analyst titled “This Total Return Vs. Dividends Smack Down Between 13 Top Dividend Aristocrat Survivors Will Wake You Up.” 

I found the article interesting, and generally well-written, and the calculations accurate as presented.However, I have a specific reason for citing this article here in my work.I was not specifically referenced in the article, but I was prominently mentioned several times in the comment thread that followed, including a comment by the author.It was that comment that served as my primary inspiration which I present in its entirety as follows:

“Psycho Analyst

Rick,

For me, the most interesting thing to emerge out of the data was how large the range was of total return in a group of stocks that are perceived by many as having very similar characteristics.

Chuck’s approach seems to be to attribute this to valuation at time of purchase, though my data doesn’t support that as being a consistent indicator. (Chuck does have a hammer, and though it is a wonderful hammer, there are times when he really should use a wrench.)”

Now I want it to be clear, that I took no offense from the above comment, or any of the other comments that were posted in the article.However, I did feel that the comment represented several assumptions that also led to erroneous conclusions that I believe were also made in the body of the article.

First and foremost, was the statement “the most interesting thing to emerge out of the data was how large the range was of total return in a group of stocks that are perceived by many as having very similar characteristics.”

(Emphasis added mine). 

From my perspective, the only things that the 13 stocks discussed in the article really had in common was that they all paid a dividend, and that they were all Dividend Aristocrats.Other than that, I intend to demonstrate that these 13 companies are a very diverse group, and as such, not really similar at all.