Question:

Hi Mark,

I always enjoy reading your articles about your investment strategy (income investor). It’s a different perspective than what I pursue, but I like the challenge of comparing it to my strategy and the pros and cons of each. A large portion of my equity exposure is based on a shareholder yield investing strategy. For reaching my goals, I like to have investments where I understand where the value is generated from. Companies with management teams that do a good job of allocating capital across the mains area (investing in their business, paying off debt, pursuing M&As, dividends, and share buybacks). Is this a strategy you have considered in the past? I would love to read an article or listen to a podcast episode on the topic.

Answer:

An investment strategy is a set of rules or criteria that governs your decision making. This includes both what types of investments you consider and how they are evaluated. It also governs your behaviour which is intended to limit the impact of mistakes.

Investment strategies develop and evolve over time. Ideally it is an evolution and not a radical change of direction as the whole point of a strategy is to provide structure that limits the impact of poor behaviour. Constantly making wholesale changes to your strategy is equivalent of having no strategy at all.

The reader asked if I considered a similar strategy to what was outlined in the email. I will start with some definitions before getting into my own thoughts.

The first thing the reader mentioned was a shareholder yield investing strategy.  Warren Buffett is a proponent of shareholder yield. A good endorsement. Shareholder yield is an approach that looks at all the ways that a company delivers cash to shareholders. This includes dividends and share buybacks. This is a more expansive view of returning cash to shareholders than simply looking at dividend yields.

To further expand the focus on shareholder yield the reader also is focused on capital allocation. Capital allocation is the most important job of senior management. It refers to how the cash generated by a company is allocated. It can go to shareholders as described above or it can be reinvested in the business to fund internal growth or to acquire other companies. It can also be used to pay off debt.

The goal is to allocate cash to the area that will benefit shareholders most. Invest in internal growth as long as it remains profitable. Acquire other companies as long as the acquisition is value accretive. When there are no other options return cash to shareholders in the best way possible.  

How does my own strategy align to this approach?

I think the approach I take is fairly aligned with what the reader oulined. There are some nuances however. I am a dividend growth investor. I want to own companies that will continue to increase dividends at a rate that meaningfully exceeds inflation over time. That way I can grow my passive income stream.

While dividend yield is not the primary way I evaluate a company it is one part of my criteria. I won’t buy a company that doesn’t pay a dividend. That does eliminate companies that may be returning cash to shareholders via buybacks. It also eliminates companies that are early in their lifestyle in fast growing industries where all cash is invested in growth.

Part of having a strategy is understanding that whatever criteria you set will eliminate investment opportunities that will have great returns. You must come to terms with that. I know I will miss some of the top performing shares in any given period. The flip side is that I am going to naturally avoid unfounded hype that often leads to disastrous losses. Ultimately my approach is on the conservative side. Waiting for a company to pay a dividend means that my portfolio is filled with more mature companies. My portfolio tends to underperform the market in times of explosive returns. It also tends to outperform the market in times of extreme market stress.

The reason that I’m ok with that is because my goal is to generate a steadily increasing stream of passive income. That goal is connected to what I want out of life. I use that passive income to pay for things that I want to do. Life is all about trade-offs. This is the one I make.

In summary, I think my approach and the readers are similar. Mine just has a different tilt. I care about capital allocation. I want companies that continue to invest in growth because that is what will fuel future dividend increases. I just want them also to return some cash to shareholders via dividends. I’m aware of all the arguments against dividends and in favour of buybacks. But buybacks require me to sell to extract cash from my portfolio. I want that cash now to help pay for things I want to do in life. And selling is unattractive because the shares I own are what will power future increases in passive income. Given that requirement dividends are more valuable to me personally.

To learn more about setting an investment strategy and find more detail on mine see this article.

If you have a question you would like answered please email me at [email protected]

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Previous editions of Mark to market can be found here.