New Post has been published on UNDERVALUED STOCKS
New Post has been published on https://www.undervaluedstocks.info/sustainable-income/
If the income investor focuses too heavily on maximizing his income and then spends it all, he risks diminishing his purchasing power over the long-term. To maintain purchasing power, some portion of the income must be reinvested in productive assets. The importance of reinvestment cannot be overstated. Compounded over many years, even modest rates of inflation will erode significantly the value of a fixed income.
For the investor who wants income from investments in companies, there are two basic reinvestment approaches:
The investor reinvests on behalf of himself.
The company reinvests on behalf of the investor.
Each approach has certain advantages and disadvantages:
The investor owns shares in companies that pay out all of their income. Rather than spending every last penny of income, the investor reinvests a fraction of the dividend. The reinvestment hopefully leads to more income in the following years, which offsets the effects of inflation on purchasing power.
For an investor in stocks, the success of the reinvestment depends on the ability of the investor to identify attractive investment opportunities. If the investor can reinvest at high rates of return, he will have good prospects for maintaining his purchasing power. On the other hand, if the investor cannot find attractive opportunities, he may fail to maintain his purchasing power notwithstanding his reinvestment program. He might as well have just spent the money on his lifestyle.
Finding attractive investment opportunities may depend on circumstances beyond the investor’s control. The price paid for the investment may be the single most important variable. The higher the price paid, the lower the future return. Sometimes prices for most assets are too high and future returns are unattractive. In those cases, it may be very difficult to sustain purchasing power.
In this approach, the investor owns shares in companies that pay out just a portion of their income. The companies reinvest the remainder in their respective businesses in order to grow; if successful, their growth leads to future increases in revenue, cash flow, earnings and dividends that offset the effect of inflation.
Management has the important task of determining how much to reinvest. Most managements will make the decision based on their ability to find investments that offer a return in excess of the cost of capital. Management determines the cost of capital. In theory, it is the rate of return “required” by the investors in the company. Management attempts to guess intelligently the what minimum rate of return the investors require.
If the cost of capital is 8%, management will invest in projects that yield better than 8%. In a perfect world, they will start with the highest return projects and work down the list, stopping once the return equals the cost of capital.
If management has excess cash and cannot find opportunities with a return in excess of the cost of capital (in this case 8%), they may hold on to the cash in hopes of finding a suitable opportunity in the near future. Since the cash likely will earn far less than 8%, holding cash will reduce the average returns of the corporation.
Alternatively, management may decide to give the excess cash back to the shareholders through a dividend. This passes the responsibility for finding an attractive investment to the shareholders. Some shareholders may be successful at finding attractive ways to invest the cash. Others will not, and those shareholders likely would prefer that management had invested at a lower rate of return (6% or 7%) because it was better than what the shareholder himself could find.
Management can also dispose of excess cash through stock repurchases. In this case, the company simply buys its own stock in the open market. The return on the investment depends on the price of the stock. If the company repurchases its stocks at a price significant below intrinsic value, the rate of return could exceed the 8% cost of capital. On the other hand, repurchases of overvalued stock could result in a rate of return far less than the 8%.
A repurchase allows the shareholders to tailor their decisions according to their own opportunity set. Stockholders with access to better opportunities than the company could choose to sell their stock during the repurchase and invest elsewhere. Other stockholders can stay put.
If we assume a reinvestment requirement, we think most investors would benefit by delegating the responsibility to company management for two reasons:
The company can reinvest directly in its business or in its own stock, whereas the investor can only invest in the stock.
Management has access to proprietary information that should position them to make a better decision than the investor.
