During the bull market, the pursuit of rapidly growing businesses obscured the real nature of equity returns. But growth isn't all there is to successful investing; it's just one piece of a larger puzzle.
Total return includes not only price appreciation, but income as well. And what causes price appreciation? In strictly theoretical terms, there's only one answer: anticipated dividends. Earnings are just a proxy for dividend-paying power. And dividend potential is not solely driven by growth of the underlying business--in fact, rapid growth in certain capital-intensive businesses can actually be a drag on dividend prospects.
Investors who focus only on sales or earnings growth--or even just the appreciation of the stock price--stand to miss the big picture. In fact, a company that isn't paying a healthy dividend may be setting its shareholders up for an unfortunate fate.
In Jeremy Siegel's The Future for Investors, the market's top professor analyzed the returns of the original S&P 500 companies from the formation of the index in 1957 through the end of 2003. What was the best-performing stock? Was it in color televisions (remember Zenith)? Telecommunications (AT&T)? Groundbreaking pharmaceuticals (Syntex/Roche)? Surely, it must have been a computer stock (IBM)?
None of the above. The best of the best hails not from a hot, rapidly growing industry, but instead from a field that was actually surrendering customers the entire time: cigarette maker Philip Morris, now known as Altria Group (MO). Over Siegel's 46-year time frame, Philip Morris posted total returns of an incredible 19.75% per year.
What was the secret? Credit a one-two punch of high dividends and profitable, moat-protected growth. Philip Morris made some acquisitions over the years, which were generally successful--but the overwhelming majority of its free cash flow was paid out as dividends or used to repurchase shares. As Marlboro gained market share and raised prices, Philip Morris grew the core business at a decent (if uninspiring) rate over the years. But what if the company--listening to the fans of growth and the foes of taxes--attempted to grow the entire business at 19.75% per year? At that rate it would have subsumed the entire U.S. economy by now.
The lesson is that no business can grow faster than the economy indefinitely, but that lack of growth doesn't cap investor returns. Amazingly, by maximizing boring old dividends and share buybacks, a low-growth business can turn out to be the highest total return investment of all time. As Siegel makes abundantly clear, "growth does not equal return." Only profitable growth--in businesses protected by an economic moat--can do that.