The Importance of Investment Moats

It can be quite tempting sometimes to think of the dividends that we receive from our investments as some kind of trinket from the company. It is especially tempting to be dismissive about dividends; when our finances get a little stretched, we simply spend those dividends instead of reinvesting them.

This is because once those dividends disappear into our bank accounts with the rest of our income, then there is a good chance that they will just get used. We are not alone if we are guilty of doing this. It is a very easy trap to fall into.

But here is something that we should think about. Once we understand it, we are unlikely to be as cavalier with our dividends ever again. That something is called total shareholder return. It is probably one of the least-understood aspects of investing, even though it is vitally important.

Never overlook dividends

More often than not, we might feel that if our shares are quickly rising in value, there is little need to do anything with our dividends. We could just save them or spend them. And why not? If the price of a share is rising quickly, then any dividends we receive may often seem like nothing more than a rounding error. Consequently, we might be inclined to overlook them rather than do something productive with them.

However, the returns from our investment in any company comprise not only the capital gains but also the dividends that we receive. It is therefore important to consider not only the appreciation in the company’s share price, but also the dividends that are paid to us.

Of course, some companies do not pay dividends at all. These tend to be high-growth businesses that need the money to finance their future expansion. There is a school of thought that suggests companies should not pay a dividend at all but instead reinvest the money on behalf of its shareholders.

A waste of money

This school of thought maintains that paying dividends is a waste of a valuable resource, namely, cash. After all, we invest in a business to take part in the growth of the company and not to have the money paid back to us. However, some of us believe that a company should always reward its shareholders with some of its profits. We feel that money in our pockets is better than in somebody else’s.

On that particular point, if we are judiciously invested in highly cash-generative businesses that tend to reward their shareholders with generous dividends, then it is important to reinvest those dividends as soon as they are received. To reiterate, total shareholder return is made up of stock-price appreciation and reinvestment of dividends.

Consequently, we should never be too disheartened if a share price does not rise rapidly, especially if the company can comfortably pay rising dividends. Those dividends, when accumulated and reinvested over time, could more than compensate for any capital loss.

Looking for moats

Additionally, there can be an inverse relationship between share prices and prevailing interest rates. So, at a time when interest rates remain high and could even rise further, there is a good chance that share prices could remain depressed or fall.

But that is altogether a good thing. It means that we could have a good opportunity to buy more income-generating assets at attractive prices. There is something else to think about, namely, that rising interest rates may not adversely affect a company’s ability to pay dividends. While the share price might be depressed, the payout could even be rising.

Companies that can perform well under any economic conditions generally have deep and wide moats. These moats can manifest itself in different ways. Some moats exist because it might be difficult and costly for customers to switch from one product to another. Think about how hard it might be to change from our favourite game console to, say, a cheaper one.

Patience is key

Sometimes, a moat could be created simply because of the large number of people who want to use it. Online marketplaces are an example of this. Intangible assets are another example of moats. These can come in the form of patents and brands. It is little wonder that fashion companies, for instance, are so protective of their designs and labels. They will fiercely prevent competitors from copying their products.

The benefit of moats may not be readily apparent when we first start investing in companies that have them. But businesses with wide moats can become more valuable over time because they should be able to consistently generate high returns on equity that can turbocharge their dividend payouts. So, patience is key.

Patience can’t be taught. Some people are born with the gift of patience. For the rest of us, we have to learn to be patient. However, only time will tell whether we have it.

Note: An earlier version of this article appeared in The Business Times.

Disclosure: David Kuo does not own shares in any of the companies mentioned.