John Bogle founded The Vanguard Group, one of the country's largest mutual fund providers. He created the Vanguard 500 Index Fund, which tracks the Standard & Poor's 500 stock index. Bogle is known for his straightforward investing strategies and is followed by a group of devotees who call themselves Bogleheads. Dividend-paying stocks form a key part of his investment strategy.
Bogle separates stock market returns into fundamental returns and speculative returns. The fundamental return is the sum of two different factors: a stock's dividend yield and the company's earnings growth expressed as a percentage. Speculative returns come from varying opinions on what to pay for a company's earnings. In his opinion, over time, the fundamental return, which includes dividends, is the true driver of market value.
Growth Comes From Dividends
To Bogle, dividends aren't just a part of what drives the long-term value of a stock -- they form the main component of stock returns. Of the stock market's 9.6 percent total return over the 20th century, 4.5 percent came from dividend yields while 5 percent came from earnings growth, with 0.1 percent coming from adjustments in market price-to-earnings ratios. However, the dividends could be reinvested in interest-bearing accounts that would protect against inflation while the earnings growth was in non-inflation indexed dollars. When you subtract the impact of inflation from the earnings growth, dividends accounted for 75 percent of the market's growth.
Cash Returns Are King
Bogle also encourages investors to focus on investment vehicles that generate cash returns. For the equity portion of a cash-generating portfolio, he recommends dividend-bearing stocks because they provide a stream of income that can be used for living expenses. To him, the income stream can be more important than the fluctuating value of the stock that pays it. He also recommends capitalizing the value of fixed-income streams so that they can be treated as equivalent to fixed-income investments and included in an overall portfolio. For example, he thinks that the typical retiree already has $300,000 to $350,000 in fixed income investment based on the value that he places on the cashflow from Social Security.
Fund Fees Sap Yields
Given that Bogle focuses on dividend yields, the low dividend yield of some stock funds is an area of concern for him. One way that stock funds can pay their management fees without diluting their asset values is to divert dividend payments to cover expenses. When a fund's fees are close to its dividend yield, it funds the management but takes cash returns away from its investors.
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