I often get this question from investors: “What makes a great company to invest in?”
And while I can give you many technical answers about discounted cash flow (DCF) valuations, future growth forecasts and the like, the best answer is really simple.
The very best companies are the ones that “pay back” their investors.
That's the big rule of investing.
Invest in companies that will “pay back” their investors.
Just think about it, you take money, invest it in a company that uses that cash to make more money. But if the company does not pay you back any of the prof its it's made, what's the use of investing in the first place?
So, how do companies pay you back?
Well, great companies reward their shareholders in two ways. The first strategy is pretty straightforward. But the second strategy… Most investors don't understand how it works.
Today, I'll cover both strategies. And I'll show you how the second strategy offers an enor mous tax "loophole."
Let's get started…
The easiest way to know a company is paying you back!
The first way a great b usiness can reward you is by paying cash dividends.
Cash dividends are usually paid twice a year, and they're good for two main reasons.
First, they provide you with a regular cash retur n on your investment. And these dividends make a huge difference.
The JSE’s All Share index would’ve returned you 347% in the past ten years. But, if you’d included dividends from the index your retur ns would be sitting on 506%. On a R10,000 starting investment that comes to a difference of R15,900 in profit over that time.
159% is huge difference in returns over a decade.
But I can hear you asking: “Francois, what has this got to do if I invest in penny shares for only 6, 12 or 18 months at a time?”
Well, my answer to you is that you must remember – you still get dividends from companies twice a year. And, two dividends on a share this year, another two on a different share the year thereafter and so forth really adds up to a lot of money in the longer run – even though you don’t hold onto individual shares for that long.
Consider Pan African Resources on which we recently took a prof it. We initially bought the company at 67c. Over the time we held it, it paid 22c in dividends. That’s a 32.8% return on the share, just in dividends!
So, when investing in penny shares we won’t easily f ind a share that’s been paying dividends consistently for ages.
But what is a g reat f ind is a company that’s set to start paying dividends. That acts as a big price booster!
Bottom-line: Dividend-paying stocks are the best place to put a large chunk of your stock-market money.
The lesser known – but tax efficient way companies pay you back
The second way companies reward shareholders is by buying back their own stock.
Why is this good for you?
Well, when a company buys back shares it reduces its share count.
It's like cutting a pie into four slices instead of eight slices. You're getting a much bigger piece of pie.
Likewise, as the company's share count falls, each remaining share is worth more.
Take for instance Onelogix, a share we closed for a 62% gain this year. The company announced a buy-back of shares and within three months from the announcement the share price shot up 32%. And, because the company pays dividends, shareholders will now get bigger dividends because the company’s profits are now divided into fewer shares.
And here's another reason why share buy-backs are good...
You have to pay taxes on cash dividends... But you DON'T PAY TAXES when a company is using cash to buy back shares... Even though a share repurchase makes your shares more valuable...
In other words, a share repurchase is like a tax-deferred, non-cash dividend that you receive for as long as you hold your shares.
So to sum up:
Look for companies that reward shareholders. Shareholders are rewarded in two ways: Dividends and share buy-backs.
Look for companies that raise their dividends every year or are about to start paying dividends.
Look for companies that buy back shares and reduce their share counts.
One more thing to keep in mind: This rule of investing in companies that pay back shareholders works. It is successful and will help you easily find great shares. But it is by no means foolproof or the only way to find great shares.