The Surprising Truth of Dividends vs Growth Stocks
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Growth stocks offer all the benefits of dividend investing and more control over your taxes
Dividend stocks are popular. Dividend stocks seem safe.
Who doesn’t like getting a cash return regularly from your investments, especially compared to the risk in growth stocks? Dividend stocks are awesome! There, I said it.
But dividend stocks aren’t the better investment.
Saying growth stocks are the better investment may be something like blasphemy in some investing circles but it’s the awful truth.
Growth stocks offer the same cash return benefits of dividend stocks plus the potential for higher returns.
The fact is, growth stocks are awesome-er!
What is the Difference Between Growth and Dividend Stocks?
The difference between growth versus dividend stocks is in the financial decision made by management. When a company has a profit, it has to decide whether to return the profit to owners or reinvest in future growth of the company.
The question is whether management thinks it can get a higher return on that reinvested money compared to what owners can get in other investments.
Companies that pay dividends are saying that future growth is limited so it’s better to give at least some of those profits back to owners so they can find better investments.
Data to November 2017 for two funds managed by BlackRock shows the growth rate of earnings at growth stock companies averages 14.5% a year. That’s more than three-times the earnings growth rate at dividend-paying companies of 4.6% over the same period.
Management at growth companies are able to use that earnings growth to produce a higher return for investors with a return-on-equity of 17.8% versus 16.4% on average at dividend-paying companies.
Because of these differences, the companies attract different investors and offer different investing promises.
Growth stocks offer the potential for higher total return for investors that don’t necessarily need the money right now.
Dividend stocks offer consistent cash flow and potentially less volatility for investors with a lower risk tolerance.
How Do Growth Stock Returns Compare Against Dividend-Payers?
Dividend stocks beat growth over the long-run, right? Reinvesting that cash return in safer companies is the smart way to invest…isn’t it?
I pulled the data for two exchange traded funds, the iShares Russell 1000 Growth fund and the iShares Select Dividend fund, for comparison.
Turns out, some of those advantages of dividend stocks just aren’t there.
The growth fund has beaten dividends in every period and volatility is only slightly higher. The myth that dividends are so much safer than growth is just that, a myth.
The dividend stocks did offer an extra 2% in cash yield each year but had a lower total return. In the next section, I’ll show you a way to enjoy the cash return of dividends plus the higher total return in growth stocks.
The graphic shows the stock sector exposure within growth and dividend funds. Dividend funds tend to be heavily invested in utilities, consumer discretionary, financials and industrials. Growth funds have their highest exposure to information technology, consumer discretionary and health care.
The problem with dividend funds heavily invested in shares of utility companies is that they are also exposed to rising interest rates and inflation similar to bond investing. Since utilities are not able to quickly raise prices as rates and inflation increase, shares get hammered and that can limit returns in dividend funds.
Growth funds also carry an inherent weakness with over-exposure to technology stocks. While these companies may b the ones growing the fastest, putting nearly 40% of your money in one sector isn’t exactly good diversification.
In fairness, Nick of Sure Dividend uses the Sharpe Ratio and research by Kenneth French to argue on the side of dividend stocks and makes some good points. We like to think of investing as this-or-that sometimes but a strategy of dividend growth stocks is also an option.
How to Get the Benefits of a Dividend Stock in a Growth Company
There are two very important problems with dividend investing and they both mean trouble at tax time.
If you don’t hold a stock for at least 60 days within the 120-day window before and after a dividend is paid, that payment is taxed at your income rate. If you hold it for at least this amount of time, the payment is taxed at lower capital gains rates.
Even if you hold on to your dividend stocks so the cash payment is taxed as capital gains, you still have no control over when you pay taxes on your investment. You pay taxes on your dividends every year, even if you reinvest your money.
Why not take the dividends you need, paying capital gains taxes when you have to, but just keep your money invested if you don’t need the cash?
That’s a problem most dividend investors don’t think about. Does it matter if a company is making a cash payment if you are just going to turn around and reinvest the money? Why pay taxes on that reinvested money, why not just keep it in the company and avoid taxes until you need the cash?
That’s the idea behind growth stocks. You can create a dividend anytime you need the cash, simply by selling shares. If you’ve held the shares for more than a year, you’ll pay the lower capital gains rate on the sale.
Of course, none of this keeps me from owning some great dividend stocks. In fact, I recently shared my dividend investing strategy for creating monthly income from just four stocks. Click to play the video here or check out the new YouTube channel and make sure to subscribe to get more videos.
I do own some dividend stocks as well as REITs so it’s not like I’m saying only invest in growth stocks. In the dividend versus growth stocks argument though, I’ve got to give the win to growth. Shares of fast-growing companies offer a higher total return with only a little more volatility and you can create a dividend anytime you need it.
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