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Income or growth?

This article appeared in the April 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Why it pays to look for the best total return.

By Morningstar

Once you've distinguished between investment and speculation, there's another important distinction about the type of shares that you buy. But first, let's take a step back and look at interest-bearing investments.

Interest-bearing investments and shares don't just differ in the level of returns that you are likely to receive over longer periods of time - they also differ in the way you receive those returns.

If you buy a three-year debenture for $3000 paying 6 per cent interest, after three years you receive your original $3000 investment plus the interest you earned along the way. If you invest the same amount in shares, however, you can potentially benefit not in one way but in two.

Firstly, you get the interest you earn along the way, only it's not called interest - it's called dividends. Secondly, you have the potential to make a capital gain on the original $3000 investment.

A capital gain is the difference between the price of a share when you sell it and when you bought (although you'll still have to pay capital gains tax on the difference, so your hip-pocket profit will be somewhat lower).

The capital value of a $3000 company debenture is always $3000. The capital value of a $3 share, however, can jump to $4. Of course, it can also fall to $2, so there's the added possibility of capital loss.

Income stocks

Some stocks - historically Real Estate Investment Trusts and the major banks - tend to pay relatively higher dividends and may therefore produce less in the way of capital gain. That's because every dollar that is paid out as a dividend is a dollar that the company is not able to channel back into its own growth.

The companies behind these types of stocks normally - though not always - have reasonably stable income streams themselves, so, in turn, they're able to be reasonably sure about meeting regular dividend payments to their shareholders.

Australian Real Estate Investment Trusts, for example, receive returns in the form of rental income. These come in pretty much like clockwork, rain, hail or shine - although income may slow during an extended slump in the economy. Many A-REITs badly disappointed investors on the income and capital growth fronts during and after the Global Financial Crisis.

While banks are sensitive to the interest rate cycle, every time you put your PIN into an automatic teller machine, queue for 15 minutes to reach the counter, or click a transaction from your home computer, your bank usually takes a cut. This makes cash flow far more predictable and, hence, more manageable, than the days when consumers saw banks as a community service and account fees were little more than a glimmer in a back-room accountant's eye.

Stocks with these characteristics are typically referred to as income stocks because investors, particularly retirees, may use them to provide a regular income.

Growth stocks

Other stocks tend to pay only modest dividends but have a pleasing capacity to produce much larger capital gains. These are generally called growth stocks because profits are being redirected back into company growth, rather than straight back into the pockets of shareholders.

Of course there are also plenty of stocks that pay poor dividends and make little or no capital gain. These are known in the business as "dogs" - and they're a long way from being your best friend.

Even at an early stage, get into the habit of identifying right upfront whether a stock is potentially an income stock or a growth stock. This not only helps you to start working out whether it will suit your portfolio, it also gives you an idea of what to expect from the stock's performance.

This is critical, because there's nothing less logical than buying a stock for its steady income stream and selling it for its stodgy capital growth. Usually, you can't have it both ways!

The quickest way to check out the growth versus income story is to get your hands on the company's relative strength chart - its share price performance over recent years charted against the All Ordinaries (Editor's note: Use the ASX Charting Tool to chart share prices). Also dig up the company's history of growth in earnings and dividends.

If a company's share price has risen strongly against the share price index, the chances are you're on to a growth stock. But just to make sure - it may, after all, be a "concept stock" with no earnings or dividends to speak of - check that earnings and dividends have been growing as well. If earnings and dividends are both flat and the share price has underperformed, chances are it's an income stock (or a spectacularly failing growth stock).

Remember also that not all stocks are firmly in the "growth" or "income" camp: some provide a bit of both, while others might be income stocks until they find something to do with all their earnings, such as building a new plant or expanding into new markets. The balance between income and growth may then shift for a period, until the new arrangements are bedded down.

So which is best?

All of which leads to the question: which type of stock should you be looking for, an income stock or a growth stock? Dividend income or capital gain?

And the answer is ... neither one.

Actually, what's most important, and many people lose sight of this, is the total return that an investment produces over a period of time: the sum of your dividend income plus your capital gain or loss.

However, underlying this principle are some practical issues that may lead you toward either income or growth stocks, depending on your personal needs.

The most important of these is: do you need a regular income to cover your living expenses?

If you can't afford to have your money tied up without generating much of an income, you'll want to look for at least a few stocks that traditionally pay reasonable dividends. On the other hand, if you can afford to invest for the long term without drawing down income, you may be well served by keeping a fair proportion of your money in the market, and selecting stocks that are likely to produce capital gains.

This way, you pay less tax from year to year because you'll only pay tax on capital gains when you realise them - that is, when you sell the shares. This is what's known as capital gains tax.

Of course, you also have to consider the "bird-in-hand" principle. Dividends are cold hard currency rustling in your pocket, while capital gains may never arise if a share price falls below the level at which you bought the share. No capital gains tax alright, but that's little consolation for no profit!

A third alternative is to take advantage of company dividend reinvestment plans (DRPs), in which dividends can be ploughed straight back into buying new shares, instead of receiving them as income payments. If you don't need the income or the dividend payments are relatively small, these plans are often well worth taking up.

DRPs generally offer you a slight discount on the current market price and there's no brokerage or stamp duty to pay on the transaction. It can also be a useful way to gradually build up your stake in your favourite long-term holdings. Companies tend to like DRPs too, because they allow the company to reward investors with a dividend but receive a regular injection of cash - this can sometimes reduce the need for messy and expensive rights issues.

The one thing that matters most

As well as considering your income and tax needs, we now need to consider both what a high or low dividend is and what it means. Let's start to deal with this point by answering the following question. Is 5 cents a share a high dividend or a low dividend?

And of course there's no way of knowing. It depends on the company in question, so we need some kind of yardstick to measure dividends by. In other words, is 5 cents a high or a low dividend in relation to what?

And the answer is: in relation to its share price.

If a share pays a dividend of 5 cents and it is currently priced at 70 cents, that share's dividend yield (the percentage of its share price paid out as a dividend) is 7.1 per cent - relatively high.

Dividend yield = dividends per share/market price per share

On the other hand, if that 5 cent dividend is coming from a share that is trading at $2, then that share's dividend yield is? Not so cheery.

Dividend yields vary according to the industry in which the company operates. But, while one company may pay generous dividends and another may not, does this knowledge about two stocks help us to pick which is better?

For now, we can say that although dividends and capital gain appear to be quite different ways of producing a gain, they are in fact linked together by the one thing that matters most - a company's earnings and its capacity to grow those earnings into the future.

A company that has solid earnings can afford to pay a dividend to shareholders if it chooses to, and a company that is able to increase its earnings is much more likely to increase its dividend payout to shareholders. This growth potential makes such stocks more attractive to investors, who are likely to drive their share prices higher - resulting in lovely capital gains.

The one thing that matters most is not whether a company pays a high or a low dividend yield. It's whether or not a company is likely to make a profit - and indeed increase that profit - in the years ahead.

About the author

Visit Morningstar for information on latest market and company trends, and sharemarket education. The Learn section on the Morningstar website has a wealth of free information to help investors.

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