Dividends or Capital Growth - which should I go for?

Should I buy for dividends or capital growth? This is the first question that has crossed my mind when looking at potential stocks to buy.

I realise that the long game for a retirement income should be based on dividend income, but what's the smart move in the run up to retirement - dividends or capital growth?

I've notice that the likes of Apple, Berkshire Hathaway and Amazon, pay little if any dividend. Wouldn't it be a good idea to invest in these until I reach retirement, then shift my cash into something that pays a more considerable income on which to live?

Like so many things in investing there really isn't a right or wrong answer to the age-old "dividend or capital growth" question.

It would have been a huge mistake to sell out of Berkshire Hathaway in 1969 (they paid their last dividend in 1968) because they were no longer a dividend payer. When assessing whether you should invest for dividends or capital growth there are several things you may wish to consider. I'll touch on them below:

First of all you need to define why you are investing. The whole point of investing is to increase the purchasing power of your initial investment over time. Otherwise, there is no point in investing. You might as well spend the cash now. You need to make a high enough return to make the sacrifice of not spending now worthwhile. 

At the end of the day what really matters when investing in the stock market is TOTAL SHAREHOLDER RETURN. This is simply your return from dividends and capital gains added together. In a perfectly rational world, you should be completely indifferent as to whether that return comes from dividends or capital growth. 

Unfortunately this is not a perfectly rational world. There are numerous other factors to consider.

Dividends or Capital Growth considerations:
1. Tax efficiency

In many countries, dividends are taxed at different levels to capital gains. There may also be allowances . In your case, Will, as you live in the UK there is a capital gains tax allowance of £11,300 (2017-18) meaning you can make up to that much without paying a penny of capital gains tax.

There is also a dividend allowance of £5,000 (proposed to be reduced to £2,000 next year) which means you can earn up to that much without paying a penny of dividend taxes. That is assuming you haven't used a tax advantaged account like an ISA (UK equivalent to a Roth IRA) or a pension. 

This means that you can shelter an awful lot of your investments away from tax and you may well be able to (legally) avoid tax altogether.

Looking at UK rules, you can contribute up to £20,000 per year in ISA accounts and £40,000 per year into a pension account (although this reduces if your earnings get very high).

If you're married, you should be able to do this for a spouse as well, meaning you can double those allowances. So unless your portfolio is very large, you should be able to avoid investment taxes completely. 

If your investments are in tax free accounts, then you should be completely indifferent as to whether you earn from dividends or capital gains.

2. Overall health of the business

When you invest in stocks, you're  investing in the underlying business. As you are a partial owner of the business then you are entitle to your share of the profits.

Profits tend to be paid to shareholders in the form of dividends, although share buybacks are a possibility. Have a read of our page for you more information on share buybacks.  

What I like to think about is, if management are not going to pay you dividends then what are they doing with the earnings? There could be several reasons for not paying dividends. Management may wish to use the cash for debt reduction, for capital expenditure, for acquisitions or for share buybacks.

All of these actions should increase your share of the value of the company over time which, should, ultimately increase the share price. You have to ask yourself if these actions from management are preferable to paying out the cash in dividends.

3. Something to remember: Dividend paying companies often outperform others.

There have been several studies that show that dividend paying stocks tend to perform better in the long run than non-dividend-paying  stocks over long periods of time, and - all other things being equal - this should guide you in the choices you make about searching for dividends or capital growth. Have a look at this excellent paper from Tweedy Browne Company LLC on this topic - it's the clearest explanation I've seen.

Why might dividend stocks outperform? I believe the main reason is that paying out more of your earnings means greater capital discipline. If you only have $5 in your wallet as opposed to $500 then you are going to be more likely to spend that money carefully and not waste it.It is the same with large companies.

A lot of cash in their treasury often lead s to wasteful spending on things like overpriced acquisitions, share buybacks at too high a price or wasteful R&D. Paying out the cash means they have to be more efficient and disciplined with their capital and this should mean higher returns on equity. 

Another reason for possible outperformance by dividend stocks is that those companies that pay dividends tend to have better quality earnings.

What do we mean by that? Well to pay dividends, the company has to be generating cash consistently, so there is probably a bigger focus on cashflow.

Earnings (an accounting term) can be "manipulated" more easily using all sorts of tricks such as changing the definition of expenses to capital expenditure or re-valuing assets on the balance sheet. It is far harder to "fake" cashflow (the true amount of money coming into the company) and this cashflow is what is generally behind dividend payments. 

Ultimately if you find a management that has proven it has excellent capital allocation skills then you should be totally indifferent as to whether you earn your returns from dividends or capital growth.

Of course, it will be up to you to assess your tax situation and work out how to maximize your post tax returns. If you find an excellent company that has a management that are excellent operators but not necessarily great capital allocators then you would want them to return the capital back to you as a shareholder.

Mike - six-figure dividend earner

Mike - six-figure dividend earner

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