Missing out on growth
I’ve always been a dividend growth investor. I thought this was the fastest way to achieve financial freedom with minimal risk. But maybe I was wrong.
Dividend growth stocks have a long history of growing profits and distribute regular income to investors. I’ve blogged about how much I like them before. But recently I realized they have underperformed growth stocks, which have averaged 13% annual returns over the last decade.
Apparently dividend focused investors like myself have been missing out. 🙁 I have been accumulating about 4 dividend stocks to 1 growth stock. In hindsight this was a mistake, and I should have done the inverse. It was a lesson in opportunity cost.
In today’s post I’ll explain why “growth stocks” will probably beat “dividend growth stocks” in the long run, and what I plan to do with my portfolio going forward.
Dividend stocks are great, but…
There’s nothing inherently wrong with dividend growth investing. In fact, a portfolio of dividend appreciating stocks will most likely beat the broad market index. According to a white paper from Hartford Funds, dividend growth investors should also experience lower volatility as an added bonus. 🙂
There’s not much to complain about a 12.87% rate of return. My pal Bob from Tawcan.com just wrote a detailed blog post today on the best dividend stocks in Canada. Buying stocks with appreciating dividends is already a highly effective and reliable way to build wealth! 😀 No question.
But what if there’s something better? This is where growth stocks come in.
Here’s what the evidence tells us. Vanguard’s S&P 500 Growth ETF (VOOG) tracks the returns of U.S. growth stocks and has returned over 300% since 2011. Meanwhile the Dividend Appreciation ETF (VIG) holds companies with a record of growing their dividends year over year and has returned just over 200%.
What’s special about the growth factor?
There’s a simple reason why growth stocks tend to outperform. Profitable companies will generally do 2 things with their retained earnings:
- If a company is growing quickly and has a high return on invested capital, it will benefit shareholders the most by reinvesting profits back into its operations.
- If a company doesn’t see much opportunities for growth, it will reward shareholders with cash (or share buybacks.)
In other words, if a stock pays a dividend, its Board of Directors is essentially admitting that they cannot find a better use for their profits. Maybe they have reached maximum market penetration, or cannot expand internally or acquire competitors. Whatever the reason – paying out cash is the only way they can offer shareholder value since there is no better alternative use for the cash in a profitable way.
This is the driving force behind growth stock performance. They earn higher returns on investment and can make better use of capital compared to other types of businesses. 🙂
Growth stocks can be quite volatile though. So even though they are appropriate for millennials like myself, perhaps dividend stocks are still better for older investors.
Getting the best tax advantage
I should have invested in more growth stocks from the beginning. There’s no need for dividend income when I have a full time job anyway. But once I quit working, I can gradually sell my growth stocks to buy dividend stocks to take full advantage of the dividend tax credit.
You can earn up to $50,000 a year in tax-free eligible dividends, as long as you don’t have a job. Maybe that’s not enough money to live on. But it’s better than a fisherman’s salary. Fishing is hard work, and it’s quite difficult to live off the net income. 😏
How the economy impacts growth stocks
The current low interest rate environment greatly benefits growth stock investors. Let’s say a growth company can generate 20% return on capital. If it can borrow money at 2% today and use the capital to grow its bottom line by 20%, then that’s an incredibly powerful use of financial leverage. 😀
On the other hand, dividend companies can’t take advantage of low borrowing costs to the same extent. Otherwise, they would reinvest their profits to maximize invested capital. Since I believe interest rates will continue to stay low for the foreseeable future, I expect growth stocks to continue performing well.
Looking at my equity portfolio, it appears my growth stocks (AMZN, NFLX, GOOG, FB, etc) have vastly outperformed my dividend growth stocks over the last 10 years. I think this trend will continue. So I am changing my investment strategy.
This is why last week I wrote about purchasing Open Text and Tesla stocks. I also bought Alimentation Couche-Tard, another growth stock, earlier in the month.
I’m not going to sell any of my existing dividend stocks. I plan to leave my job in a couple of years and will need the passive income so I’m a staunch buy and hold investor.
But I still have a long investment journey of 50 more years, assuming I live to see my 83rd birthday, lol. Since building long term wealth is my priority, dividend stocks doesn’t seem like the best way forward. From now on I will focus more on investing new money in growth companies. 🙂
Random Useless Fact:
The median income for an electrician is $50,000 according to salary.com.