Dividends vs capital growth: Which should you choose for long-term investment?

When it comes to investing in the stock market, one common question traders face is whether dividends are more valuable than capital growth, or vice versa. In other words, should you focus on earning a consistent dividend stream, or aim for stock price growth over the long term?

Motivation and intent: what’s your investment goal?

Before diving into the pros and cons of dividends versus capital growth, it’s essential to consider your motivation and investment goals. If you have a lump sum to invest and are looking for a tax-effective position, dividends could be more relevant. This is especially true in countries like Australia, Canada, and parts of Europe, where the superannuation industry and pension funds hold a significant portion of shares.

For example, the Australian stock market sees an average dividend yield of 4-5%¹, compared to the US, where dividend yields hover around 1.5-2%. This difference is due to the contrasting strategies of companies in these regions. In the US, companies prefer reinvesting revenue into stock price growth, often through share buybacks, which help push the share price higher by reducing the supply of shares on the market. Conversely, European, Canadian, and Australian companies tend to return profits to shareholders through dividends, resulting in more stable share prices for dividend-paying stocks.

Dividends vs capital growth: Which is more profitable?

To determine whether dividends or capital growth is more profitable, you need to consider both factors over the long term. While dividends offer a stable cash flow to investors, capital growth generally tends to outperform dividends when averaged over time. However, this is a generalisation, and personal circumstances will also affect the equation.

For Australian investors, the franking credits system is an important factor. A stock paying a 5% dividend may, with franking credits, see that return increased to 7.5%. But it’s worth noting that not all companies offer franking credits, and this should be checked before investing.

Understanding market growth and dividend yields

Another critical factor is the average annual growth of the market you’re investing in. On average, the stock market grows by 7-10% annually. If a stock offers a 10% dividend yield, the choice is clear. Some Australian and Canadian stocks consistently pay dividends of 10% or higher, making them an attractive option for investors seeking steady returns.

However, keep in mind that high-dividend-paying stocks often show lower price growth than non-dividend-paying stocks. These companies tend to be more mature, allocating a significant portion of profits to dividends rather than reinvesting in growth and expansion.

Defensive stocks: stability vs growth

High-dividend-paying stocks, often found in defensive sectors like banking, utilities, and essential consumer goods, are known for stable earnings, which can be used for consistent dividend payments. However, these stocks typically offer less price growth than companies focusing on reinvestment.

For instance, let’s look at two major Australian banks: Westpac Bank and Commonwealth Bank. While both banks pay reliable dividends (4.8% and 2.85%, respectively), their stock prices show relatively low growth over certain periods. If you compare the start and end prices on their 20-year charts, you’ll notice substantial capital gains – but these gains come after long periods of sideways movement. Would you have been happy to hold these stocks during those times? Timing plays a crucial role when evaluating dividends versus growth.

Buy and hold: A long-term strategy

The discussion above primarily revolves around long-term investing, where the goal is to collect dividends or achieve price growth over an extended period. This strategy, commonly referred to as ‘buy and hold,’ still holds a valuable place in many investors’ portfolios. Timing the market may not always be necessary if you’re prepared to ride out periods of flat or slow growth.

The best of both worlds: Growth and dividends

Ideally, investors would seek stocks that offer both price growth and dividends. However, such stocks are rare. Trade Radar provides filters to help you identify these types of stocks, making it easier to pinpoint opportunities that offer the best of both worlds.

Whether dividends or capital growth is more profitable depends on your personal investment goals, timeline, and the market conditions you’re operating in. Both strategies have their merits, and sometimes the best approach is a balanced one.

Source:

1. Analyzing High Dividend Yield Strategies in Australia, Feb 2023, S&P Dow Jones Indices