A dividend versus a growth investment strategy depends on the client.sorbetto/iStockPhoto / Getty Images
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Some clients may be asking their advisors for ways they can get in on the “Magnificent Seven” group of U.S. technology stocks’ gains – either by buying the stocks directly or through funds linked to the soaring sector. The issue raises a fundamental debate: Is it better to invest primarily in companies with high growth potential, or more established companies with a proven track record that reward investors with dividend payments?
“There are many different investing styles – that’s what makes a market,” says Rebecca Teltscher, portfolio manager at Newhaven Asset Management Inc. in Toronto. Her firm likes dividends for the stable income they produce in portfolios – but also for the commitment to shareholders.
“Unlike share buybacks that management can turn on and off like a light switch, dividends are a permanent commitment and a crucial signal of a company’s sustainable profitability,” she adds.
Ms. Teltscher also notes that dividends are good at offsetting inflation. Unlike traditional bonds that pay a set interest rate, dividends often grow over time as the company becomes more profitable.
“We track portfolio dividend growth to make sure the growth in income keeps up with or is higher than inflation on a long-term basis,” she says.
Downside protection is another reason Ms. Teltscher cites for investing in dividend-paying stocks.
“It’s much safer to collect some of the total return up front in the form of the dividend rather than relying only on share price appreciation,” she says, citing Valeant Pharmaceuticals and the entire cannabis sector as Canadian examples considered to be convincing growth stories that resulted in unhappy endings for investors.
Some observers feel the choice between investing in dividend-paying versus growth stocks depends on an investor’s age or risk tolerance, but Ms. Teltscher doesn’t see it that way.
Differing approach for younger versus older investors
“The ‘old school’ investment approach would suggest a higher risk tolerance for younger investors and a higher yield/income focus for older investors. We disagree with this advice and believe dividend investing works at any stage of life,” she says.
Ms. Teltscher points to the power of reinvesting and compounding dividend payments.
“Ideally, you should be able to live entirely off the income generated in the portfolio without having to sell down any of your capital,” she says, adding this provides peace of mind for her clients because they don’t need to look at stock prices every day and can focus on the income they collect from the portfolio.
Some other money managers have a different perspective on the “dividends versus growth” debate. Barry Schwartz, executive vice-president and chief investment officer at Baskin Wealth Management in Toronto, says that in a world in which interest rates were close to 0 per cent, holding dividend-payers made sense for income.
“Now that bonds and [guaranteed investment certificates (GICs)] are yielding 4 to 5 per cent, you don’t need to own a mediocre business that has no growth, lots of leverage and a bad business model to get your income,” he says.
Mr. Schwartz says investors should own good businesses, whether they pay a dividend or not, and hold bonds and GICs for income.
“Dividend stocks are not risk-free and can be much riskier than a company that doesn’t pay dividends. It all comes down to the prospects for that business,” he explains. “A high dividend-payer can cut its dividend by 50 per cent or to zero quite quickly if the environment changes.”
Mr. Schwartz adds the best businesses in the world can invest the free cash flow they generate at high rates of returns by either making acquisitions or launching new business lines.
“They’re free from the constraints of a dividend policy that eats up all the excess cash flow.”
He notes some of the top performers over the past five to 10 years are companies that have little to no dividends, such as Constellation Software Inc. CSU-T, TFI International Inc. TFII-T, Alimentation Couche-Tard Inc. ATD-T and Dollarama Inc. DOL-T.
On the other hand, he feels the problem with many Canadian dividend-focused companies is they’re generally slow-growing businesses with significant leverage that are facing technological disruption and even regulatory concerns.
Some money managers take the middle ground on this issue.
“The growth versus income debate has been going on for as long as there have been equity markets,” says Lyle Stein, president of Forvest Global Wealth Management in Toronto. “The simplest answer is it depends on one’s need for income and time horizon.”
Mr. Stein notes that an employed 30-year-old has an extremely long horizon and can emphasize growth in terms of achieving a retirement objective while a 70-year-old with no income other than from the Canada Pension Plan and a portfolio would find selling holdings continually to be distressing.
“Buying equities based on growth potential sounds wonderful, and when done right, is spectacular in terms of return – look at Nvidia Corp. NVDA-Q most recently,” Mr. Stein says. “The risk comes in when the earnings slow, and worse, when the multiple shrinks.”
He cites Palo Alto Networks Inc. PANW-Q as a recent example of a high-multiple stock that lost 25 per cent of its value in one day when the company warned its growth rate would be slowing down. He also points to lithium mining and plant-based foods as examples of stories that never made it, and Blackberry Ltd. BB-T as a world-beating company that came crashing down to earth.
Mr. Stein likes a diversified portfolio with both growth and income components. As well, he is a believer in watching all holdings closely and being ready to sell when a company’s dividend-paying ability becomes impaired, or when a high-growth stock rises too quickly.
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