Investors are often characterised as being either growth or income. But many experienced investors take a more pragmatic approach and successfully combine the two to achieve a total return that is less volatile and still meets their primary investment objective.
One strategy is to use income stocks to help a growth-focused investor achieve a strong total return.
When a company pays a high dividend it often means that it is distributing a larger portion of after-tax profits, and leads to the misconception that is is unsuitable for an investor seeking capital growth. Growth investors typically prefer a company reinvest its profits for future expansion, rather than paying them out to shareholders.
To understand why income stocks might suit a growth investor, let’s break down the components of a dividend that we receive from a company. First, there is a dividend payment, which is often expressed as a yield to give an indication of the payment relative to the company’s share price. The average yield on the All Ordinaries is 3.9 per cent.
Then there are imputation or franking credits. This is the amount investors receive back from the Australian Tax Office in compensation for the tax already paid by the company on their behalf. Investors on a zero or low marginal tax rate, such as self-managed superannuation fund members, will receive an amplified benefit as their dividend will be boosted to a greater extent by the franking credits.
The franked dividend yield for the local market is 5 per cent. Looking at the almost 500 constituents of the All Ordinaries Index, there are 170 that have a higher yield than the average. It is quite conceivable that, with a bit of finessing and due diligence, investors can achieve a dividend yield that is 2-3 percentage points higher.
But, a growth investor looking for income stocks knows it’s not about finding dividends at any cost. Investors need to ensure that dividend stocks are financially strong enough to support the dividend moving forward.
And herein lays the final piece of the total return puzzle for the growth investor and that is to reinvest the dividend back into the company and let the power of compounding, and the quality of your business, look after the rest.
The accompanying table shows the Stock Doctor star income stocks and their performance over the past year, on both a share price basis and with dividends reinvested. You’ll see the impact of reinvesting the dividend for the period. And these figures exclude the additional benefit of franking credits, boosting total returns even further.
The real benefit of such a strategy is far beyond a one-year time frame. When done over five or 10 years, strong consistent dividends, the power of compounding and companies with strong fundamentals, growth investors have another, potentially less volatile, path to achieving their objective.