Dividend-Paying Stocks versus Growth Stocks

MSN Money recently suggested that people invest in dividend-paying stocks. Their summary:

At times like this, dividends are king. Stocks paying a high yield will hold up better as the market goes south. If interest rates go down, the prices on these stocks will go up because high yields will attract yield-hungry buyers. If recession fears turn out to be overblown, these stocks will go up along with the market. If inflation strikes, companies will see revenue and earnings increase, and they'll be able to raise dividends, making dividend-paying stocks a better bet than bonds.

I had a reader send me an email giving his thoughts on dividend-paying stocks versus growth stocks. His viewpoint:

My opinion is that ownership of dividend paying stocks vs. growth stocks is as much an emotional question as a financial question.

Let me explain.  Dividend paying stocks, particularly when the dividends are re-invested using a DRIP, are a valuable part of an overall stock portfolio.  The idea is that you buy more of the stock when the price is low, and less when the price is high.  In addition, you add stocks at a low cost per transaction and the purchase is automatic and routine, much like a payroll deduction 401(k) contribution.  You grow wealth steadily, but not spectacularly.

From a safety point of view, companies are typically very reluctant to cease paying dividends.  In fact, dividends are often increased.  This provides inflation protection as well as ROI protection.

On the other hand we have growth stocks.  Growth stocks can and do provide a slightly average higher return on investment.  Here, as always, the key questions are timing and risk. 

Buying Google at $80 is a brilliant move; buying Google at $750, not so good.  Even more difficult, for many people, is when to sell.  They often have an emotional attachment to a growth stock and are reluctant to sell it for fear the price will go up and they won't have made the maximum profit.  They are also reluctant to sell it when the price is down, because then they will have to recognize a loss and admit they made a mistake. 

Even worse is the emotional pain when an investor buys a growth stock, sells it at a loss, and then watches it go back above the sale price.  That really hurts!

With a dividend paying stock, the emotional attachment is typically less.  If an investor needs income, they simply stop the DRIP and have the dividends sent to them directly.  This way they get income, but don't face the question of when to sell the stock.

Of course, I invest primarily in index funds. But for those of you who buy stocks, what's your take on this issue?

Comments

[Rick]

I don't have a lot of experience buying stocks, but one thing I might recommend is: DIVERSIFY! Maybe buy a few growth stocks and then buy a few dividend paying stocks. One thing to note is that dividend paying stocks are not as safe as many people make them out to believe. For instance, Wachovia just announced a 41% cut in its dividend. Washington Mutual cut its dividend 71%. Another bank (I don't remember which one; National City?) cut its dividend 95% to just a penny per share.

Certainly, these are trying times, but it's not always true that a company will leave its dividend intact during recessionary times.

[tom]

Besides diversification another necesssary component to investing in individual stocks is RESEARCH.

You must do your homework on each and every stock you invest in. We never know what the markets or each company will do, but with thorough research, you minimize your risk.

[Christopher Smith]

I would say that the article's implicit distinction between dividend-paying stocks and "growth" stocks (which are held largely for their capital-gain potential) is misguided. Many companies that are in the rapid-growth phase do not pay dividends, true, but some companies (such as Frontline [FRO], a company I've invested in) both pay handsome dividends and have lots of room to appreciate.

I tend to take Warren Buffett's general approach and focus on the company's return on equity. The ROE indicates how profitable a company is in terms of how much capital was invested by shareholders. The company can then either pay the profits out immediately or reinvest them to expand its business.

Finally, although paying a dividend does have the downside of double taxation immediately, you would pay at least the same in capital-gains taxes if you sold appreciated stock, and one major advantage to dividend-paying stocks is that if you decide, for whatever reason, not to keep investing new money in a particular company, you can just stop reinvesting dividends and keep the cash stream without having to sell the stock.

[Bill]

Beware the false safety that dividend-paying stocks imply. WM, or Washington Mutual, had been paying a really good dividend, that is, until the company went to hell in a handbasket. It had been paying over 50 cents per share (or 6.6 percent), only to reduce it to 15 cents, then a penny (is that like leaving a penny tip? Now, it yields .3 percent) -- next quarter, you may see $0.00 per share.

So don't count on the dividend lasting. That which can be giveth can also be taken away.

[Noah]

I've always thought dividend paying stocks were strong in Roth IRAs, for the tax breaks. I don't know if that's true(I'm woefully market ignorant), but it does sound like taxation has some connection to this issue.

[Adam]

The safety and security of dividend paying stocks is directly linked to the company itself. The examples of falling dividend payments all come from the financial sector. This sector is having its own problems across the board with the mortgage crisis coming into full swing. Again research is the key regardless of looking into growth stocks, value stocks, dividend paying, or any other class you are interested in.

I find that dividend paying stocks help in reducing my emotional response to my 401k. I have taken to not looiking at the value of my dividend paying stocks and looking only in how much in dividneds I have recieved. This allows me to ignore the stock price which is fluctuating wildly (or seems to be) and treat them as if it was a long term savings account. On the other hand my growthh component of the protfolio has its entire value based solely on the value of the stocks which take big hits (and small gains) on a daily basis right now.

[Lord]

The known deviations from efficient markets are small caps, value, and momentum. These outperform large caps and growth over the long term. At certain times, notably late in the business cycle, large caps and growth can outperform, but eventually small caps and value deliver.

[Jimmy]

I run a virtual portfolio that has done really well with dividend paying stocks. I make sure the companies I invest in have solid balance sheets so there is less risk with them. These stocks increase in value as well as pay a good dividend income. It's a win-win situation.

[largebill]

To paraphrase others, it is all about the strength of the underlying company. The term Blue Chip is used to describe a company that reliably increases their dividends. A growth company typically doesn't pay a dividend as it is reinvesting their earnings into expanding the company which will hopefully lead to greater earnings. They both have risks and each investor has to understand their own tolerance for risk. Personally, I go about 60/40 and take the dividends and reinvest in other stocks.

[Param Iyer]

One needs to refer back to Ben Graham's Intelligent Investor for a better understanding of this issue.
Earnings & earnings growth is fantasy, dividends are real. A management that is accountable to investors must pay dividends beyond a reasonable reserve if it cannot find ways to increase return on equity. Management should focus on managing the business, not managing the money - which is a choice investors should make once they get the dividend.
Of course taxation angle makes this simple economics more complex, but the right way to fix it lies with legislature instead of stock picking...