This is an interesting topic that I was asked by a friend to share my thoughts on, and probably one that might be of interest to a wider pool of readers – hence I thought of penning some of my thoughts and analysis down in this post.
Comparing apples and oranges
Dividend and growth investing are on opposite ends of the investing spectrum where we aim to achieve long-term returns. Investment returns can be both from dividend income or capital appreciation through stock price growth, usually as a result of earnings growth.
Accountancy teaches us that when companies earn a profit, they may either distribute a share of these profits to investors as dividends, or reinvest into their operations as retained earnings to provide for potentially higher future earnings and future dividends. Some companies may also opt to buy back their shares with their capital, artificially increasing the value (EPS) of their shares and hence the price. There is usually a trade off – paying higher dividends now means little room for reinvested capital for future growth.
Dividend stocks are a cornerstone in many investors’ portfolio, especially in Asian countries like Singapore. The fact that many Singaporeans often invest in ‘blue-chips’ – stocks with a stable track record of dividend payouts or REITs demonstrate their attractiveness as an investment tool.
In particular, the Singapore STI has a current dividend yield of 3.4%, much higher than the US S&P500 which yields roughly 2.2% annually. A large proportion of our local stocks are made up of stable dividend-paying stocks from the financial services industry or from real estate investment trusts which are mandated by law to distribute 90% of their income as dividends. Compare this to the S&P500, which is made out of numerous growth stocks especially from the consumer and technology industry.
While some of you might appreciate the higher yield of the STI, remember that total return is a function of both dividend yield and capital gains yield. Looking at the past 10 years of growth of both indexes as a proxy of the economic growth, we see that the US market actually significantly outperformed in total returns due to its significant growth in share prices.
What could be some possible reasons for this disparity?
I believe that the US is the world’s capital for technological innovation – with a significant number of innovative firms from the tech sector like Apple, Google, Amazon, Netflix disrupting traditional industries, gaining market share and growing their earnings very quickly through a high growth strategy. They command global supply lines and sell to a worldwide audience with great ability to further consolidate and buy up smaller competitive firms to retain their pricing power.
Furthermore, low interest rates and supportive monetary policy has significantly aided the value of stocks in the US. Interest rates have fallen tremendously over the years, driving cost of borrowing down. Post the 2008 financial crisis, the Fed has also added trillions of dollars of assets to its balance sheet – driving asset values up.
What is going to happen?
As borrowing costs are expected to normalize, the Fed raising interest rates poise two significant risks to stock prices. One, a higher interest rate imply a higher discount rate in stock valuation, making the market more expensive at current prices. Secondly, borrowing costs go up and firms invest less for the future given the higher hurdle rate. Consumers spend less and put more in bank deposits, reducing overall economy demand and lead to falling revenues. Inflation may be kept in check and put downward wage pressure, keeping prices and costs low. Firms looking to deploy capital might opt to buy back shares if they are an attractive option. But nobody really knows what will happen.
For growth stocks, chances are, the market has already baked too much optimism in future growth and will see their prices correct in the short term to more reasonable valuations. Dividend stocks with strong payout history will see demand as investors look for better yields and safer stocks amidst the flight to safety.
Another flipside scenario is continued earnings growth from corporate tax cuts, share buybacks, productivity growth and continued strong earnings growth might push stock prices even higher.
For a young investor, we should take advantage of global market conditions to see whether growth or dividend stocks might be more attractive in the short term. As growth stocks perform strongly in times of strong economic growth, and recessions tend to be less frequent than economic expansions, a greater percentage of growth stocks in a portfolio is a faster way to grow your wealth.
The ultimate question then, is which to have in your portfolio
If you’re a young investor, then you might not require regular cash flows in your portfolio from dividends. Consider the fact that these cash could be either reinvested by the company and you have to deploy further effort to reinvest these cash anyway, dividend stocks might be less attractive.
On the other hand, dividend stocks provide stable recurring income that you know can put your mind at ease, knowing that in times of bear markets, these stocks provide a certain level of safety and income support.
But why not both? I’d recommend being exposed to US economic growth – driven by its innovative economy, accessible financial markets and decades of proof that investing in the broad US market for the long term always works.
At the same time, while threading cautiously on forex risks while investing in overseas markets, staying invested in the Singapore market provides some form of portfolio diversification. If we are planning to retire in Singapore then a Singapore core portfolio will help to provide the needed dividend income or lump sum withdrawal options easily without US estate tax or dividend withholding tax complications.
As always, I like diversity and simplicity in building a portfolio – so broad market ETFs work for me to gain equity exposure. If you are keen on US growth stocks, check out IUSG or the broad S&P 500 accessible via US exchanges (SPY) or local exchanges (S27).