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Dividends Versus Capital Gains: Which Side Are You On?

Aug 2, 2016

In this issue:
» Is the Shipping Industry Set for a Revival?
» Price Wars in the Aviation Sector!
» ...and more!
00:00
Rohan Pinto, Research analyst

Two weeks ago, I wrote to you about dividends. More specifically, about the thoughts of a chairman of a company that had just hit the IPO market. In case you missed it, you can read it here.

This gentleman did not believe in dividends. He went on record to state that capital gains were more important. What's more, he believed that the aam investor should start thinking like the big guys. He should forget about dividends and only pay attention to the stock price.

Unfortunately, many people, especially those new to the markets, think the same way. They see dividends just a bonus. I would like to set the record straight.

First, the theory. According to finance textbooks, a company is only worth the amount of money that the owners can take out of it. In other words, if there is no free cash flow from the business in the long run, it's not worth anything.

Sure, the land, buildings, machinery, inventory, etc will be worth something. But not the business itself. You would do well to buy such a business well below its book value...if you want to buy it at all.

However, many companies have strong cash flows and are run by managements that regularly pay out a part of them. Over time, such 'steady stocks' can easily beat 'high-growth stocks'.

How?

Growth stocks are those listed companies that reinvest most of their profits. In other words, they either don't pay any dividends or they pay very little. Stock markets love these companies. Their share prices go up. Chasing capital gains in stocks that have already run up a lot is not a good idea.

But in a bull market, like the one we are in now, these stocks go up very fast. Investors conveniently forget two basic realities.

First, the total return on any investment includes the dividends as well as the capital gains.

Second, the capital gain you get from a stock is directly dependent on how much you paid for it.

As boring as it may sound, following the simple process below is more than enough to get rich with stocks:

  1. Select businesses with solid fundamentals
  2. Buy the stock only at a reasonable price
  3. Collect the dividends
  4. Reinvest those dividends
  5. Hold on for the long term

This timeless process gets lost in the din of the markets. If you're not convinced and need some proof, I found some very interesting data in an article on about.com.

So let's do a long-term performance comparison. The stocks in question are a fast-growing IBM and a slow-growing Standard Oil (now part of Exon Mobil). All growth rates in the table below are annualised and in per share terms. Dividends were all reinvested.

Which one do you think would have been the better investment? Hint: IBM's stock multiplied 300 times while Standard Oil's stock multiplied 120 times during this period.

IBM versus Standard Oil (1950 to 2003)
  Sales growth Earnings growth Dividend growth
IBM 12.19% 10.94% 9.19%
Standard Oil 8.04% 7.47% 7.11%

The surprising answer: Standard Oil.

US$1,000 invested in IBM in 1950 returned US$961,000 in 2003.

US$1,000 invested in Standard Oil in 1950, returned US$1,260,000 in 2003.

That's a difference of 31.1%.

How is this possible?

It's simple. The Standard Oil shareholders could reinvest their dividends at much cheaper prices. It was not a growth stock and thus people did not buy it for capital gains. IBM on the other hand, was a hot growth stock in those days. It would never trade cheap.

Thus, Standard Oil shareholders ended up with 15 times the number of shares compared to the IBM shareholders! This resulted in higher compounding.

The conclusion?

IBM's higher capital gains were completely overshadowed by the better dividend reinvestment opportunities in Standard Oil.

This is why, for long-term investors, dividends are at least as important as (if not more important than) capital gains.

You could buy a low dividend-paying growth stock at a high price today and hold on for a long time. Many people are doing so right now. But if you join this bandwagon, don't be surprised if the returns end up lower than your initial expectations.

In frothy markets like these, don't chase growth stocks. Stay safe and buy solid dividend paying businesses at reasonable prices. Reinvest those dividends and hold on. You will make good money in the long run, with much lower risk.

If you wish to explore this further, gain access to our special report, How To Pocket 10-30% Returns Without Selling Your Stock.

Do you think dividends are as important as capital gains? Let us know or post your comments on Equitymaster Club.

03:05 Chart of the Day

The global shipping industry has been struggling since the commodities super cycle boom went bust in 2008. Drastic fall in demand, excess capacity built on leverage were primarily the undoing of these shipping companies. The segment that was worst affected was the dry bulk shipping segment. The dry bulk shipping carry bulk commodities in large quantities like coal, iron ore, etc. China's enormous appetite for such commodities due to its infrastructure needs drove the dry bulk freight prices higher.

Shipping Recovery on the Cards?


The Baltic Dry Index (BDI) is a measure of freight rates for transporting bulk commodities. The BDI recently made all-time lows at 290 around Feb-2016. At these levels the bulk vessel owners struggled to even cover their operating expenses. However, there have been some signs of recovery. The demand for bulk commodities has firmed up, while excess supply is getting scrapped at a record rate. Both these factors should help to sustain the recovery of the markets over the long run.

03:50

Jet fuel prices broke their five-month uptrend with fuel prices falling nearly 4% for the month of August which provided some relief to the aviation companies. Fuel costs form around 30-35% of the operating costs for these companies thus affecting their profit margins. More than the level of fuel prices, it is the volatility of these prices which adversely impacts aviation companies.

The airline industry is highly competitive, where the customers have a higher bargaining power than the airlines. Thus, it becomes difficult for the airlines to dictate fares to its customers. Thus, constrained on raising fare prices, any increase in costs directly affects the companies' margins.

Driven by lower fuel prices, airlines have been able to reduce their losses with some of the low cost airlines even making profits. State owned Air India though continued to languish under its high operating costs and huge debt. The airline plans to come back to profitability by 2019. The long term profitability of the airlines remains to be seen in the face of volatility in prices going forward. One thing is for certain, they will face intense competition in their quest for sustainable profits.

04:40

After opening the day on a flattish note, the Indian stock markets rose and continued to trade above the dotted line at the time of writing. The BSE-Sensex was trading higher by about 115 points (up 0.41%), while the NSE Nifty was trading up by 30 points (up 0.34%). Majority of the sectoral indices were trading in the green with FMCG and Capital Goods sectors witnessing buying interest.

04:55 Today's Investing Mantra

"The universe I can't play in has become more attractive than the universe I can play in. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rohan Pinto (Research Analyst).

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4 Responses to "Dividends Versus Capital Gains: Which Side Are You On?"

DS

Aug 3, 2016

Good piece. but...the assumption here is that investors will park their money back into the stock the same very day they receive the cash - or thereabouts. While its easy to say to do so in theory, in practical terms, this is rarely followed. At the end of the day, an investing decision does take into consideration opportunity costs, and thus not necessarily fair to say that the stock from which one receives dividend is the best pick at the time, every single year, for such a long period.

Like (1)

SJ

Aug 3, 2016

Well written and insightful.

Like (1)

Chitranjan Gupta

Aug 2, 2016

The article touches upon an interesting topic. However, I do not agree with the views expressed therein.

While it cannot be denied that any dividends distributed by a company need to be added to the return from the Company, the superiority of dividends over growth may or may not be true.

In my view, if the company is able to reinvest the profits into the business with high returns, such reinvestment should bring higher returns to the investor. The comparison presented between IBM and Standard Oil may not be representative of other companies. Firstly, the comparison should not be over such a long period. A high growth company may not be able to maintain the pace of growth in the later years and may suffer in comparison.

Specifically, in the Indian context, dividends are inferior for the simple reason of taxation. While long term capital gains are fully tax exempt at the Company and shareholder level, the Company has to pay the Dividend Distribution Tax on dividends declared thus reducing the size of the total pie.

Like (1)

shrikant

Aug 2, 2016

Dear Rohan,

Thanks for your such wonderful and interesting article. In fact, last 30+ years I am following the same strategy. Because of your this article my policy gets strength and support .
Regards,

Shrikant

Like (1)
  
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