Portfolio building: Should we start with dividend or growth stocks

Abstract – In a dialogue with a student, he asked me whether he should start off with growth stocks or dividend stocks if he plans to build a portfolio. This, obviously was not a do-or-die situation, because building a portfolio does not require an instantaneous action or have to be right first time. But still, it actually set me a bit of thinking because that starting point was a long time ago for me. I was trying to picture myself what I would probably do in that situation. Presumably he was young working adult, perhaps with some decent savings. Obviously, he did not divulge how much he had as he meant it to be a passing question.  

Dividend stocks are stocks that pay good dividends. Usually the companies behind these stocks have grown to a level that the growth potential is unlikely to be significant (at least in the near future). Given that the company still has good earning power, they are able to distribute out their earnings in the form of high dividends. Of course, we are talking about companies that are able to distribute sustainably good dividends and not those that distribute dividends from debts. Apart from REITs, some high dividend stocks can have their dividend pay-out as high as 90%. Constant dividends usually help create a floor price for stock unless the market detects a fall in future dividends.

Growth stocks, by their stage of development, distribute little or even no dividend. Investors are usually rewarded through significant growth in the share price (if we purchased the correct stocks). However, we can expect more volatility in their stock price because there is little or no fall-backs on dividends as we go forward in time. The obvious risk of buying growth stocks is when the company share price plunge for whatever reason and shareholders get close to nothing when they sell their shares.

By nature, companies usually start off as a growth stock paying little or no dividends before they finally become mature and start to pay good dividends. So, if we were to buy into such a right stock early enough, we are effectively riding on the path of growing dividend and finally enjoy the big, fat dividend as the company matures. Of course, during its development, investors stand a high risk that the company could not take off, got derailed or becomes debt-laden(*). In such a case, it is likely to end up in a big hit on the share price and, of course, the loss of dividend. In making such decision whether to buy into a growth stock, one really needs to assess the affordability as well as the WILLINGNESS TO LOSE. It is a question of risk tolerance based on our own experience and background. No one else knows better of our own financials and investing character other than ourselves. The only thing that is obvious to me is that this young man is in a life-stage when he has a higher risk tolerance compare to another person supporting a family with mouths to feed. To me, buying the right stock in growth companies actually helps grow our wealth. Imagine if we buy a stock at $5 per share and it grows to $10 per share, it would have grown our wealth by 2 times, apart from the growing dividends along the way.  This is obviously the objective of getting into any investments (not necessary buying into stocks). But, of course, getting into such investments comes with huge risks which we have to be always mindful of. Perhaps, the saving grace in maintaining a growth stock portfolio is that, at any one time, each stock is at a different growth stage and the good and bad ones tend to offset or cancel out each other.

Now on the dividend stocks. It is likely that when a company pays good dividend, it has already passed its growth stage and that is why it is able to pay us good dividends. They are generally proven companies. So, buying a dividend stock is like buying an annuity, as if we pay an insurance company a sum of money and we get back the payments in the form of dividends. There is some kind of protection from an investor’s point of view. On the share price, it is relatively difficult for dividend stocks to advance significantly because a huge percentage of the profit is paid out to the shareholders. In effect, shareholders do not really get to enjoy share price appreciation but just good dividends. Still, this type of investment is good in a falling interest rate environment because risk-averse investors would look for alternative investments to park their money. Obviously, under such a circumstance, there would be price appreciation not due to the company growth but due to liquidity in the system. The situation would certainly reverse itself when we get into upside slope of the interest rate curve. We are likely to see the share price drop because the same group of investors would start to shift their money back to the bank, base on their risk-reward philosophy. Nevertheless, this type of investment appeals to people who do not have an active income and they need to see their returns almost immediately, in particular, the retirees.

Back on the young gentleman’s dilemma. While it is always good to see rewards coming back to our pockets almost immediately after we invested, the uprising interest rate environment would certainly see the value of the portfolio shrinking going forward if we have too many of these high-yield stocks. Perhaps, he can take on a more aggressive path of growth than income at this stage. After all, he has an active income to fall back on. It is unlike another person who has no active income. If he really needs a protection, then perhaps he can separately purchase an annuity. On the other hand, the capital appreciation for growth stocks can be very rewarding. Imagine the above-mentioned growth stock has a dividend yield of just 2% at $5 and it continued with the same yield, would mean that the dividend is 20 cents when the share price is at $10. At the purchase price at $5 with a dividend of 20 cents would mean that the dividend yield is 4%. In time to come, this dividend yield can be even higher than the dividend yield from a dividend paying stock. In effect, it is a capital appreciation, a growing dividend and a low capital outlay. Certainly, it is even more rewarding if we invest the dividends because it is a growth stock. This is exactly how wealth is made. Wealth is not made by buying an annuity. An annuity is just a protection. But that said, we have to constantly aware of the risk that we are in, especially when we hold growth stocks. A lot of growth companies fall from grace, not because they are in the wrong product, but because of pure mismanagement. Never wear a hat that is too big for our head. Certainly for his case, I am not saying that he has to be 100% on growth stock. I am just saying that he can afford to be slightly more aggressive at this life-stage. Taking on some risks at this stage can be very rewarding for the future. But, whether he is willing to take that risk is another question.

(*) At the time of post, at least three SGX stocks were in such a situation, namely, Noble, Midas and Hyflux.

Disclaimer – The above arguments are the personal opinions of the writer. They do not serve as recommendations to buy or sell the securities, the indices or any ETFs or unit trusts if they are mentioned.

Brennen has been investing in the stock market for 28 years. He trains occasionally and is a managing partner for BP Wealth Learning Centre. He is the instructor for two online courses on InvestingNote – Value Investing: The Essential Guide and Value Investing: The Ultimate Guide. He is also the author of the book – “Building Wealth Together Through Stocks” which is available in both soft and hardcopy.

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