I’ve been writing here about growth investing more recently. However readers shouldn’t infer that I’ve turned my back on dividend investing at all.
I started my investment journey as a dividend investor. I could see the obvious attractions of being invested in stocks that were mature enough to return cash on a regular basis to me. That typically meant that they had good underlying cash flow, strong financial management and disciplined capital allocation processes.
Furthermore from a personal perspective, generating a growing passive income stream continually brings me one step closer to financial independence.
However in the last few years I’ve been reading a lot of material from various investment sources. World-class investors who been able to perform benchmarks over the long-term. The common thread of insight that I’ve taken away from most of this material is an overwhelming focus on simply finding the best business.
In many instances too narrow a focus on dividend paying investments restricts your potential universe of candidates to a very narrow subset. By and large you tend to miss some of those businesses that are the emerging leaders of tomorrow not the really early-stage small caps that have as much chance of success as they do a failure, but emerging businesses that have carved out a promising niche which could grow into something substantial.
I tend to employ the same types of discipline when searching for these growth businesses as I do with my traditional dividend portfolio. My focus tends to be on businesses that generate substantial cash flows, can deliver strong and increasing rates of return on capital and which tend to be asset light.
This ensures that returns from the business can be distributed to shareholders by dividends and buybacks and don’t need to be plowed back into the business to fund capex or working capital.
However back to the fundamental question of this blog post. Can growth and dividend income strategies coexist? My definitive viewpoint here is absolutely.
In fact I see both of the strategies working hand-in-hand with the primary goal of generating long-term passive income.
See, dividend focused companies tend to be mature cash generating machines. Their operations have relatively low need for ongoing investment because by and large they’ve tapped most of the growth opportunities that are available to them.
They’re at the position now where they can simply harvest much of the cash to their operations generate and distribute that out to the shareholders in the form of stock buybacks or dividends. Payout ratios of these businesses can be high and with growth prospects limited. The ability of these businesses to substantially ramp cash returns to investors are fairly limited, though dividends are secure.
Growth businesses on the other hand are at a point in their journeys where substantial income and reinvestment is required to go after the many growth opportunities at their disposal.
That typically means reinvesting capital back into the business to capture available market growth. Provided that capital is being redeployed into opportunities that generate substantial returns on investment then excess capital makes more sense being redeployed into such a business rather than being distributed to investors.
The real secret and beauty of what these companies are doing is they’re allowing excess capital to compound in a tax effective manner in their core operations to build substantially larger enterprises.
However at some point, like more mature companies, these growth machines simply run out of growth opportunities that require such substantial reinvestment of capital back into the business. At that point in time when surplus capital presents itself, it will naturally make its way out to shareholders in the form of dividends. Until that time this capital is effectively able to compound in a tax-free manner on behalf of shareholders.
When analyzed in this context, growth investing and dividend investing can certainly coexist, particularly for the younger investors. Dividend investing allows the steady accumulation of modest amounts of passive income today from businesses that are more mature and have largely tapped out their growth opportunities.
Growth investments lay the seeds for that next class of passive income generators. These are likely the next decade’s dividend payers. In the interim these businesses are effectively compounding capital internally at high rates of return and creating massive enterprises and dominating their respective markets. However in the medium to long-term as these enterprises progressively exhaust growth opportunities, the need for such high reinvestment back into the core operations steadily decreases such that excess capital can be returned to investors either through buybacks or steadily increasing dividends.
Thus growth investing can really be considered to be all about finding the big dividend payers of tomorrow. With a focus on cash rich businesses that have large and growing growth opportunities in front of them an investor should be able to foresee the point when those growth opportunities are eventually tapped out and capital can be returned back to shareholders.
In the meanwhile if these businesses are truly compounding machines then capital appreciation will steadily rise to the benefit of the investor via strong capital growth. This article was written by Financially Integrated. If you enjoyed this article, please consider subscribing to my feed.