Why both growth and income make sense

Many people look at income and growth investment strategy as mutually exclusive. Its either one or the other. I actually suggest that most people could benefit from both.

I often write articles on Seeking Alpha and there seems to be a perpetual debate that rages that between income investors and growth investors.  Most tend to be in either one camp or the other and I very rarely seen those that have a combination of both strategies.

The fact is that all investors could benefit from a combination of approaches. Dividend income stocks tend to provide steady consistent growth without much volatility.  They’re the type of stocks that will give you a good 5 to 10% increase in earnings and dividend income year on year, which will mean that you’ll get income over the long-term.  However these businesses are unlikely to be life-changing events in terms of wealth accumulation unless you’re willing to give them 20 or 30 years to work.

The fact that they provide a consistent income stream and are generally less volatile businesses make them attractive for a portfolio because they won’t be subject to extreme capital fluctuations. AT&T (T), Verizon (V), Coca-Cola (KO) and Procter & Gamble (PG) are stocks that you can almost set your watch by.

You can almost predict down to the dollar exactly what their earnings and dividend growth will be. By the same token these businesses are quite mature so the opportunity to drive dramatic earnings growth is fairly slim. That will eventually mean that you run into a situation where these businesses will give you dividend growth at marginally above a rate of inflation.

Of course that’s nothing to laugh at given where bond rates currently are and for retirees who built up a fairly good capital base getting income preservation adjusted for inflation is probably a good outcome.

For those that have a longer-term horizon I’ve often thought that it makes sense to pursue more growth oriented stocks that have a better chance of allowing you to accumulate quite a large nest egg relatively quickly.  There is to be a lot of misconception about what constitutes a good growth stock.

I’m not talking here about speculative businesses that generate negative earnings with poor cash flows. Your penny stock that rises from $0.01 to $0.50 before crashing again.  I’m talking about really high-quality businesses that generate good earnings growth, strong margins and consistent operating cash flow growth that just don’t happen to pay dividends .

MasterCard (MA) and Visa (V) are 2 very good examples of two such businesses. While it’s true that these businesses both pay dividends, the yields are so low that they are nothing to write home about. In fact both MasterCard and Visa generate a sub 1% dividend yield.

However the capital returns on these businesses have been fantastic. In Mastercard’s case over a long of time. Investors who put in $10,000 at the MasterCard at the IPO would see a stock that’s generated almost $200,000 in the period since.

The argument that the business didn’t pay a dividend is pretty moot because surely even the most hard-core dividend advocate would’ve figure out a way to turn some of that capital into steady income. In fact just as important as the capital accumulation to date is the fact that both MasterCard and Visa both have long term opportunities to see substantial growth.

These businesses should see growth well in excess of inflation for at least the next decade. And for income oriented investors these businesses will start spitting out significant amounts of cash well in excess of their ability to be reinvested back into the business.

In fact that’s the beauty with some of these growth oriented businesses. Eventually their cash generation will be so far in excess of the core needs of the business that these will be your future dividend payers in years to come. Apple is a very good example of that sort of trend.

Apple eventually had such surplus excess cash requirements that couldn’t be properly redeployed in the business that they had no choice really but to pay out a dividend. Starbucks also is a business that has started paying a dividend and will likely be a very promising dividend payer into the future.

For dividend oriented investors high-quality growth businesses help provide the opportunity to generate some meaningful capital growth. They also offer the ability to pick the next generation of dividend oriented businesses. In addition, they act as a hedge to your core dividend portfolio and reduce the risk that your more mature businesses will run into major headwinds and only be able to offer very modest rates of dividend growth.

For example the more mature oil payers run the risk of alternate energy being a meaningful threat to the businesses. AT&T and Verizon also have the risk of broad-based Wi-Fi penetration and “wifi first networks” reducing the potential revenues that they will derive in the future.

For growth oriented investors, dividend paying businesses help reduce the explicit volatility of their portfolios. You don’t need to look any further than the recent events around Chipotle to understand just how volatile growth stocks can be.

Chipotle has plummeted almost 40% over a period of 12 months given some of the company specific issues that it is facing. The reason that the drop was so steep was largely because of the premium that the business had as a growth stock.  You’ll never see stocks like Verizon or AT&T have that level of volatility and that extent of price change over such a short period of time.

My approach has actually been to combine both high-quality dividend growth as well as rapidly growing growth stocks with high margins and minimal debt.  I want dividend income today but I also want a shot at being able to accumulate a fairly substantial nest egg over the next decade,  as well as being able to pick some of those cash rich businesses that will likely turn into the dividend paying stocks in the future.

The key always with growth oriented stocks is to ensure that you get them at reasonable valuations and the way I’ve been constructing my approach is to try and find those businesses that are offering growth at relatively reasonable prices.  Ideally somewhere with the peg ratio of between one and 1.5.

For those of you that are younger with a substantial amount of time on your hands who are primarily dividend investors at this point, a modest allocation to these high-quality growth stocks could well be worth considering.

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