There are plenty of different investment strategies and styles for investors to choose from. But two have created a fierce debate that has been raging on Wall Street since its early days.
Which is better, value or growth stocks?
The two styles of investing certainly have their respective fans, and there has been much ink spilled over which is ultimately better for your portfolio over the long haul. But when it comes to dividends, there certainly is one that is better than the other.
Various pieces of academic research show that investors should be looking towards “value” when it comes to dividends. A combination of various factors helps the style deliver on the dividend front.
For investors seeking income, steering your portfolio towards value is key.
The Basics
In order for investors to understand why value stocks are an income seekers best friend, you first have to understand what they are.
Growth stocks are basically defined as those firms that have the potential for “growth” in the foreseeable future. Typically, these stocks will experience faster-than-average increases in revenues, earnings or cash flow than broader market or sector averages. Additionally, investors are willing to pay higher prices – and therefore higher price-to-earnings multiples – for the privilege of owning that growth potential.
Value stocks are those stocks that are trading for prices below their fundamental worth. That can simply be on price-to-earnings or it can be on a combination of factors including book value, assets on hand, debt to equity, etc. The reasons for these stocks to become undervalued by the market can vary wildly. But the overall theme is they are worth more than they currently can be had for.
With these two definitions in hand, we can form the basis of why value is a better dividend buy.
The Simple Reason Value Beats Growth on Dividends
For starters, the definition of growth stocks lends itself to much smaller firms. The vast bulk of growth stocks tend to be mid- and small-caps. As a result, these firms devote most of their current revenue toward further expansion or acquisitions. Dividends tend to be the last thing on their minds.
Contrast that with value stocks, which tend to be large-caps. These are mature companies that primarily use their earnings to pay dividends. As a result, value stocks tend to produce more current income than growth-oriented firms. Aside from simply paying out more, value stocks generally have higher yields based on their lower prices. If two stocks both pay $2 in dividends, and one can be had for $100, and the other for $90, the $90 stock yields more, assuming all things are equal.
Looking at the surface, it’s easy to see how value is a dividend investor’s best friend. But there are some more complex reasons why investors should look at value stocks.
Dividends & the Value Premium
According to a recent study by Bank of America/Merrill Lynch, value has crushed growth. And the reason for that has been dividends. Over a 90-year period starting in 1926, growth stocks returned an average of 12.6% annually. Not too shabby. Except that value stocks have delivered an average return of 17% per year. This extra boost is dubbed the “value premium” by academics, and much of it comes from dividends.
Smart-beta pioneer Research Affiliates’ latest study on the value premium showed that value investors actually end up capturing much of the “growth” of growth stocks. The problem is that the market gets wrapped up in a growth stocks story. Investors tend to pay too much, too soon for the firm’s future cash flows, i.e. its dividends. This causes growth stocks to underperform over the long haul. At some point, the market loses its enthusiasm for a “growth story” and bails on the stock. It’s here that value investors step in and buy these cheap growth stocks at the right moment to actually capture future dividends and cash flows.
The beauty is that investors don’t have to be active in this sort of capture. Broad indexes – when they reconstitute and rebalance – do it automatically. This causes value indexes to have higher rates of dividend growth, which in turn push higher total returns.
Get Some Value Stocks
So where does that leave income seekers? Hopefully, in the value camp. Value stocks simply beat growth. There’s no other way to describe it. The combination of high current yields, and the so-called “value premium,” ultimately lead to outperformance and a high level of total returns.
For anyone serious about dividends, value stocks should be the only ones on your list.
