That all-dividend diet you're on may not be as healthy as you think.
Stocks paying dividends have been superstars for three years now, but nothing works well at all times in investing. That's why a dividend-based portfolio should include some growth stocks, which for the most part tend to be non-dividend payers.
As a permanent portfolio foundation, dividend stocks are absolutely great. I use them myself as an investor, and I've written reams on the subject. The word "dividend" has been mentioned 104 times in the column over the past two years.
Let's not overplay the dangers of dividends. One thing you do not need to worry about is a dividend bubble – that's a bogus term used by attention grabbers who like scaring retail investors. But while dividend stocks won't crash, they will fall out of favour at some point. It might happen when the economy is flying and interest rates are rising steadily. Slow-and-steady dividend payers in sectors like utilities and pipeline could easily be roadkill for a time.
Growth investing focuses on companies, usually small to medium-sized ones, that are reinvesting all or almost all their profits back into the business rather than paying money to shareholders in the form of dividends. Ideally, the returns a growth company will generate by building its business through acquisition or expansion will exceed the total return of a dividend stock (dividends plus share price gains). Of course, it doesn't always work out like this in reality.
"There are plenty of growth stories where capital is squandered," said Stephen Hui, portfolio manager and partner at growth specialist Pembroke Management Ltd. in Montreal. "I can understand the cynicism that people have on growth stories where they raise money, they go out and spend that money and they don't generate any decent return on capital."
And then there are growth stocks like Peer 1 Network Enterprises Inc. (PIX-TSX), an Internet infrastructure company and Pembroke holding since mid-2008. Mr. Hui said Peer 1 management saw an opportunity several years back to expand capacity to meet rising demand for data storage. They responded with a multiyear expansion that last year started to generate the fast-rising revenue and cash flow that define growth stocks.
Cogeco Cable Inc. has a deal in place to buy Peer 1 for $3.85 per share. Pembroke starting acquiring shares of Peer 1 for its fund portfolios as far back as mid-2008 for as little as $1 per share. "This is a stock where a dividend was never in the conversation," Mr. Hui said.
Another example of what growth investing can do is O'Reilly Automotive Inc. (ORLY-Nasdaq), a U.S. retailer of after-market auto parts that has increased both sales and earnings per share by about 20 per cent annually since the end of 1992. Pembroke started buying O'Reilly stock in 1993, when it ended the year at the split-adjusted equivalent of $3.63 (U.S.). Today, the company trades around $88. Dividend: none.
Dividends and growth investing are not mutually exclusive. In fact, 23 of the 50 or so stocks in the GBC Canadian Growth Fund pay dividends, and seven of 40 in the GBC American Growth Fund do so. Mr. Hui said these dividend payers still have attractive growth opportunities, but they generate more cash than they need to exploit them.
That said, few of the dividend payers in Pembroke portfolios would appeal to yield-oriented dividend investors. Two of the Top Five holdings in GBC Canadian Growth as of the most recent update were Linamar Corp. (LNR-TSX), an auto parts maker with a dividend yield of just 1.3 per cent, and Gildan Activewear (GIL-TSX), with a yield of just under 1 per cent.
Dividend stocks have deservedly received lots of attention in recent years because of their market-beating performance. But Pembroke's growth funds have done well, too. GBC Canadian Growth had a five-year annualized return of 2.8 per cent as of Dec. 31, while the S&P/TSX composite index gained 0.8 per cent. GBC American Growth has a five-year return of 4.3 per cent, compared to 1.7 per cent for the S&P 500 in Canadian dollars.
You likely haven't heard about these funds because Pembroke is a small outfit that doesn't compensate advisers for selling its products and charges a minimum $10,000 as an upfront investment if you buy through a broker ($100,000 if you buy direct from the company). Also, growth is an obscure, if not malign, strategy in the eyes of some investors. Mutual funds use the term growth generically, and there's also the legacy of Nortel Networks, a former growth story that became one of this country's greatest ever wealth destroyers.
It's no coincidence that income trusts became popular as Nortel was collapsing. Trusts were built on the idea of management paying most or all profits to shareholders rather than reinvesting them.
Mr. Hui said Pembroke's challenge as a growth manager is to find companies run by people who have a credible plan to build the business profitably. "If a CEO I trust is seeing growth opportunities that his company can invest in, I'd want the dividend to be zero," he said. "I would want them to always redeploy that cash flow back into the company, where they can earn a higher return than I can myself."
Pembroke uses a three- to five-year time frame in assessing the growth potential of a company, Mr. Hui said. It's not enough for a company to have one great quarter of better-than-expected earnings. Assessing growth prospects means looking at both revenue and the ability to turn it into profits for shareholders. "It's very difficult to grow the bottom line without growing revenue," he said. "You can only cut your expenses a certain amount. But what really matters to us at the end of the day is earnings per share and cash flow per share."
Dividend stocks have earned a reputation as a comparatively safe way to invest as a result of their relatively strong performance in the past five years. Growth investing certainly sounds riskier as a result of its focus on smaller, more speculative companies, and that was certainly the experience of 2008, the year of the big stock market crash. Both GBC Canadian Growth and GBC American Growth did a little worse than the broad market that year.
Sizing up prospects for growth in the near to medium term, Mr. Hui said there may be advantages over dividend investing. "If you've got a portfolio stuffed with high dividend paying, low growth businesses and then suddenly you're in an inflationary environment, those sorts of stocks get pressured. It tends to be the faster growing companies that deal with inflation. They have pricing power to pass that inflation along down to customers."
Dividend stocks have served investors well and there's no reason to abandon them. But a little growth in your diet can be good for you, too.