In theory, the companies that provide the best return are the ones with projects that produce the best ROIC (return on invested capital). Let’s say a retailer (Company X) has discovered a new format of store that generates an ROIC well above what investors could get elsewhere. For this company it would make sense to retain all earnings to reinvest in more stores. It wouldn’t make sense to distribute cash back to investors.
Company X can generate better returns for investors by reinvesting in its own growth prospects. Therefore, Company X stock price should outperform other companies with less favourable growth prospects.
I get the theory and it makes sense. A stock with high growth prospects will tend to have a higher total return than a stock with lower growth prospects. (Of course, not all growth prospects become real so many growth companies eventually fall behind expectations. In fact, there is some research that suggests dividend growers outperform non-dividend stocks over the long run. But for this article, let’s use the simplistic assumption that growth stocks outperform dividend growth stocks.)
The assumption that growth stocks outperform dividend-paying stocks fails to consider investor behaviour and what actually happens at the account level. At the account level, a big segment of investors will perform better by investing in slower growing companies that pay regular and growing dividends.
Stock prices frequently experience corrections and bear markets. Investors have a tendency to ‘buy high, sell low’ – the opposite of what they’re supposed to do – because when stock prices are falling it often feels like the world is crumbling. The news is bad and investors have no idea how much the decline will be. So they see that their holdings are down 10, 20% and they sell. These emotional buy/sell decisions made at the wrong time have a huge negative impact to long-term returns. Indeed, investors tend to drastically underperform the S&P 500.
One of the critical components to becoming a decent investor is to control emotions. We need to fight millions of years of evolution telling us to run when things start to look bad.
My view is that dividend streams help to do that. An investor that holds a portfolio of dividend paying stocks will still receive a stream of cashflow into their account, regardless of stock price performance. I believe these payments are a form of positive reinforcement that rewards good investor behaviour – namely, doing nothing or investing more when stocks are down.
Taking this a step further, many dividend investors view their capital as the price of entry to receive a perpetual and growing dividend stream. You’re trading a lump sum for a stream of income. Investors who look at their portfolios this way will be even less inclined to sell when markets correct, for that would cut their stream of income.
In summary, dividend growth stocks might not produce higher total returns than growth stocks. However, dividend growth investing might because of the positive effects on investor behaviour.