A Conversation You Are Dying to Hear
Here we are, 6 months of blogging have passed and I have invited Jason over at Islands of Investing as my first guest blogger to talk more about investing. I talked last week about the most common paths to financial independence and asked Jason to work his magic and put together something Even Steven Money would be proud of and just as I expected this put a smile on my face. But hey this is guest post, let’s give Jason a big hand while he steps up to the stage………
When you’re getting started with investing in stocks, it can feel a little tricky getting a handle on which basic style or strategy to adopt. There are so many different buckets you can put investment styles in to, but one of the major distinctions is between ‘growth’ and ‘income’ investing.
So what is the difference between growth and income investing? How can you tell the difference between a growth and income stock?
Well, I was lucky enough to stumble across a recent conversation between a Growth Stock (GS) and Income Stock (IS), and even more fortunately, I managed to record every word. I think this will be helpful for getting some insights into these two different approaches!
1. Where do the company’s profits go?
GS: ‘Hey Income Stock, how’s life treating you these days?’
IS: ‘Oh, you know Growth Stock, same old. Just churnin’ out dividends for my investors, steady as she goes. No real exciting news. You?’
GS: ‘Yeah pretty good, just doin’ my best to reinvest those profits back in my business and create some serious value for my investors!’
IS: ‘Really? You mean, you don’t pay out those profits to your investors??’
GS: ‘Nope. I need those funds for myself to spend on research and development, to make my current products even better, and come up with new products. I’m constantly innovating! And besides, I’ve got a pretty awesome business here, and I know I can create much greater returns with that money than my investors. Seriously, that money is much better put to use in my hands! I mean, have you seen my return on equity lately? It’s nearly 30%!’
IS: ‘Well, I can never find any real use for those profits in my business. It’s pretty mature, and I don’t generate a great return on equity, so I just keep doing what I’m doing and pay out those profits.’
Key point 1: Growth stocks tend to reinvest their profits back in the business (and ideally generate a high return on equity), whereas income stocks tend to pay out most of their earnings to investors via dividends
2. The price you pay for earnings – now and in the future
IS: ‘But man, I have to say your stock is expensive! Your P/E ratio is over 20, and mine is only 8! Who in their right mind would pay for such an expensive stock like yours!’
GS: ‘Well, just look at one of my buddy’s, Resmed (ASX:RMD), who creates products to treat sleep disorders. About 3 years ago, he had a P/E ratio of about 21. So many people looked at him and said he’s way too expensive. But they didn’t realise that my buddy is awesome at growing earnings! And look at him today – earnings have nearly doubled over 3 years, and the stock is now worth twice as much!’
IS: ‘But what about that other guy, Cochlear (ASX:COH). He sounds pretty similar, just focuses on developing hearing aids rather than those weird sleep apnoea devices. And when he told people he wasn’t going to be able to grow earnings like he previously promised, investors punished him! The stock fell around 20%! Some of your high growth buddies with high P/E ratios really have a long way to fall if things go wrong!’
GS: ‘Yeah, true, but that’s the trade-off! There’s usually more up’s and down’s for sure, but there’s much more potential for really growing your money than with your Income Stock buddies. But as I’m sure you’ll agree, those investors that tend to do really well are the ones that buy our stocks when they’re relatively cheap compared to their own intrinsic value, whether they’re ‘growth stocks’ or ‘income stocks’. If you pay too much, no matter how good our businesses are, it’s pretty hard to make great returns!’
Key point 2: Growth stocks tend to have higher P/E ratios (i.e. you tend to pay more for a dollar of today’s earnings) relative to income stocks, as investors are expecting higher earnings growth in future (expected earnings growth is a major factor for the P/E ratio – see our series on P/E ratios if you want to learn more)
3. When do you need your cash?
IS: ‘Most of my investors are relying on me to cover some of their expenses – sometimes I’m all they’ve got to live on! How on earth could you support these guys if you never even send them a cheque once in a while?’
GS: ‘Well, no-one ever really asks me for money, as long as I keep doing a good job reinvesting the money I make, and they see my stock price growing bigger and bigger. They just don’t need the cash any time soon. I guess they’re not planning on retiring just yet, and just want to grow a nice, big cushion for the day when they do need some cash! Then they’d probably sell me to another younger investor and buy one of your Income generating buddies!’
IS: ‘Well, not only do I actually pay out cash regularly, but my earnings tend to be pretty stable, so investors can really count on me to pay those dividends every quarter.’
GS: ‘True IS, but not all dividend payers are as rock solid as you are. Some cut their dividends when they run into trouble. I guess you really need to know a bit about how solid the business is, and its history of paying out dividends, as well as whether those dividends can grow over time (guys like Dividend Mantra are pretty good at this!). It’s easy to get seduced by a huge dividend yield, but not realise that it’s unsustainable!
IS: ‘Yeah, Dividend Mantra is pretty awesome, I’m hoping I make it into his portfolio one day :)’
GS: ‘I also know a few people who invest in income stocks, but they think they’re getting free money! They just don’t realise that when they pay out that dividend, the company doesn’t have that cash any more – it didn’t just come from nowhere. And its share price usually falls by roughly the value of the dividend paid out. You don’t just get that money for free, that’s for sure!’
Key point 3: Investors who rely on dividend income to cover their expenses should generally focus more on dividend paying stocks vs growth stocks
4. Tax considerations
GS: ‘But every time you pay a dividend, your investors have to pay tax on that income! By keeping it in the company, I can keep growing our investors funds for years and years without them having to pay any tax! All those tax costs can really add up over the years you know!’
IS: ‘Well, until they decide to sell your shares – then they might end up with a huge capital gains tax!’
GS: ‘True – I guess the tax man gets us either way. Neither of us are tax specialists anyway, so I’m sure you’d agree that any investors should also consider their own specific circumstances and seek specialist tax advice? (Not to mention seeking specific investment advice, since we’re really just a couple of old stocks having a general chat about investing 😉 )
Key point 4: As with all investments, tax is an important issue to consider, and growth vs income investing can have different tax implications
Wow, some great insights from hearing those two chat about each other’s styles and characteristics!
One other important point to remember – it’s the TOTAL after tax returns that usually matters for most investors, whether that’s in the form of dividends or capital gains.
What’s most important in all this is to understand what you’re investing in, and why, and work out a strategy that suits you in terms of expected returns and income. If you’re relatively young and looking to aggressively grow your stock portfolio, then leaning towards growth stocks is probably the way to go. But if you’re investing to generate a passive income stream, you’re probably better off focusing on investing for dividends.