Today we will take a look at the difference between dividend and growth stocks. What do these two things mean? For most long investors it is mainly a difference in expected returns over several years.
Are Dividend Stocks Better Than Growth Stocks?
- It depends. What matters is a dividend stock should have lower combined returns than a similar growth stock but a dividend stock is less susceptible to price fluctuations than a growth stock. A dividend stock behaves more like a bond than a growth stock and can be a good choice to go with high flying stocks and bonds in a portfolio.
The bottom line for traders is that since investors receive some returns as cash directly from the company, price movement follows different patterns than a growth stock.
Let’s quickly go through the rationale for issuing dividends. A company competes for investor cash against similar companies, with the company having the highest returns tending to attract more capital. Makes sense right? When companies are private (like Koch Industries for example), this is a very significant market force, because in general, investor cash goes directly into the company for use by the company to use as they see fit.
In the public markets shares are traded between investors, cash is exchanged between investors, and the company’s capitalization does not change when these trades occur.
Exceptions to the Rule
- A firm will reinvest some earnings, leading to growth in stock price, and distribute some earnings as a dividend, depending on what the firm judges to be better, using various criteria. Therefore, a growth stock should be expected to trade in a wider range than a dividend stock, with some exceptions.
Dividend Stock Prices Are Sensitive to Quarterly and Annual Reports.
This is because earnings directly correlate to the amount of near-term dividends. For very large firms that have been paying dividends for many years this is not true.
The firms tend to have large cash holdings and want to pay the same dividend every quarter regardless of earnings. So a dividend stock is likely to experience price changes over the period of time between earnings guidance and earnings reporting.
If earnings are lower than expected, the price should fall, and if higher than expected, the price may rise. During the time leading up to earnings reporting, news about the firm can cause earnings expectations to rise or fall, leading to a price change.
Fundamental Investors Will Value the Company Differently the Moment a Dividend Is Announced.
The reason being that the company has reduced its cash holdings and literally become less valuable. Any investor who buys a share the day before a dividend is announced will receive the dividend, and an investor who buys a share one day later will not.
This is why you may see prices rise into a dividend date on a stock chart. It is reasonable to expect to pay a different price in these two situations.
Investors in Growth Stocks Depend on Other Investors to Provide Returns by Selling Shares Rather Than Directly Receiving Returns From the Company.
This means that factors unrelated to the company’s success or value are in play. If positive news (like a cure for cancer) about a competing sector come out one morning, a lot of investor cash will move into that sector, possibly temporarily lowering prices for other sectors.
If that is the day you choose to trade to take profits, you may have to take a lower price for your shares than you might have on a different day. Knowing support and resistance levels can help with this situation greatly.
Dividend Versus Growth Stock Differences Are Abundant
Another major difference between the two types of stock is in the tolerance of the market to volatility. If a dividend stock cuts its dividend for the first time in a long time, investors will react negatively.
If a growth stock misses targeted earnings, in many cases, the market barely notices. If a dividend stock starts trading in a wider range than expected, investors may be concerned and the company may need to provide additional guidance.
If a growth stock starts trading in a different pattern or range, long term investors will tend to shrug it off and the company generally will make no attempt to explain or influence the price.
Thus, volatility in price can be expected to happen for longer periods for growth stocks than for dividend stocks.
This also means that a growth stock can recover quickly from a significant drop in price, while a dividend stock may face more resistance in recovering from a loss.
If you are following technical analysis, you might consider focusing on the price action playing out on the chart.
What Is a Value Blend Growth?
- Now consider a blended stock, that is, a stock that provides a dividend but also relies on growth. Such a stock would likely be a firm with multiple lines of business, some of which are mature and provide steady returns and some that are growing quickly. The firm is likely to be paying dividends from its mature lines of business and reinvesting profits from its growth oriented lines.
How Would Such a Stock Trade? There Are Two Possibilities:
- First, the stock may simply trade in a blended way. Consider an ETF with two stocks: a growth stock and a dividend stock. The dividend stock’s contribution to the price of the ETF would behave like a dividend stock price and the growth stock’s contribution to the ETF price would behave like a growth stock. Eliminating the pricing behavior of the ETF itself, the price of the ETF ought to fundamentally be the average of the prices of the two stocks. In this case you could just think of the firm’s stock price as the sum of two other prices: The dividend-oriented price and the growth-oriented price, with those prices changing naturally and independently.
- Second, the stock could change behaviors over time. A mature growth stock might announce new products at a certain time of year, leading to price changes at that time of year reflecting the growth attributes. At other times of year the earnings and dividend announcements may have more effect, leading to price changes reflecting the dividend-paying attributes. Again, consider an ETF or two-stock portfolio. If one stock is Apple, then the value of the portfolio or ETF will change in September, when Apple makes its annual announcements. If the other stock is, say, Exxon-Mobil, whose dividends are significant, then the portfolio will also change value during earnings seasons.
Dividend or Growth. Why Not Both?
- Let’s recap the major differences between the two types of stock:
- Dividend stocks are easier to fundamentally value because a portion of returns are predictable.
- Stock prices for dividend stocks are sensitive to news.
- Growth stock prices are sensitive to overall market activity.
- Dividend stocks have predictable price movements at certain times of the year.
- Growth stocks tend to trade in a wider range than dividend stocks.
We hope you enjoyed this post on dividend versus growth stocks. The Bullish Bears enjoys teaching our readers about different concepts in the stock market.
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