Your Capital Growth Stock Is Actually A Dividend Stock In Disguise

 |  Includes: AAPL, ABT, INTC, MCD, MO, NVDA, PG, SIRI
by: Geordy Wang

Seeking Alpha regulars are no doubt aware of the recent storm of controversy surrounding dividend growth stocks that has been brewing on this site. Readers interested in the debate can jump right into the fray in the Investing for Income section, but for this article, I'm only going to present the idea that the popular differentiation between capital growth stocks and dividend stocks is a false dichotomy. It doesn't make sense to bash on dividend companies because I guarantee that you have some dividend stocks in your own portfolio. You own Sirius XM (NASDAQ:SIRI)? Yup, that's a dividend stock. Apple (NASDAQ:AAPL)? Dividend stock. Nvidia (NASDAQ:NVDA)? Dividend stock with a capital D. The reality is, all stocks are dividend stocks. Some of them just happen to have a yield of 0% at the moment.

I know this is a rather radical proposition that's going to cook a lot of people's geese, but hear me out for a second. To understand this line of thought, we have to return to Investing 101 and consider what stocks are and why we buy them. It's easy to get wrapped up in the green numbers and red numbers and pretty graphs with squiggly lines that go up and down, but it's important to remember that when we buy a stock, we are buying a partial stake in a revenue-generating business. A business has no value to an owner except the cash flow it produces. You exchange your hard-earned savings for an ownership slice of the business in hopes that it will return, in total, more money to you some day in the future.

However, many of us are willing to buy businesses that don't return any profits to shareholders, aka "capital growth stocks." Why? Because shareholders have collectively decided to reinvest those earnings back into the business in order to stimulate further growth. Current investors are making the same decision initial investors did: trade cash in hand for more cash in the future. As such, these re-invested earnings come with a necessary condition: it is expected that the company will eventually return profits to shareholders in the form of a dividend distribution, and this dividend is expected to be much larger than it otherwise would be if the company didn't reinvest any earnings.

In one of my earlier articles, I brought up the idea that all companies must eventually pay a dividend, otherwise investing is just a pyramid scheme where investors profit off those who follow them, until some poor sap is inevitably left holding an empty bag. This proposal was met with immediate and fervent resistance ... one reader even accused me of being a cynic. This isn't cynism, but reality. After all, what is a dividend but money a company returns to its owners? And why would we ever buy a business that we know will never return any money to us? The simple answer is this: we wouldn't. No sane investor would.

When we buy a company, we buy it for the dividend. It could be today's dividend, could be tomorrow's, could be 10 years from now, but a company that has tangible value must one day pay a dividend. Capital gains only serve to transfer wealth from one shareholder to another - dividends are the only way shareholders as a group can become wealthier.

Apple may not be paying a dividend right now, but it'll no doubt begin to do so some time in the future. With over $70 billion on its balance sheet and a market cap surpassing $300 billion, that day is probably near. Sirius is a much smaller company that's just beginning to blossom, but it's a certainty that it, too, will eventually pay a dividend, assuming it can survive the challenges and obstacles in its future. Both these stocks are popular growth stocks, both have an enormous fan base of enthusiastic investors who follow them. And if they were to declare that they would never, ever pay a dividend, I can guarantee that both stocks will instantly go to zero tomorrow.

A new investor once asked me why people buy stocks. "You buy a stock because you think it'll go up, so you can sell it to someone else," he said. "But then why does that guy buy it? If he's going to sell it to a third person, why would that third investor buy it? Eventually, wouldn't you run out of people to buy the stock from you?" A simple question, but it cuts right to the heart of investing ... this amateur investor saw what many of his more experienced peers do not.

Any dividend growth investor would have no problem answering this question - after all, capital gains are secondary to them, their primary concern is the income stream their portfolio generates. However, the same principle applies to so-called capital growth investors as well. For these investors, your company may not be paying a dividend now, but you don't have to sell your stock to someone else to make money. All you need to do is hold on to it and wait for the dividend that you know is coming. The longer you wait, the fatter that dividend check will be, assuming that your company's management has been doing its job and creating value with reinvested earnings instead of destroying it.

Dividend growth investors are familiar with the concept of yield on cost, which is your current payout divided by the cost basis of your investment. These investors know that current yield isn't everything. They are often times perfectly willing to invest in excellent businesses with substandard yields that they anticipate will grow their dividends many times over in the coming years, which will inflate their yield on cost. Let's look at Intel (NASDAQ:INTC), which is one of the biggest dividend payers in the technology sector and a favorite for dividend investors who desire exposure to that industry. Ten years ago, the stock paid $0.07/share in dividends. It has since grown that dividend 800% to $0.63. The purpose of this example isn't to advance the case that Intel has been a great investment over the past decade (it hasn't been especially), but to illustrate the concept of yield on cost.

Though almost exclusively employed by dividend investors, the yield on cost metric is crucial to capital gains investors as well, who, as a group, choose to plow earnings back into their businesses in hopes of eventually achieving an outsized yield on cost. Dividend growth investors typically have cut-off points that they use to screen their stocks. One investor may require a minimum yield of 4%, another 2%. The second investor would expect higher dividend growth in exchange for a lower current yield. Think of the capital gains investor as a kind of dividend investor who's willing to accept a 0% yield. The end goal is still the same: to maximize one's yield on cost within a given time frame.

Imagine what would happen if Apple decided to pay out 50% of its earnings in dividends tomorrow. The company has a trailing one year EPS of $25.28, so an investor would receive $12.64 in dividends if Apple's earnings next year remain flat (not likely). What happens to an early investor who bought into Apple 10 years ago when it was trading at $10 a share? This lucky son of a gun would be reaping in a yield on cost of over 126% on his initial investment. Capital gains investor, you say? False ... our Apple investor will never need to sell his Apple shares to profit handsomely from them.

The only difference between a dividend growth stock and a capital growth stock is not whether they pay a dividend, but when. All companies must eventually pay dividends, otherwise they have no worth to owners. What distinguishes a company like Sirius from a company like Procter & Gamble (NYSE:PG) is just the stage of their lifecycle that they're in right now. PG has reached the point where it can no longer redeploy all earnings and achieve an acceptable return on equity, while Sirius hasn't. However, the goals of both the Sirius investor and the PG investor are aligned: to achieve legal ownership of a large income stream in the future. Okay, Sirius is one of the heaviest traded stocks on the market, so many buy the stock for the sole purpose of unloading it at a premium, but we're talking about investors, not traders.

However, the definition of future is different for our Sirius investor and our PG investor. The PG investor can expect a healthy dividend as early as next quarter, while the Sirius investor had better be prepared to wait for a (possibly very) long time. That's why many older investors tend to gravitate toward the dividend growth camp, because they can't afford to wait decades for their windfall. They prefer proven dividend players like Altria (NYSE:MO), McDonald's (NYSE:MCD) and Abbott Laboratories (NYSE:ABT), who are already rewarding shareholders right now. After all, it doesn't matter how large a dividend you will eventually receive if you croak before you can spend it. However, assuming the capital gains investor has time to wait, his approach is exactly the same as his dividend growth compatriot's other than the time horizon. In a perfectly efficient market, by the time his capital growth stock begins to pay a dividend, his yield on cost would be exactly the same as if he had originally invested in a dividend growth company and reinvested all distributions. Of course, we know the market is far from efficient ... but that's a story for another day.

Disclosure: I am long AAPL.