Last year, I visited a certified financial planner in order to drill him with some burning questions that had been on my mind for some time. One question that had been keeping me up at night pertained to the best type of investments for a Roth IRA. Should we go with utilities in order to compound the hefty dividend tax-free, high growth stocks in order to avoid the maximum amount of taxes on our capital appreciation or with dividend growth stocks that may exhibit some qualities of both?
In his professional opinion, adding strong growth stocks to your Roth IRA is the best idea, due to the fact a significant amount of taxes can be avoided in this manner. The argument for growth stocks, rather than utility-style dividend payers caught me a little off guard, since I've often heard that including high yielders, like utility powerhouse Exelon (EXC), is a good idea since no taxes will be required on distributed dividends, as well as future returns.
After thinking about this a great deal, however, I have concluded that using a Roth IRA to fund dividend growth stocks - perhaps even stocks that offer slightly more volatility and lower dividends - might just be the best solution. Please allow me to explain.
Take, for example, an investment in the SPDR S&P 500 ETF (SPY) that was allowed to grow in a Roth for the last ten years and picked up a rather disappointing 32% return. However, if we replaced SPY with a stronger growth stock with a solid history of performance and a good chance to outperform the market in the future, our returns would even be magnified much more significantly. Take Church & Dwight Co., Inc. (CHD) for example. Over just the past ten years alone, CHD has returned roughly 363%, while SPY has shown a rather disappointing 32% over the same period. Though I know it's unfair to cherry-pick to make a point, it does stand to reason that choosing a high quality stock can certainly accelerate future returns.
If we had one $10,000 Roth IRA account fully vested in SPY and another in CHD, guess which one would require more taxes to be paid? If you're paying attention, the correct answer is neither since the taxes were paid prior to funding the account; however, CHD's return was roughly ten times higher than SPY. After seeing the potential return for growth stocks in a Roth IRA without a future tax burden, it does have me wondering what stocks might just be suitable for wealth-building over the long term.
Here are five stocks I'm a huge fan of for Roth IRAs:
1. Visa Inc. (V) looks like a long-term winner if I've ever seen one. With a $98 billion market cap, a forward P/E around 16 and a dividend that's doubled in the last few years alone (with a 17% payout ratio), I think it's safe to say Visa has a good chance of continuing to crush the overall market. As the economy improves, it stands to reason consumers will begin spending significantly more money than they currently do and Visa will certainly profit during this economic recovery. Visa holds no debt and a cash pile just shy of $3 billion dollars. A credit card company without debt - that's a bit ironic, is it not?
2. Church & Dwight Co., Inc. is often a stock that consistently flies under the radar, yet has been making some big moves for a very long time. As I mentioned above, the stock has produced some amazing returns over the last decade, while the company continues to make strategic acquisitions to increase revenue and has put in place an aggressive dividend policy to reward shareholders. CHD boasts $7.5 billion market cap, a forward P/E of about 20 and a dividend that's grown from $0.07 a share in 2000 to $0.24 a share in 2012 with a payout ratio of only 30%. Its line of useful and necessary household products continues to drive the company's sales and fuel its dividend increases.
3. Dover Corporation (DOV) is another stock that has an extensive history, yet is often overlooked by investors. The company is a collection of businesses that specialize in engineering products. I believe DOV is a good long-term bet and boasts a market cap of $10 billion, a forward P/E just over 10, and a 2.2% dividend that has grown consistently for over 50 years, while the payout ratio still stands at only 26%. DOV holds a beta of about 1.3 and often exhibits fairly significant market swings, so I often try to pick up more shares when the price dips below $50. Moreover, Dover's business model is inherently diversified by the nature of the business. I think DOV makes an excellent addition to an investor's Roth IRA and with the company's long history of raising dividends, it would be safe to assume more raises are in the pipeline.
4. Apple Inc. (AAPL). It likely doesn't come as a surprise that AAPL would make the list of good Roth IRA investments. With many analysts more or less assuming it will become a trillion-dollar company in the near future, it makes quite a bit of sense to add this company to a Roth IRA to avoid future taxes. Additionally, Apple will begin paying a dividend in 2011 and with roughly $1 billion in cash being added to its bank account on a weekly basis, it's safe to assume this dividend has room to run. Apple sports a $500 billion market cap and a forward P/E just under 10, with over $100 billion of cash equivalents on hand and no debt. The stock is currently trading in the lower $500 range, which many investors believe is highly undervalued; I tend to agree.
5. TJX Companies, Inc. (TJX) is a business that in many respects capitalized on our most recent economic recession. Consumers who were used to purchasing higher-end brands wanted to continue buying these name brands, but no longer wanted to pay higher prices. As it turns out, TJX welcomed these consumers with open arms. As the economy improves, many will likely continue to shop at TJX and this will help the company during periods of economic growth as well. TJX boasts a market cap of $30 billion, a forward P/E of 15, a dividend yield of 1.15% and a payout ratio of 22%. TJX has roughly $1.7 billion in cash on hand and only $775 million in debt. Though I undoubtedly missed out on purchasing TJX in the past while waiting for a pullback, I still look for a suitable entry point to jump in.
The bottom line
Though the argument of which type of stock is best suited for a Roth IRA will likely rage on, I believe utilizing a combination of not only growth, but dividend growth as well, is an admirable strategy. I believe the highly diversified five picks highlighted above stand a good chance of performing better than the market for the foreseeable future.