Which type of fund is better: high yield but low, or low yield but fast growth?
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Have you ever looked at a dividend yield and thought the yield seemed too good to be true?
Dividends are never guaranteed and often unusually high yields can be a red flag. It is possible that investors think that the payment may be permanent.
However, it may be that the stock is out of fashion and turns out to be a terrible long-term bargain.
A small yield can be a weak starting point
And, while high yields can be a red flag, many low- or mid-yield stocks are also seeing dividend cuts. When I said above that assignments are never guaranteed, I meant any assignment.
But there’s another challenge with low-yield stocks. A low base means that even rapid growth in the budget can take a long time to reach an attractive level.
To illustrate this, compare two stocks that I like for different reasons: growth stocks JD Sports (LSE: JD) and dividend share IM&G (LSE: MNG).
They yield 1.1% and 6.3% respectively.
Last year, M&G increased its interim dividend per share by 10%. JD Sports’ equivalent was a smaller 1.5%.
Even if JD Sports continues to grow its profits by 10% a year, it will take 19 years to achieve the same yield as M&G now. Meanwhile, if M&G simply maintains its payout – let alone raises it every year as it intends to do – its shareholders will continue to receive dividends.
In this example, by the way, I think the prices are low, to illustrate the point. In fact, prices fluctuate, which affects earnings. But the broader point, about starting over, is clear.
There is more to life than benefits
Above, I refer to JD Sports as a growth stock and M&G as a dividend stock. Their yield makes those explanations obvious – but profit growth doesn’t. After all, JD Sports’ dividend growth is much higher than M&G’s.
So why do I see it as a growth share?
IM&G is a mature business operating in an industry that has been around for a long time – we can even call it mature, although in some less developed markets asset management continues to grow rapidly.
So M&G could grow significantly, for example through acquisitions, but its current business strategy does not focus on that.
In fact, one of its challenges in recent years has been to stop policyholders from withdrawing more money than they put into its funds, which could affect earnings. That is always dangerous.
In contrast, JD Sports was growing rapidly, building hundreds of new stores and acquiring overseas chains. In the short term there is a cost to that – dividend yields are lower and earnings per share last year actually fell rather than rose.
However, in the long run, that expansion could help the supercharger’s growth. Or, it could be a costly mistake that damages income for years. Time will tell.
But, when I invest share by share with little or no budget, I at least hope for growth.
To make a choice
For me, a small yield share would be fine if I think we have decent growth prospects.
I’m also happy to own stocks with limited or no growth prospects for their income potential.
Either way, I’m looking for a quality business and an attractive price.
