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When dividend shares are a better choice than growth shares

Much has been made of Australian investors’ love of dividends for income, although that story has come apart at the seams, after the big four banks saw their share price savagely sold off in recent months.

Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd (ASX: NAB) and Westpac Banking Corp (ASX: WBC) all saw their share prices sink by more than 10% from August 6 to November 10, 2015. ANZ’s share price fell the most losing 21.6%.

The big four have been the go-to stocks for income as well as growth in the past few years, with shareholders well rewarded for staying the course over the past several years. Since the lows of the GFC in March 2009, CBA’s share price has more than doubled, while ANZ, NAB and Westpac have  seen their share prices rise 76%, 50% and 56% respectively.

But if investors had reinvested their dividends, they would have seen returns of 232% from CBA, 162% from ANZ, 136% from NAB and 155% from Westpac. By comparison, the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) is up 47%.

Even without dividends, the big four banks have well and truly thrashed the market. Shareholders can reinvest their dividends back into the business either through dividend reinvestment plans (DRPs), which the big four all offer, or by taking the cash and buying more shares on market. The DRP method has a slight advantage as there are no brokerage fees payable, and is automatic. Of course, it also means investors are still liable for tax on the dividends, despite not receiving the cash.

All good things come to an end of course, and the big four banks have enjoyed 24 years of recession-free growth. We will have a recession at some stage, but I don’t profess to know when, and will leave that for economists to predict.

But the main point I wanted to make (before being sidetracked) is that companies that pay dividends can outperform growth stocks over the long run, and there are a number of reasons for that.

A sign that companies pay consistent dividends suggests that management are on the ball and making profits each year. It’s also a sign that management respect shareholders, by offering them a partial return on their investment each year.

As I wrote in August this year,

There are other benefits associated with companies that pay dividends…

  • According to noted US fund manager Tweedy Browne, evidence (PDF) suggests that portfolios consisting of higher yielding shares can produce returns above those of lower-yielding portfolios and overall share market returns over long periods.
  • Stocks with high and sustainable dividend yields can be more resistant to price declines because the share is ‘yield supported’.
  • The ability to pay cash dividends is a positive factor in assessing the underlying health of a company and the quality of its earnings.
  • Research has shown that over 101 years from 1900 to 2000, a portfolio with dividends reinvested would have generated nearly 85 times the wealth generated by the same portfolio relying solely on capital gains.
  • Mature companies may no longer be able to generate high returns on equity, so it makes sense to pay out excess free cash flow to shareholders.

Foolish takeaway

A mix of dividend shares and growth shares in your portfolio offers the best of both worlds, income and capital gains. But often investors choose dividend paying shares without realising the many reasons why it can be a superior strategy.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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