There are two main ways that regular investors can benefit from the share market, being capital growth and dividends.
Depending on the time scale, geographical location and shares, some calculations put dividends as contributing around half of the total returns of the share market over the long-term.
The above statistic doesn’t necessarily mean that non-dividend paying stocks are worse though.
In accounting terms, to pay a dividend a company must have previously generated profits. Investing in profitable shares is obviously better on average than choosing loss-making shares. That’s probably a correlation rather than causation with dividends though.
The best investor in the world, Warren Buffett, has shown that it can be very beneficial to retain profits rather than paying it out at Berkshire Hathaway.
Berkshire Hathaway can hold onto the cash and compound it for shareholders at a strong rate, historically at around 20% per annum over the long-term. Berkshire shareholders would struggle to create returns that strongly in their own names.
If Berkshire shareholders do want to access money then they can sell a small portion of shares and create their own income. Berkshire shares could go up 10% and an investor could choose to sell 3% or 5% of their shares and still have a higher capital value than a year ago.
This is the same concept for every individual share on the market. They can either payout 100% of their profit each year or maintain some to invest for growth. Some shares maintain a significant amount of their profit to re-invest, such as Challenger Ltd (ASX: CGF), Ramsay Health Care Limited (ASX: RHC) and TPG Telecom Ltd (ASX: TPM).
Some ASX shares don’t pay any dividends. Some examples are a2 Milk Company Ltd (ASX: A2M), Galaxy Resources Limited (ASX: GXY) and Nextdc Ltd (ASX: NXT). If those companies can earn 20%, 30% or 40% on the cash they keep by investing into their assets then it makes sense to keep the cash.
As with the Berkshire Hathaway example, the only way to access the capital growth is to sell some shares if you need some money.
The main danger with management keeping all the cash is that it can turn into ‘empire building’. The management conceivably could waste the cash by investing in projects that don’t work out. Paying a dividend can make management think more carefully about capital allocation.
This top stock has management which are excellent capital allocators and have a good balance between investing for growth and paying a dividend.
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Motley Fool contributor Tristan Harrison owns shares of Challenger Limited and Ramsay Health Care Limited. The Motley Fool Australia owns shares of and has recommended Challenger Limited and TPG Telecom Limited. The Motley Fool Australia owns shares of A2 Milk. The Motley Fool Australia has recommended Ramsay Health Care Limited. 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 Scott Phillips.