Capital Gains vs Dividends

I was halfway home
I was half insane
And every shop window I looked into
Just looked the same
--Style Council

Stocks are often called 'shares' because, when you buy them, you essentially purchase fractional ownership of a business. This opens the door to sharing in a company's success in two ways. One way is through capital appreciation of your shares. Your 'capital appreciates' when the share price of a stock that you own increases above your purchase price.

If you previously bought Apple (AAPL) at $160/share, then at this morning's opening quote of about $192 you currently have a $32/share capital gain on your investment. That profit is on paper only, however, until you 'ring the register' by selling your shares. It is quite possible that today's $32/share gain in AAPL could turn into a future loss if the share price declines significantly from here. After all, AAPL shares were selling at about $140/share in early January.

Materially profiting from capital appreciation, then, requires selling your shares at a higher price. This raises several hard-to-answer questions. When should I sell? What are the tax consequences of doing so? What should I do with the proceeds after I sell? What if prices decline below my original purchase price before I can sell? How do I invest for the long term if I'm constantly selling my stock positions in pursuit of capital gains? Buy-to-sell investment strategies can be difficult to consistently execute well--as I can attest from personal experience.

The other way to participate in the success of a company is through dividend payouts. Dividends are cash payments made by companies to their shareholders. Think of dividends as a form of profit sharing. Companies that pay dividends decide to take a portion of their earnings and distribute them to investors. Dividends are often paid on regular (e.g., quarterly) basis.

Dividends often come from companies that have been around a while. These firms commonly have mature, profitable businesses that no longer benefit from plowing all earnings back into internal growth projects. Instead, some profits are returned to investors in the form of cash.

Take Coca-Cola (KO) for example. The company was founded in 1892 but did not begin paying a dividend until 1920. As the company has matured, it has become a consistent dividend payer. In fact, KO has increased its annual dividend payout to shareholders in each of the past 55 years. Current KO pays a quarterly dividend of $0.40/share, or $1.60 share annually. With KO currently trading at about $46/share, that's a 'dividend yield' of $1.60/$46 = 3.5%

Unlike capital gains from share price appreciation--which remain unrealized until/unless you sell your shares--dividends constitute actual cash in hand from your investment. As such, dividends provide a source of real income. Dividends can supplement the income that you earn from your job. When you retire, a portfolio of dividend-paying stocks can be an important source of regular income. This situation reflects the classic idea behind investing: lay out investment capital today and, if you have chosen wisely, that investment throws off a stream of future cash in your direction.

Dividend paying stocks do carry risks. A company's business can deteriorate, causing a it to reduce or even eliminate dividend payouts. Moreover, declines in a company's share price can offset gains from dividends. For instance, a 3.5% decline in KO's share price can be seen as wiping out a year's worth of dividend payouts from the company.

While investment strategies grounded in capital gains certainly have a place in investment portfolios, circumstances over the past few months have re-introduced me to the value--perhaps the superior value--of investment strategies grounded in dividend-paying stocks. We'll discuss why in a future post.

position in KO