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Income investors usually think of quarterly dividend payments as their primary objective. However, this eliminates many of the best investment options from consideration. Some companies can use the cash for growth and generate far more wealth than they could by paying a small dividend.
Warren Buffett does not pay a dividend to Berkshire Hathaway (NYSE: BRK-B) shareholders because he believes it is better to reinvest cash flow generated by Berkshire companies. As long as management can earn a market-beating return on its capital, it is better for shareholders if the company reinvests the money instead of paying a dividend.
Buffett is unique and other companies often fail to consistently deliver returns like Berkshire does. Some companies would find it impossible to reinvest a large amount of money in their business.
One example of this is tobacco companies, which generate a high return on capital but have adequate capacity to meet customer demand. Because of their rich dividends, tobacco companies are now considered to be income stocks. But their high yields don't necessarily make them great investments.
Altria Group (NYSE: MO), the parent company of Philip Morris, for example, offers a dividend yield of 5.6%, while the yield on the stocks in the S&P 500 is only 2.14%. Income investors, ignoring growth potential, could easily view MO as a great investment.
Investors in MO should be able to count on their dividend payments in the future, but dividend increases may be small. Analysts expect earnings per share (EPS) growth averaging about 7.8% a year in the next five years. The current annual dividend of $1.92 accounts for 80% of the company's earnings. This means the company has only limited ability to increase its payout while maintaining funds needed for operations and maintenance.
Since 1970, MO has increased its dividend at an annual rate of about 12.7% a year, but the company might not be able to maintain that pace in the future. Given the long history of dividend increases, management is likely to continue providing at least a small annual increase. At the historical rate of increases, dividends would exceed earnings four years from now. This indicates that the future is likely to be less profitable than the past was for investors in MO.
Despite expectations for slower growth, MO is trading with a price-to-earnings (P/E) ratio that indicates the stock is overvalued. MO's P/E ratio of 13.25 is slightly below the market average of 15.3, but stocks in the S&P 500 are expected to see average earnings growth of 13% in 2014, nearly twice as much as MO's 7.1% estimated growth for 2014.
Many analysts consider a stock to be fairly valued when its P/E ratio is equal to EPS growth, a metric known as the price/earnings to growth (PEG) ratio. By this measure, MO would be worth about $20 a share, more than 40% below its recent price.
Other income stocks face a similar problem where dividends have been growing at an unsustainable rate. As a group, dividend stocks seem to have limited upside potential, which means the majority of future returns are likely to come from dividend payments of 2%-5% a year, and investors may not see significant price gains in these stocks.
Growth stocks offer the potential for capital gains and can be much more profitable over time than income stocks. For example, Green Mountain Coffee Roasters (NASDAQ: GMCR) is up more than 250% in the past 12 months but doesn't pay a dividend. Income investors could have sold 1% of their holdings each quarter and obtained income that would have been higher than that available from most dividend stocks.
Options strategies can also be used to benefit from stocks that don't pay dividends and are usually ignored by income investors. Selling put options or covered calls are two great ways to generate instant income.
For example, selling puts on GMCR could provide income that beats the average dividend. In Income Trader, Amber has identified four trades in GMCR that have generated $285 in income over five months. The margin required for these trades is less than $1,500. Income investors following this strategy have realized a 19% return. Over the full year, a return of 40% is possible.
Income investors often limit their gains with a focus on dividends. Buying growth stocks and selling a few shares every quarter could generate more income than dividends. Selling puts or covered calls could also deliver more income than a typical dividend stock. These strategies are especially appealing at a time when many dividend stocks offer limited upside potential.
Note: If you want to learn more about how Amber has helped her Income Trader subscribers earn anywhere from $1,873 to $150,000 in Instant Income this year alone, click here.
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