Dividends Are Always in Style

In today's market, which is your best bet -- investing in dividend payers or higher-growth companies?

The question is most often backed up by the theory that dividend-paying companies have been hot the past few years mainly because low interest rates made companies with large yields more attractive. Now that interest rates are higher, and looking to go higher still, dividend yields of 3% to 4% start to lose their allure, because money market accounts and other short-term offerings with similar yields are now more competitive.

In more basic terms, the question is whether dividend payers such as Pfizer (NYSE:PFE) or Kimberly-Clark (NYSE:KMB) offer a better future total return than focusing on higher-growth non-dividend-paying companies such as Chico's FAS (NYSE:CHS). The question is not without merit and while I'm certainly just a little bit biased, I do believe that sticking with an income-investing strategy is the way to go.

The dividend is only part of the equation
Let's tackle the portion of the argument that deals with the competitiveness of dividend companies in relation to rising interest rates and other investing options first. Common wisdom has it that equities in general suffer during periods of rising interest rates.

But dividend payers have a couple of things in their favor. The first is that as living entities, they are growing, expanding, and, most importantly, passing on portions of those increases to shareholders. Bonds and other static instruments do not change. They exist as they are created. This effect becomes even more important during periods of inflation, because companies' assets and products appreciate in value.

Second, as the stock prices of such dividend-paying companies as United Technologies (NYSE:UTX) begin to fall, the yield attached to the shares rises. This makes equities both more attractive in their own right and because they do a better job of protecting investors from inflation.

Growing is often more difficult than it seems
By far the more interesting part of the question -- or theory -- is whether growth-oriented investments are more attractive than their dividend-paying counterparts. A large portion of this argument revolves around two commonly held pieces of wisdom that can be dangerous: that dividend payers are slow growers, and that fast growers are rarely or never cheap. So to get in on the action, you have to pay up.

Though both statements are true in some cases, they are not as common as you may think. Yes, dividend-paying companies are typically slower growers. However, dividend-paying companies are often simply returning cash they do not need to expand their business instead of spending it on acquisitions and other potentially value-destroying activities. In addition, a healthy yield frequently goes hand in hand with an investment that offers a solid value.

As for the argument on paying up for growth, let's take a look at an example of a fast-growing company and slower-growing dividend-paying company. For the sake of argument, I made the dividend payer the slower grower by more than 10% and kept the growth premium in the faster-growing company's P/E (price to earnings) relatively reasonable. It is quite common for the market to provide much higher trailing P/E multiples for 20% growth.

Now let's assume that the fast grower misses its earnings growth target and turns in growth of 18%. Still a phenomenal performance, but investors were expecting more and the initial P/E above reflects this. After coming in just a little bit short on growth, here are the results an investor is likely to be faced with.

The purpose of the above example is not to show that dividend-paying companies always win but instead to demonstrate the effects of overpaying for growth (I actually think I may have been too kind). The killer here isn't that growth was a little light -- it's the contraction in the P/E that comes along with just slightly slower growth. Accurate judging growth and paying a premium for it is a strategy that is fraught with peril. Very often, the misses are larger or the contraction in the P/E multiple is more severe. In a bear market, P/Es simply contract across the board, but at least dividend-paying companies are providing investors with cash to reinvest at lower prices.

Foolish final words
It's important to note that the investor who holds onto the high-growth company in the example above for one more year would find herself not only whole again but sitting on a total return of 14%. However, I'd argue that most investors don't have the patience or the gumption to hold on. It's more difficult than it sounds.

It would be ridiculous for me to say that no non-dividend-paying companies will beat the market. I'm sure there will be a fair number of them. I even own a few, but they are the minority in my portfolio of dividend payers and value investments. I think it would be a mistake for investors to allocate the majority of their portfolios to companies that are high-growth stories and move away from dividend payers because I see the example above play out in the market week after week.

If you're interested in learning more about companies that pay you to hold them, consider a free 30-day trial to Motley Fool Income Investor. Over the last two years, lead Income Investor analyst Mathew Emmert has delivered an average total return of 17% against the S&P 500's 10.97%. There's no obligation to buy if you aren't completely happy.

Nathan Parmelee has been to Harajuku many times and enjoys the area, but cannot understand Gwen Stefani's ongoing fascination with it. He has no financial interest in any of the companies mentioned. You can view his profile here. The Motley Fool has an ironclad disclosure policy.